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May 16, 2007

NYSE Arca Comes Up a Winner in Penny Trading

Maker-Taker Model Model Makes Options Debut

By Peter Chapman

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If the penny pilot now under way in the options market is viewed as a referendum on NYSE Arca's unique market structure, it would be hailed as a victory for the exchange. NYSE Arca has seen its market share in the 13 options classes subject to trading in penny increments jump from 8 percent in January, before most of the pilot launched, to 12 percent in mid-April. In the same period, the respective market shares of the five other exchanges have declined or remained unchanged. "We thought the penny pilot was a good opportunity to try a new market model that rewards those people who provide liquidity at very tight spreads," says Jon Werts, a New York Stock Exchange vice president for derivative products. "Early indications are that the results are very positive."

At 12 percent, NYSE Arca now has the third-largest market share in the 13 penny classes. It trails only the Chicago Board Options Exchange and the International Securities Exchange, which dominate options trading. Overall, NYSE Arca ranks fourth, with 11 percent of total equity and index contract volume.

Of the six options exchanges, NYSE Arca is the only one to pay rebates to traders who provide liquidity and to charge fees to those who take it. This so-called maker-taker model is popular in the equities trading industry, but brand new to options trading.

Specialists' Privilege

The other exchanges reward liquidity providers-mostly specialists or market makers-by guaranteeing them a large chunk of any incoming order. To qualify for a typical 40 percent allotment, specialists must show considerable size at the market's best prices.

That model may be coming under pressure with penny trading. Spreads have shrunk because of fierce competition between traders, making it more risky and less rewarding for specialists to be at the inside.

Options with strike prices of $3 or less per contract now trade in penny increments, and not nickels. Those with higher strikes trade in nickel increments, not in dimes.

The penny pilot was not, of course, intended as a referendum on NYSE Arca's business model. The Securities and Exchange Commission largely prodded the industry to reduce its trading increments in order to narrow spreads and, it's hoped, reduce payment for order flow.

NYSE Arca, formerly the Pacific Exchange and now reinventing itself under new management, chose to introduce the maker-taker model to the options world for two reasons. First, it has had success with the model in the equities industry. Second, it may be more attractive to market makers in an environment of declining spreads.

The penny pilot, launched by the six options exchanges, has led to a 50 percent drop in spreads in the selected classes.

Narrowing Spreads

By some accounts, average spreads in the 13 classes were 12 cents before the pilot and are 6 cents today. Some of the more active names are down around 2 cents or 3 cents. For those options, that translates into a $2 or $3 gross margin per contract for specialists.

The smaller gross makes a 30-cent rebate-the amount NYSE Arca is paying specialists per contract-enticing. The exchange also eliminated two standard exchange charges, a 25-cent levy on market makers used to pay retail brokers for their order flow and an average 20-cent transaction charge. That brought the marginal benefit to trading on NYSE Arca up to 75 cents.