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March 15, 2007

Talking Pennies, PIPs & Payment for Order Flow

Why trading in pennies is more trouble than it's worth

By Tony Saliba

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Sometimes the best intentions are misplaced. Take the attempts to introduce the $1 coin, the videodisc and the attempt in the U.S. to convert to the metric system. The same might be said for the current "pilot" program in listed options. As of January 26, the industry began offering quotes in 1-cent increments in options on 13 underlying

securities-"penny quoting," if you will. While the regulators may believe they have found an answer to the "cost" of bid-ask spreads by displaying penny increments, in reality the cost is just being re-allocated elsewhere, and will eventually be borne by users anyway. The only thing novel about this plan is that these prices are displayed for all to see.

First, let's dispel some of the myths:

Myth #1

Options were not trading in pennies before this pilot program.

Options have actually been trading in pennies for just over three years. The Boston Options Exchange launched PIP, its penny-trading program to improve prices, in February 2004. Other options exchanges soon replicated it. The BOX claims that customers have saved over $100 million through price improvement over the last three years. I have no reason to doubt that.

Some brokerage firms like Interactive Brokers, optionsXpress and my firm, LiquidPoint, already offer the benefits of penny quoting to their customers via these price improvement mechanisms and posted penny prices on their trading applications. They have done so for quite some time. These mechanisms work with the exchange facilities to bring together customers' orders and the liquidity providers willing to improve displayed prices. Allowing market participants-rather than regulators-to decide which securities are traded in pennies increases efficiency in the options market. These digital auction capabilities are already in place

Myth #2

Penny quoting will eliminate payment for order flow (PFOF).

One of the key drivers for penny quoting is the SEC's desire to eliminate the practice of payment for order flow. Payment for order flow is a transaction-based rebate from the Liquidity Provider Organizations (LPOs) at various exchanges to those supplying the order flow. Those funds are supposed to either go back to the customer or subsidize the cost of routing. The irony is that the PIP and its clones could have altered or even eliminated that payment process already, but these innovations have not been well publicized and not all firms have chosen to hook up to them.

The theory goes that if the markets are tighter, it will squeeze out the ability of the LPOs to subsidize the order flow. But just because options are quoted in pennies does not mean that the bid/ask spread will be narrowed. I have so far seen a lot of "5-up," 4-cent wide series. Not the kind of stuff that's going to entice the growing, serious user of the product.

Instead of redoubling efforts to educate customers about innovations in the delivery system that are already in place, the SEC intends to remove the impact of PFOF by substituting penny quoting. The result will be a wildly expensive infrastructure paid for by the customer, while possibly leaving a vacuum for a less desirable (or unregulated) form of PFOF to manifest.

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