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October 4, 2007

Options Customer Tiering Debated

By Peter Chapman

The International Securities Exchange, rebuffed in a previous attempt, is trying again to create two classes of customers. The options mart is seeking Securities and Exchange Commission approval to permit active trading customers to voluntarily designate their orders as "professional." These would then be distinguished from the orders of less active "regular" customers.

Behind the move, the ISE told the SEC, are complaints by active traders that the exchange's cancellation fees are too onerous. Because many high-frequency traders cancel more of their orders than get filled, they wind up paying large cancellation charges. They have asked their brokers, ISE members, for relief.

A change in the rules would put the traders on a par with brokers and dealers that do not pay for cancellations. But going on par with brokers and dealers however means the professional customers would lose three crucial benefits-priority over market makers in the trade allocation process; zero transaction fees; and eligibility for payment for order flow.

That's just fine with a lot of market makers who have complained in recent years that sophisticated hedge funds were taking advantage of the generous treatment given to customer orders to out-trade them.

The ISE's move is its second attempt to create two classes of customers - one more privileged than the other. Last year, it sought SEC approval to label any customer placing over 100 orders per day as a professional.

Those traders would have been stripped of their priority and zero transaction fee privileges. Only customers placing fewer than 100 orders per day would retain the customer benefits enshrined by the options industry since its early days.

Then the ISE was motivated by dealer complaints that sophisticated hedge funds did not need the benefit of priority that perhaps the average retail customer did. It put the dealers at a competitive disadvantage, they said. The SEC, however, never took up the issue, concerned over issues of fair access.

Even if professional customers aren't stripped of their priority status, many industry execs maintain they should at least be charged for transactions. The absence of such fees is "too much of an incentive for an active trading group," Tony Saliba, president and CEO of brokerage BNY ConvergEx LiquidPoint, says.

Many dealers and brokers alike consider the growing number of "professional" customers as wolves in sheep's clothing.

"To have a professional institutional trader who is using customer priority to jump in front of the market maker is bastardizing the system," complained Peter Bottini, in charge of trading and customer service at brokerage OptionsXpress, at a recent industry conference.

"We value the liquidity the specialists and market makers bring. I don't think options trading can develop into an order driven market like equities did."

A common complaint of dealers is that a professional customer will use his priority standing to grab an incoming order ahead of a dealer and then turn around and sell it to the dealer when the market starts to move against him.

That may be becoming less of a problem now that the industry is moving to trading in penny increments.

At least one large dealer expects penny trading, currently in effect for several options classes, to give market makers an edge over the professional customers. Thomas Peterffy, chief executive of Interactive Brokers Group, whose Timber Hill unit is one of the industry's largest dealers, told analysts recently: "If we can move a penny at a time, we will move a lot more. So it is going to be a lot more difficult for [the professional customer] to copy us and, if the trade goes against him, to turn around and undo it with us."

He adds: "We make the price and they do the trades and they get paid for it. We want to reduce their ability to compete with us on our prices and we do that by moving away quickly."