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October 4, 2007

Options Maker-Taker Markets Gain Steam

By Nina Mehta

In adopting a price-time priority market model and shifting to maker-taker pricing for the pilot options, NYSE Arca Options and BOX have challenged the market by eliminating the ability of public customers to jump to the head of the line and to trade for free. They've done so by utilizing an ECN-like incentive structure.

Adam Nunes, head of the new Nasdaq options market, notes that the traditional trading model in options grants public customers a "property right to priority." In contrast, he says, maker-taker pricing in a strict price-time priority market provides a "property right based on what [participants] do." Nasdaq plans to launch its options exchange in December with a first-in-first-out model and aggressive maker-taker pricing.

In contrast to quote-driven systems, NYSE Arca Options and the other maker-taker markets are counting on new, high-frequency participants to attract liquidity to their venues. "There's a set of clients that like price-time priority and no cancel fees," Adcock says. "We've created a new class of customers with this model-they're liquidity providers acting like market makers remotely."

Other industry trends are abetting the development of this new options class of aggressive liquidity providers. BOX's Morris notes that portfolio margining, coupled with maker-taker pricing in a penny environment, will enable nontraditional and smaller liquidity providers to compete with larger market-making firms to tighten markets. Portfolio margining permits trading firms and liquidity providers to gain some of the cross-margining advantages available to traditional market makers, thereby reducing their cost of capital.

Market participants have mixed opinions about how well this may work. George Ruhana, an options trader at trading firm PEAK6 in Chicago, agrees that maker-taker pricing is a bid to attract volume through aggressive quoting. If exchanges with that type of incentive pricing "post markets that are tighter because they have more liquidity providers on their exchange, then people will be forced to go there because they have the better price," he says. However, that may not happen as planned. "What tends to happen, especially for small size, is that exchanges match better prices elsewhere," he notes.


In Ruhana's view, maker-taker pricing helps statistical arbitrage and black-box trading firms that are continually in the market electronically. "This gives them incentive to do that more because they get paid to do it," he says. Ruhana adds he expects incentive pricing to draw volume to Arca in penny options classes-and that "if anybody knows about doing this well [based on the equities-market experience], it's Arca."

For the CBOE and other quote-driven exchanges, the changes wrought by the maker-taker markets spell competition not just for market share but for their market models. In a penny setting, they must ensure they're at the NBBO to hold on to their volume. If they do that, customers will be able to choose which market will receive their flow. And those accustomed to paying no fees, if given a choice, are expected to continue to avoid paying exchange fees by trading on quote-driven exchanges when markets are tied at the NBBO.