(July 19) – “Competition has come to the market for traded stock options, and the customers may not be the winners,” writes Floyd Norris in today’s New York Times.

“The four exchanges that trade stock options in this country became more aggressive last fall in seeking to trade options that had formerly been dominated by one exchange.
In the aftermath of that move, Arthur Levitt, the chairman of the Securities and Exchange Commission, exulted that competition was narrowing the spread between bid and asked prices for listed options.”

” ‘In four of the five actively traded options we examined, effective spreads have fallen between 22 and 44 percent since these options went from single exchange trading to multiple listings,’ Mr. Levitt said in a speech last September.”

“But those declines were temporary. Since then, competition for options business has grown ever more steep — but the competition has taken the form of paying brokers for order flow. Spreads appear to have widened, albeit not back to the previous levels. Today the S.E.C. will announce a new study aimed at determining whether payment for order flow is causing problems.”

“For several months, the S.E.C. has sat by as the payment for order flow has intensified, to the irritation of many in the industry. Some who are paying for order flow are furious that the S.E.C. is not stopping others from doing so.”

“‘They are all saying, “We abhor this practice, and we wouldn’t do it if the S.E.C. would just stop us,” ‘ said one S.E.C. staffer in exasperation.”

“Payment for order flow, long a practice in the stock market, provides a way for brokerage firms to profit from sending their orders to a particular place to be executed. Most of the electronic brokerage firms now collect such payments in the options markets, and other brokerage firms are beginning to look at getting such payments.”

“There were no such payments in the options market until last fall in large part because there was little real competition in that market. Even when options were listed on more than one exchange, virtually all the business tended to be on one market. Orders went where there was liquidity, which was where the orders already were.”

“That began to change last fall. The International Stock Exchange, a new exchange, announced plans to begin trading many options. (It did so in May, but so far has not had a very large impact.) In addition, the Justice Department antitrust division began showing interest in the options market. In short order, the existing exchanges began to show more interest in competition.”