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May 16, 2007

NYSE Arca Comes Up a Winner in Penny Trading

By Peter Chapman

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While the pilot doesn't end until June, NYSE Arca's success is prompting other exchange officials to reconsider their models. The open question is whether or not the maker-taker model will be adopted by NYSE Arca's competitors.

"We think maker-taker has merit," says Scott Morris, chief executive of the last-placed Boston Options Exchange, or BOX. "I think the BOX and other exchanges will have to look at the maker-taker model and consider it."

The BOX initially launched with much fanfare in 2004 with a radical business model of its own, opting for a more egalitarian construct devoid of specialists and based on strict price-time priority.

So Unkind

It also created a so-called "price-improvement period," or PIP, that allowed traders to quote and trade within the 5- and 10-cent spreads during special auction sessions.

The BOX captured order flow almost immediately, but then just as quickly plateaued with a market share of about 5 percent.

And the penny pilot has not been kind to BOX. Its market share in the 13 classes shrank from about 6 percent in January to 4.5 percent in mid-April, according to the Options Clearing Corp.

Its PIP was expected to suffer in penny trading, because there would be less need for trading in between the spread if the spread narrowed significantly, and those expectations were on the mark. PIP volume has declined by about two-thirds, according to Morris.

"We're in sixth place," he says. "We need to do something to get moving."

Morris won't say whether or not BOX will adopt the maker-taker model. One reason BOX and other exchanges have been shy about trying the model is the fear that retail brokerages, the source of most options flow, would reject it.

Not Really

The customers of retail shops could balk at paying a fee on top of commissions for taking liquidity. Plus, the brokerages themselves may not be able to institute such pricing.

"Frankly, maker-taker is not something retail customers like at all," says Randy Frederick, Charles Schwab & Co.'s director of derivatives. "Customers want a simple model they can understand."

NYSE Arca's success may be fleeting. Some observers believe the new spreads do not reflect economic reality. They speculate that market makers are still experimenting with their pricing and will soon quote less aggressively.

"People are trying to figure out whether this narrowing of spreads is sustainable," says David Fisher, president of optionsXpress, another retail brokerage.

"Everyone is playing around with the new pennies, testing their systems. Many people believe there is some artificial quoting going on that is not sustainable."

Defying Logic

The BOX's Morris notes that some spreads on options with nickel increments declined from about 10 cents to a nickel, something that could have happened without a penny pilot.

"It defies logic," he says. "I am sure the end result will be a tightening of spreads, but I would be very surprised if they end up being as tight as people expect."

The level at which spreads ultimately settle will play a big role in determining the success or failure of the maker-taker model, but a bigger factor may be whether the pilot is expanded to encompass more options.