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February 1, 2005

Tipping for Order Flow

By John A. Byrne

What is wrong with tipping the waiter generously for excellent service? It's the American way, as American as the apple pie that came with dessert. The conventional rate for tips, or gratuities, ranges from 15 percent to 20 percent. This tipping for service has, in effect, become the custom in much of the hospitality sector, a custom some overseas visitors detest. It may be an embellished urban myth, but stories are told of fistfights breaking out in New York City restaurants between service staff and outraged foreign diners who refused to tip. But what exactly has this to do with Wall Street, the power lunch notwithstanding? It has to do with tipping for order flow, or more precisely, payment for order flow. This practice is as legendary as the infamous SOES bandits of the 90s, and it is as hot as shepherd's pie today in the options industry. The practice, still around in the equities markets, falls into a twilight zone of quasi under-the-counter payments, according to critics. They say it is a sort of black market for routing orders to service providers. But others say it's the American trading way, as American as a firm bid and offer. But there's one problem with this picture. The practice is as unacceptable to some trading pros as a waiter refusing to serve cheapskates who tip the customary 15 percent.

If some of the malcontents are ultimately forced to wash dishes in lieu of tipping the staff with hard cash, then the options industry itself has come up with its own implicit payment arrangements. "Before payment for order flow, there were trips to Puerto Rico. There were arrangements that firms made to barter order flow," according to Meyer Sandy' Frucher, Chairman and CEO of the Philadelphia Stock Exchange. Frucher and other leaders in the industry are now speaking out about payment for order flow practices. Read all about it in Mark Longo's column [The Options Trader], which is entitled, "Deception or Discounting?" Longo is a financial journalist who comes from the trenches, having traded as a member of the Chicago Board Options Exchange. He also pours some excellent journalistic wine in his Cover Story, which takes the trader deep into the heart of an equity options industry exploding with innovation and fine service. In some parts, the future is the hands of the regulators. These are a little like executive chefs at the Plaza Hotel, a group who may surprise or disappoint at any moment. What will the regulators serve up as the debate rages over payment for order flow? How will they respond to critics, such as CBOE Chairman Bill Brodsky? Come back for the dessert.

John A. Byrne

Editor

E-mail: john.byrne@thomsonmedia.com