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July 31, 2004

War Over Trade Crossing: Market Makers Butting Heads With Brokers and Exchanges

By Mark Longo

Also in this article

  • War Over Trade Crossing: Market Makers Butting Heads With Brokers and Exchanges

As you read this column, a life-or-death struggle is being waged in the option trading pits across the U.S. At the heart of this conflict is a controversial practice known as trade crossing. Trade crossing occurs in two distinct forms. The first takes place when a brokerage house becomes the counterparty to its customer's order. Alternatively, brokerage houses can also arrange for customers to become

order counterparties. In either scenario, the transactions are arranged prior to reaching the exchange and involve little or no market maker participation.

Trade crossing has sparked a fierce debate. Opponents of the practice - primarily market makers - believe it is a direct usurpation of their role as liquidity providers. Supporters of the practice - primarily brokerage houses and exchanges - believe that trade crossing brings in more revenue, increases trading volume as well as customer satisfaction. As with most debates, the most reasonable position is in the middle.

Here's how trade crossing works: Brokerage houses, looking for counterparties for their orders, show the orders to other customers. This is a practice known as shopping. Since it is time-intensive, it was initially done on a very limited basis. However, as competition intensified, many firms began to look for alternative sources of revenue. The double commissions generated by trade crossing, as well as the customer goodwill fostered, made it an irresistible lure. Today, most large option orders are repeatedly shopped before they ever reach the trading floor.

According to most market makers, early access to critical information is a primary benefit of exchange membership. Exchange members are usually the first to learn about significant orders and the first to see trends develop. However, these benefits vanished when brokerage houses began showing their orders to other customers. Order shopping gave non-members access to order information before it was revealed to market makers and other exchange members.

Over time, the tracking of customer and brokerage positions, a necessary function for market makers, was obscured by the large volume of shopping and crossing activity. It became virtually impossible to determine which side of a trade represented the customer; whether the customer was opening or closing positions and who took the other side of the trade. As a result, it became difficult to identify trends and inefficiencies in the marketplace. In addition, since crossed trades are counted as regular volume in the daily volume reports, option traders can no longer distinguish true customer activity from "fake" crossing activity. Many traders have put on positions in products only to discover that the bulk of that product's volume is crossed off the trading floor.

The options exchanges had always tolerated trade crossing as a way to facilitate customer transactions. Nevertheless, they took steps to regulate the practice. Trades could not be crossed on the bids or offers disseminated by the market makers. Brokerage houses had to provide the market makers with a chance to participate in the trade.

Heated Battle