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October 4, 2007

Options Maker-Taker Markets Gain Steam

By Nina Mehta

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NYSE Arca Options increased its market share in the penny options classes to 12.9 percent in August, from 9.7 percent in December 2006, before the pilot began. A large portion of that increase stemmed from activity in QQQQ and IWM, the two options on exchange-traded funds in the pilot. The exchange's overall equity options market share in August was 12 percent. Last December, as a result of unusual volume, it had risen to 14.6 percent, although its 2006 average was 10.7 percent.

The goal of NYSE Arca Options and BOX-both price-time priority markets, in which orders at the national best bid or offer are executed in the order they were received-is to attract volume by encouraging liquidity providers to tighten the spread in a penny environment. "It's a way to try to differentiate themselves from the other exchanges and build their marketplace," says Tony Saliba, president and CEO of BNY ConvergEx LiquidPoint. "We're in a quote-driven market and that's an order-driven approach."

The two largest options markets are the CBOE and the International Securities Exchange. The CBOE had 29.8 percent of the single-equity options market in August, while the ISE's market share was 30.5 percent (these numbers exclude index options, most of which aren't multiply listed). These two market leaders, along with Amex and the Philadelphia Stock Exchange, are quote-driven markets with traditional "pro-rata" models.

Primary market makers quoting at the inside market on these exchanges can cumulatively execute against up to 40 percent of each eligible incoming customer order, based on the size of their quote-or some variation on that model for certain options classes. In multiply listed classes, these exchanges don't charge member firms transaction fees for orders from public customers. All primary market makers and broker-dealers pay per-contract fees for executions on quote-driven markets.

Eyes on Arca

Maker-taker pricing is predicated on a penny-increment environment. As the penny pilot expands-to another 22 options classes last month and 28 more in March-the industry has seen volumes increase in the penny names at a much faster clip than in non-penny options classes. Spreads have decreased in the pilot names and liquidity at the NBBO has shrunk, in some cases dramatically. The quote-driven markets have warned the Securities and Exchange Commission that the changes to liquidity for all but the most liquid classes could hurt the options industry generally.

In the meantime, the established exchanges are analyzing how broker-dealers and customers are responding to maker-taker pricing. "It's probably too soon to tell if the model is working," says Gary Katz, president of the ISE. "Algo trading is anticipated to grow, but whether that grows with or without a maker-taker model or is spurred on by that model has yet to be seen."

Katz stresses that the options and equities markets have different structures and their products trade differently. "There isn't as much liquidity in any one options product as there is in stocks, so this will be a different experience [with pennies]," he says. "Algo traders and customers will see what works for them."

BNY ConvergEx's Saliba notes that algorithmic traders usually take liquidity from exchanges instead of posting bids and offers. "So the maker-taker model wouldn't lend itself to that group," he says. "They'd take more liquidity than they add and have to pay increased exchange fees."

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