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February 16, 2007

Time-Price Priority Gains

By Mark Longo

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Some examples of these abuses included planting one-lots in the book at ridiculous prices and then automatically executing trades at those prices. They also used RAES' rapid execution to take advantage of any quirks in the exchange's auto-quote system. If a particular product's auto-quote began to lag behind the market, a relatively common occurrence during fast market conditions, then the consequences could be disastrous. Market makers suddenly found deep in-the-money options hitting their accounts at prices no sane person would ever contemplate.

The culprits behind these exploits eventually became known as "RAES bandits," a title, no doubt, borrowed from the name given to rapid electronic traders who picked off market makers on Nasdaq's Small Order Execution System (SOES): the so-called SOES bandits.

On RAES, the number of opportunistic trades was so prolific that it prompted many exchange members to boycott the RAES system entirely. Although the problem was eventually fixed, that experience opened the industry's eyes to the dangers of customer priority in the modern era.

The emergence of the RAES bandits and other "professional customers" has also prompted a debate over the definition, and relevance, of a customer. In this era of electronic execution, is the public customer designation even relevant anymore? With so many professional-level tools at the disposal of the retail customer, the argument that they need priority to effectively participate in the options markets is moot.

If retail customers no longer need priority, then is there anyone left who should still qualify for this exalted privilege? As the RAES bandits proved, the world of electronic trading makes it all but impossible to determine who is a retail customer and who is a professional trader. By giving all public customers priority, the exchanges have handed trading pros a clear advantage over the true retail investor, who, in effect, now has to compete for the same fills.

Despite its dangers and looming irrelevance, there are still those in the industry who subscribe to the gospel of customer priority. "When it comes down to it, customers love being on the top of the book," said Jay Knopf, vice president of SLK Hull Derivatives at Goldman Sachs. "Unfortunately, we've had some problems with people pretending to be customers just to gain that priority, and we've had to deal with that. However, I'm loath to do anything that hurts the customers. Eliminating priority definitely falls into that category."

Dwindling Ranks

Although some in the industry still champion customer priority, their ranks are rapidly dwindling. All of the recent entrants to the options marketplace have seen fit to abandon customer priority in favor of price-time priority systems. Both the BOX and the revamped NYSE Arca Options have adopted variations of this approach.

The notion of a flat and open marketplace, where every order can compete on equal footing, may sound idealistic, but the markets are moving inexorably toward that goal. "Our goal is to create a level playing field for all participants," said Scott Morris, the new CEO of BOX. "Unfortunately, many of our competitors still see fit to grant certain aspects of their customer base special privileges. We just don't see why anyone should receive priority or special privileges in this day and age."