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Sunday, July 17, 2005

S.E.C. Looks At Options Trades

Decimalization hit stock markets a while back. As a result, some heavily traded stocks have bid-ask spreads of only a penny a share (the "spread" is the difference between the quoted prices that market makers would be welling to buy and sell stock at).

However, other markets are far less transparent, and spreads in those markets are often much larger. A recent example of this can be seen in a study done by Amy Edwards, Mike Piwowar and Larry Harris of the SEC, who find that spreads on corporate bond transactions are typically many times those on equities.

Now the SEC is looking at options markets. According to a New York Times Article in yesterday's paper:
The Securities and Exchange Commission is investigating whether major brokerage firms are fulfilling their obligation to secure the best price for customers who are trading options, according to a letter sent to Wall Street brokers.

The letter, sent July 5, says the S.E.C. is examining whether the practice of payment for order flow - brokers and exchanges paying retail trading firms for their orders - violates a broker's fiduciary duty to secure "best execution," a vague term which essentially defines getting the best deal for a customer.

In many options exchanges, options are trades at nickel or dime spreads. This leaves the market maker enough money on the table that they can offer rebates to brokerage firms to take some of a trade. The SEC is investigating whether this inducement leads brokerage firms to violate their duty to act in their customers' best interest.

As I tell my introductory finance students, "Agency Problems Are Everywhere". Whenever a task is delegated by one party (the princiapl) to another (the agent), there's an opportunity for the agent to take advantage of the principal.

But, there's good news on the horizon. When there are abnormal profits to be made, there's an incentive for a competitor to offer the same product or service (in this case the ability to trade options) for a lower price. In this case. the International Securities and Boston Options Exchanges have started trading options at penny quotes. In short order (no pun intended), this should force the other exchanges to either follow suit or lose order flow.

Click here for the whole article.

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