SEC releases order routing report

Payment for order flow and internalization of retail options orders to affiliated dealers by brokerage firms has become more pervasive, the Securities and Exchange Commission found in a study

Payment for order flow and internalization of retail options orders to affiliated dealers by brokerage firms has become more pervasive over the past seven years, in contrast to the equities markets, the Securities and Exchange Commission found in a study of eight major brokerage firms.

While best execution for retail options orders to get the best price has improved since 2000, brokerage firms still frequently rely on payment for order flow since markets often offer the same best price, the “Report Concerning Examinations of Options Order Routing and Execution,” which was released yesterday, said.

The report is based on exams of options order routing practices at eight unnamed brokerage firms that have a significant amount of retail options order flow.

The exams were conducted in late 2005 and 2006 by the SEC’s Office of Compliance Inspections and Examinations, the division that examines brokers and advisory firms, and the Division of Market Regulation, which oversees regulation of the brokerage industry.

The report is the first follow-up to a 2000 study that found that brokerage firms often routed orders based on payments for “order flow,” and other inducements to send their customer orders to particular markets. At that time the SEC was concerned that such practices discouraged price competition to get better prices.

Many firms have since begun using order routing technology such as “smart routers” to ensure that retail options orders are sent to the market offering the best price. But many market centers often display the same best price, the SEC found, leading the firms to rely on other competitive factors to decide where to conduct trades.

Options prices continue to be quoted in 5-cent and 10-cent increments, the SEC said, “artificially wide” spreads.

“Excess dealer profits often are shared with order flow providers through payment arrangements,” the report said. That contrasts with equities markets, where payment for order flow decreased substantially following the move to quoting in penny increments, the report said.

A lack of standardized data by options exchanges makes it difficult for brokerage firms to analyze the execution quality for their customer orders, the report said.

Options exchanges began a six-month “penny pilot” program in January of this year.