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October 4, 2007

Options Maker-Taker Markets Gain Steam

The Potential Impact of Exchanges' Pricing Decisions

By Nina Mehta

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The Boston Options Exchange has become the latest exchange to reject the options industry's traditional transaction pricing model in favor of that pioneered by the cash equities business. Following the lead of NYSE Arca Options, which switched to "maker-taker" pricing last January, BOX will now pay a rebate to suppliers of liquidity and charge liquidity takers a fee.

Both are counting on this pricing scheme to attract volume to their venues as the penny pilot underway at the six U.S. options exchanges expands to include more options classes. Both are also far from the industry's largest exchanges.

Whether the rest of the industry follows the path of NYSE Arca Options and BOX is an open question. Because the industry gets half of its order flow from public customers who have trading priority and pay no exchange transaction fees, it would be difficult for the established exchanges, which have the vast bulk of liquidity, to change how they're treated. But if maker-taker pricing succeeds in winning and sustaining market share, those exchanges may have to consider altering their market models.

Falling in Love

It's very easy to fall in love with the idea of maker-taker incentives, but hard to think through the consequences in terms of what that means for how public customers trade and how our markets work," says Michael Bickford, senior vice president in charge of options at the American Stock Exchange. Public customers are the non-broker-dealer clients of exchanges' member firms.

Ed Tilly, executive vice chairman of the Chicago Board Options Exchange, refers to maker-taker pricing as the "reintroduction of customer fees" since public customers are primarily liquidity takers. But, he acknowledges, serious competition could affect how the established exchanges operate in the future. "Will the bigger exchanges ever add back customer fees in some classes?" Tilly says. "The answer has to be that 'ever' is a long time and probably. But when that occurs is a question."

For BOX, the smallest options exchange, the pricing decision was easy. "Arca's maker-taker pricing allowed them to create tighter markets [in the penny options classes] because they had an incentive for people to post additional liquidity," says R. Scott Morris, the exchange's chief executive. "We decided it was the best way to go, especially as the penny pilot is expanded." BOX, which launched in 2004, had a market share of 5.6 percent in August.

NYSE Arca Options switched to maker-taker pricing for the pilot classes last January. "If you make the best price, [a trading firm's] router must come to you whether you pay for order flow or not," says Paul Adcock, executive vice president at NYSE Euronext and head of trading operations at NYSE Arca and its options market. "That model worked for us in the equities world, and it's why we built an exchange with no cancellation fees that's the fastest in the industry." (Both Arca and BOX have standard transaction fees for non-penny names.)

Liquidity Draw