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July 5, 2006

Options Industry Facing Penny Pilot Program

By Mark Longo

The Securities and Exchange Commission will soon launch a pilot program permitting the quoting of options contracts in penny increments. That's what an SEC official said at the recent annual Options Industry Conference.

"I believe it is not a question of whether options will be quoted in pennies, but how pennies will be introduced to the marketplace," said Elizabeth King, Associate Director of Market Regulation for the Securities and Exchange Commission.

For years regulators have advocated penny pricing in the options markets. That's despite almost universal industry opposition. Key details of the pilot, such as which exchanges will elect to participate and which options will be included, are undecided. And King, in her prepared remarks, conceded opposition to the penny trading philosophy.

"While it may be preferable for all exchanges to quote in the same increments, achieving such uniformity could result in a significant delay in the availability of better prices to customers," according to King. "For this reason, we are considering whether to set a date by which those exchanges interested and ready to quote in pennies could do so in a limited number of options," she added.

Nevertheless, skeptics have raised questions about the practicality of such a pilot. For example, will exchanges that opt not to participate in the program still be allowed to match prices at the NBBO? Also, given that the SEC has yet to address the dicey issue of quote mitigation, what will be the impact on the already exploding bandwidth problem in the options world?

One conference participant suggested a solution-charging for quotes.

"The one mitigation strategy that may ultimately become the norm is an economic one," said Meyer "Sandy" Frucher, chairman and chief executive officer of the Philadelphia Stock Exchange (PHLX).

"Right now all of the exchanges, with the exception of the ISE, offer quoting for free," he said.

But Frucher noted that there is no free quoting lunch. "It (quoting) is a very expensive part of our business. In light of the SEC's comments, we may have to start looking at economics, in terms of charging for quotes, as the most practical mitigation strategy of the future." Charging for quotes would, initially, be unpopular with liquidity providers and institutional customers, industry observers have said, but would be very popular with exchanges. Charging for quotes eases the strain on capacity. It also eliminates fake cancel/replace quotes, which currently flood the market. It would also, supporters note, offset the costs of storing each quote for seven years, which is mandated by the SEC. King agreed that these are valid issues because the effect of penny pricing in options now is disputed. However, she is confident the regulators can soon resolve these problems.

"I do not expect that this will remain the case for much longer," King said of the uncertainty.