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February 16, 2007

Time-Price Priority Gains

Customer Priority in Options Marts Comes Under Pressure

By Mark Longo

There once was a time when public customers were the kings of the options marketplace. Their orders immediately jumped to the top of every order book, leaving market makers and other professionals to choke on their dust. Fortunately (or unfortunately, depending on your opinion), the days of priority for public customers' orders are now coming to an end.

In today's marketplace, customer orders are essentially left to the wolves. Two exchanges-NYSE Arca and the Boston Options Exchange (BOX)-now treat them the same as every other order that flows into their marketplace. However, this development undoubtedly represents the beginning of the death of the public customer.

The Gospel

How did it come to this? Until recently, customer priority was a fundamental tenet of the options markets. The belief that options customers needed special privileges to facilitate their trading was held as gospel. That rationale made a great deal of sense in the first few decades of the options business.

In those days, public customers had to overcome enormous hurdles just to participate in the options markets. For the typical one-lot retail customer, the trading pits were almost completely inaccessible. This prompted a genuine concern that small orders would be lost or manipulated by opportunistic brokers and market makers.

Granting priority to customer orders was seen as the only way to guarantee the accessibility of the marketplace and increase the industry's user base.

But all of that changed with the recent rise of electronic trading and the onset of multiple listing. These were knockout punches for customer priority in the options markets. As multiple listing erased options margins and deprived liquidity providers of access to order flow, many of these professionals turned to the dark side.

Envious of the priority and access that was granted to customers, they created their own customer accounts and used this newfound priority as a competitive weapon. These wolves in sheep's clothing have made many in the industry wary of customer orders. "The customer is no longer what it was," said Timothy Brennan, executive vice president of equity options for Automated Trading Desk. "The customers of today are actually the market makers of yesterday. There is an entire class of professional and semi-professional customers lurking out there that you have to be aware of. Those who ignore these sophisticated customers do so at their own peril."

Perhaps the most infamous example of professional traders taking advantage of customer priority occurred on the Chicago Board Options Exchange in 2000. At the time, the CBOE routed most of its public customer orders through its Retail Automated Execution System (RAES).

This system was designed as a way to facilitate small customer orders that didn't warrant open-outcry execution. These small customer orders were automatically executed at the exchange's disseminated prices and then assigned to a participating market maker. However, a handful of former market makers and other "professional customers" soon found their way onto this system and began abusing it in ways that were never anticipated.

RAES Banditry