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September 28, 2006

Innovation Breeds Copycats

By Editorial Staff

To win market share, an exchange must innovate to attract liquidity. However, if an exchange comes up with a new wrinkle that market participants like-and that draws volume-other exchanges will copy it.

The all-electronic ISE introduced remote market makers when it launched in 2000. That increased competition among liquidity providers and tightened the bid-ask spread. As ISE's market share increased, remote market making made its way to the CBOE and Philly. Amex, the final laggard among the exchanges with floors, recently unveiled a remote market maker program.

The same skirmishing occurred when the brand-new BOX rolled out a price-improvement mechanism in the form of three-second private auctions in 2004. The other exchanges had spent months criticizing this feature. They appealed to the SEC to deny the interloper. In the words of the CBOE, the concept was a "rather novel but anti-competitive and non-transparent internalization scheme."

Then they copied it. The ISE came out with its own price-improvement mechanism in 2005, as did the CBOE earlier this year. Philly is now developing its version, but has not decided whether to release it. The decision will rest on the consequences of penny quotes, since options quoted in pennies won't need price-improvement auctions.

The innovation NYSE Arca Options hopes to get credit for is a matching engine based on price-time priority, with order participation incentives for market makers.

Allocation algorithms rarely make headlines. But by defining the way orders interact, they can be described-at least from the perspective of market structure-as the soul of an exchange.

BOX already operates a first-in, first-out regime, but it does not have market makers with participation rights. NYSE Arca Options has guarantees in place that give market makers a reason to quote aggressively on its new OX electronic trading platform.

Broadly, allocation algorithms include pro rata systems, which create deep markets by rewarding market makers for quoting large size and price-time priority matching engines. The latter reward whoever improves the best bid or offer first. According to market participants, FIFO matching algorithms are geared toward a penny-quoting environment.