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In this exclusive to Traders Magazine, John Turney, Global Head of Outsourced FX at Northern Trust, discusses the evolution of the fx infrastructure and what is to come.

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November 8, 2005

Order Flow Battles Continue: Whose side are you on?

By Mark Longo

Also in this article

  • Order Flow Battles Continue: Whose side are you on?

Although the guns have been silent lately, anyone who is even remotely familiar with the options industry knows that the battle over payment for order flow is not over. The furor over this practice has divided the industry. Advocates for both sides clash, leaving the average trader in doubt. With both sides entrenched and the SEC refusing to join the fray, this fierce debate is going into extra innings. However, a surprising development is forcing many combatants to rethink their allegiances and their old ways of doing business. I am speaking about the latest evolution of payment for order flow preferenced trading.

The Good Old Days

Although the guns have been silent lately, anyone who is even remotely familiar with the options industry knows that the battle over payment for order flow is not over. The furor over this practice has divided the industry. Advocates for both sides clash, leaving the average trader in doubt. With both sides entrenched and the SEC refusing to join the fray, this fierce debate is going into extra innings. However, a surprising development is forcing many combatants to rethink their allegiances and their old ways of doing business. I am speaking about the latest evolution of payment for order flow preferenced trading.

The Good Old Days

For those unfamiliar with the issues involved, here's a brief history lesson. Back in the good old days of the options markets, people used to compete for customer orders. Groups of highly caffeinated men would fight to make the fastest and tightest markets for a customer. The trader who made the best market would get as much of the order as he wanted. The rest of the crowd got the remainder. It was not an elegant way to conduct a transaction. In fact, more than a few observers likened it to watching angry gorillas fighting over scraps at the zoo. However, it incentivized competition among liquidity providers. It gave the customers deep, liquid and reasonably tight markets.

But that's history. The dawn of multiple listing and the onset of electronic trading have created a brave new world where trading screens have replaced the gorillas. Transaction speed is no longer limited to the snail's pace of the open outcry system. Instead, it is limited only by the bandwidth of your data feed and the processing power of your computer. However, these advances have created a new set of problems.

Competition between individual market makers has been replaced by competition between exchanges and large trading firms. Although it was unthinkable only a few years ago, competing market makers and their specialists now routinely join forces when filling large orders. This is all done in the hope of attracting more volume to their trading crowd or electronic trading bin. Unfortunately, with many equity options trading in nickel wide margins, there is little room to compete on price. How, then, do exchanges, specialists, DPMs, trading firms and others compete for customer orders? The answer is payment.