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September 12, 2006

The Sequel

By Michael Scotti

Trading in penny increments is on the horizon for the options industry. That's the topic of this month's cover story, and it's a tale that equity traders know all too well.

Some comments in our story, "The Options Industry Braces for Penny Revolution," sound similar to what equity pros were saying back in 2001. That's when the cash market moved to penny pricing.

Two points that immediately spring to mind are that displayed liquidity is expected to disappear, and the pros will start penny jumping displayed orders. The equity markets withstood the dramatic change, but not without significant pain.

Pennies turned the equity marketplace on its head before the industry got a handle on how to trade in the new environment. What the new trading increment did, however, was to help usher in the electronic-trading era, which has brought benefits in the form of greater efficiency and lower commissions. Contributing Writer Nina Mehta explains how the use of algorithms is expected to play a more prominent role in this new options arena. That's exactly what happened in equities. So an increase in algorithmic trading shouldn't come as a surprise.

But options will continue to trade in nickel or dime increments until the pilot program is launched next January. The story also mentions that as options market makers are squeezed by the smaller trading increment, this will pressure the six options exchanges to become more efficient and less expensive. That means there could be consolidation among the U.S. options marts. The story on Wall Street rarely strays far from the script. It was this same striving for greater efficiency that brought us the so-called "duopoly" of the new Nasdaq and the New York Stock Exchange, with each acquiring an ECN.

Under penny increments in options, if too much liquidity goes undisplayed, how much of a stretch would it be to imagine the rise of crossing networks in options, too? They are certainly gaining steam in equities, but crossing networks for options are undoubtedly a long way off.

You will also find in this issue a new development in the crossing network space. A group of broker-dealers is forming its own crossing network. The new system, called BIDS, is entering a crowded field. Concerns of fragmentation are high among the buyside. But the ultimate answer in alleviating this problem lies in connectivity. There are private vendors who will be vying to link these disparate pools of liquidity, according to a story in our At Deadline section.

Michael Scotti

Editorial Director