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February 1, 2005

Discounting or Deception? Like Death and Taxes, Payment for Order Flow Goes On and On

By Mark Longo

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  • Discounting or Deception? Like Death and Taxes, Payment for Order Flow Goes On and On
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Trips to exotic resorts and bottles of fancy wine were once offered in the options industry in exchange for order flow. It was a practice familiar in the equity trading markets. And sadly, it was an accepted cost of business. Call it shady. Whatever it was called, this was once part of the controversial system known as payment for order flow.

But if you think this practice is now history, think again.

Payment for order flow is bigger than ever before. Indeed, it may be one of the most contested issues in the options business today. In a few short years, it has divided the options world. In one corner, proponents claim that the practice is still merely a natural evolution of competition between the exchanges. In the other corner, critics describe payment for order flow as outright bribery.

David Johnson, a managing director at Morgan Stanley, once famously referred to payment for order flow as "the devil itself." Strong words from a powerful industry captain. But unfortunately, there is little hope that the fight over these payments will end soon.

Market makers, exchanges and trading firms have been buying access to orders for decades. Back in the bad old days, of course, these payments were subtle and rarely, if ever, did they involve cash. There were other ways to compensate order flow providers, recalls one exchange official.

"Before payment for order flow, there were trips to Puerto Rico. There were arrangements that firms made to barter order flow," says Meyer "Sandy" Frucher, Chairman and CEO of the Philadelphia Stock Exchange. "Is all of that wrong? Some of it, maybe, but frankly you're never going to eliminate payment."

Indeed, recently the practice has become more blatant. Today, market makers, trading firms and exchanges explicitly pay brokers an "incentive" fee - say $2 a contract - for every contract routed to them. It is part of the "marketing" costs. These payments are negotiated openly and listed in brokerage bills alongside commissions.

The explosive growth of payment for order flow has coincided with increased competition in the options industry. And since the options trading markets are tighter than ever, exchanges and DPMs now have a difficult time competing on price alone.

So payment for order flow has become an integral part of the competitive forces. For example, if every exchange lists the same bid for an option, but one exchange pays a higher "incentive fee" than its competitors, brokerage houses are more likely going to route most orders toward the exchange with the best incentive. It's a simple fact of economic life, but it has critics up in arms. These same critics charge that the practice gives brokerage firms a reason to violate their fiduciary responsibility.

After all, whenever the exchange with the highest incentive fee is not the exchange with the best price, a conflict can arise between the brokerage's and customer's economic interests. Most reputable brokerage firms should choose to honor their fiduciary responsibility: Route orders to the exchange with the best price. But, as some market makers will tell you, this is not always the case.