The Securities and Exchange Commission Staff recently released a report relative to the retail option execution practices of eight major brokers. The report concluded that there has been improvement over the last six years in order routing firms’ processes to obtain best execution for their retail customers’ options orders. However, two impediments to best execution for retail customers exist: (i) payment for order flow and other inducements continue to play a substantial role in broker-dealers’ order routing decisions; and (ii) the negative impact of the lack of standardized, widely available execution quality data. Many firms have begun to utilize order routing technology to ensure that marketable retail customer options orders are sent to the market displaying the best price. But because multiple market centers often display the same best price, firms rely on other competitive factors to determine to which market center, among those displaying the best price, to route customer orders. These include payment for order flow and situations in which the firm has an ownership interest in the exchange or in the specialist on the exchange to which the order is routed. The Staff noted that because most options prices continue to be quoted in 5¢ and 10¢ increments, spreads remain artificially wide and the excess dealer profits often are shared with order flow providers through payment arrangements.

The SEC’s efforts to encourage the options markets to quote in penny increments and support the need for standardized execution quality data in best execution analyses for the options market includes the sixth month long “penny pilot program,” which began on January 26. As part of the penny pilot program options exchanges are quoting certain series of 13 options classes in pennies.

http://www.sec.gov/news/studies/2007/optionsroutingreport.pdf