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September 12, 2006

Options Industry Braces for Penny Revolution

By Nina Mehta

Also in this article

  • Options Industry Braces for Penny Revolution

It happened in the Nasdaq market. Could it happen with options? Five years ago in the equities market the minimum trading increment was cut from six-and-a-quarter cents to a penny. The biggest impact was felt on the dealer-dominated Nasdaq side as spreads collapsed, dealer profit margins got whacked and the structure of the market transformed almost overnight. What once had been largely a quote-driven dealer market turned into an order-driven agency market. Now a similar drama may be about to play itself out in the options world. Although trading occurs on exchanges, options is primarily a dealer-driven market.

In June, the Securities and Exchange Commission urged the options exchanges to adopt a pilot in which a number of options contracts would be quoted in penny increments, instead of the current nickel or dime increments. The SEC is working with the exchanges to construct the pilot, scheduled to commence on Jan. 29, 2007. Penny increments are widely expected to be rolled out more broadly for actively traded options sometime next year, pending the results of the pilot.

"Moving into a penny environment is the greatest challenge before us," says Gary Katz, chief operating officer of the International Securities Exchange (ISE), the options industry's first all-electronic exchange. "As long as the pilot is done in a conservative fashion and responsibly, we'll all benefit-the customers will benefit, the exchanges will benefit, and the market makers will benefit-because volumes will go up," he adds.

Pilot Slated

But across the industry the uncertainty ushered into the market by the prospect of a pilot in penny quotes is palpable.

The fear boils down to two issues: 1) a likely dearth of posted, or visible, liquidity, and 2) insufficient computer capacity to handle the expected explosion in quote traffic (See sidebar).

In recent years the SEC has repeatedly said it wants to road test penny increments for options quotations. What's fueling this push is the desire to improve the availability of better prices and improve customer executions.

The SEC expects penny increments to reduce the bid-ask spread for most actively traded contracts, which would benefit investors by providing tighter pricing and greater transparency.

SEC Commissioner Annette Nazareth noted in May that the national best bid or offer (NBBO) for the most actively traded options is at the minimum increment more than 50 percent of the trading day, which suggests that the current quote increments "are keeping spreads artificially wide."

The SEC also expects reduced spreads resulting from penny increments to diminish or end payment for order flow and the internalization of orders. Payment for order flow occurs when market makers provide rebates to order flow providers for directing customer orders to them. Internalization occurs when a brokerage firm trades directly with its customers at a price equal to or better than the NBBO.

What Benefit?

According to the SEC, both practices hurt the options industry. They do this by providing incentives for order routing decisions that are not fully transparent and that potentially conflict with a customer's best interest. In the equities market, payment for order flow largely disappeared after decimalization was instituted in 2001. The narrower spreads made rebates too costly and unprofitable.