Fast traders could shake up U.S. options pay system
Fri Sep 25, 2009 4:35pm EDT
By Jonathan Spicer – Analysis
NEW YORK (Reuters) – The influx of high-speed electronic traders in U.S. options markets may spur regulators to finally move on decades-long concerns over how some exchanges lure business their way.
The three biggest exchanges — the Chicago Board Options Exchange, International Securities Exchange and the former Philadelphia Stock Exchange, now called Nasdaq OMX PHLX — have long used a payment-for-order-flow system where brokers are paid for routing orders to them.
The U.S. Securities and Exchange Commission first complained about payment-for-order-flow’s lack of transparency when it became aware of the system in 1984. The issue has since smoldered largely undisturbed.
But the arrival in force of high-frequency traders, coupled with a broader crackdown on the crisis-hit financial markets, could bring changes to the fast-growing U.S. options markets.
Brian Nigito, managing director at giant high-frequency market-maker Getco, this week called the structure of traditional exchanges, particularly their use of payment-for- order-flow, “Byzantine.”
High-frequency traders, which use lightning-fast computer software to make millions of trades a day, are increasingly the market-makers for those looking to trade options. Branching out from the equities markets to options, these traders typically prefer a maker-taker fee system that gives them rebates for posting liquidity.
“If you don’t have order flow and you want to express your prices, maker-taker is a simpler way to do it … and more consistent with what equity high-frequency firms are,” Nigito told a conference hosted by the Futures Industry Association.
NYSE Euronext’s (NYX.N) Arca options platform and Nasdaq OMX’s (NDAQ.O) NOM platform use maker-taker, which dominates equities trading. Although this newer system has stalled at less than 20 percent options market share, it is expected to grow next year with the planned arrival of two new exchanges.
“We’re slowly moving toward a market structure where we’re seeing more participation from institutions and firms that are using rebates and fast-trading components as part of their strategy,” Andy Nybo, head of derivatives at research and advisory firm TABB Group, said last week.
Nybo expects proprietary trading firms — which are often high-frequency — to grow to 20 percent of trading volume by 2011 from less than 2 percent now.
Under payment-for-order-flow, market makers decide on a case-by-case basis how much to return to a broker that sold the right to trade with its clients. Retail clients, the most attractive counterparties for market makers, are said to benefit from the system.
Critics say the system is opaque and tempts brokers to forfeit the best prices for their clients in favor of higher payments from market makers, which usually do business with only one or two exchanges.
“It’s a distasteful practice … and a symptom of an inefficiency in the market,” Elizabeth King, associate director in the SEC’s market regulation division, told Reuters this week. “Payment for order flow has always been on the agenda.”
In 1993, then SEC Commissioner Richard Roberts complained in a speech that the ongoing debate “conjures up the image of the proverbial snail sprinting past the Commission in a race.”
This week, King said it would be difficult to ban all of the possible ways market makers could pay brokers.
“Even if you could ban it, it’s not clear that that’s the right answer. Payment for order flow at least gets the money closer to the customer,” which could lead to better services and reduced commissions, she said.
The three top options venues had a combined 75 percent of the market last month, according to the Options Clearing Corp. Payment-for-order-flow has helped these “traditional” exchanges retain a solid foothold for years.
Smaller rivals would of course welcome a crackdown. At the least, renewed SEC interest seems likely as the Obama administration overhauls financial regulation and politicians increasingly complain about what they see as unfair markets.
The SEC last week proposed to ban “flash orders” in equities and options markets, another move that could hit the traditional venues.
William Easley, vice chairman of the Boston Options Exchange, forecast this week that payment-for-order-flow “may be the next thing after flash orders in (the SEC’s) sites.” Ed Boyle, director of options at NYSE Euronext, said the way the funds are collected in the traditional model is “disconnected” from the way they are distributed.
“The idealist in me doesn’t like the concept of payment- for-order-flow,” Jon Schlossberg, product manager at Lime Brokerage, said at the conference. “The reality is that payment-for-order-flow has helped to subsidize commissions on the retail side and actually helped to grow this industry.”
(Reporting by Jonathan Spicer; editing by Andre Grenon)