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January 30, 2008

Access Fee Cap Coming to Options?

By Nina Mehta

With maker-taker pricing settling into options, the Securities and Exchange Commission is paying attention to exchange access fees.

Robert Colby, deputy director of the Division of Trading and Markets, said the SEC is "watching this area-access fees in options." For now, he said, the "fees involved might increase overall costs, but not enough to affect the attractiveness of the quotes."

As the options industry undergoes significant change, complaints involving access fees are emerging from top market makers. Matt Andresen, president of Citadel Execution Services, the giant broker-dealer subsidiary of Citadel Investment Group, said the shift to maker-taker pricing by NYSE Arca Options has led to "disruptive behavior" in the form of intentionally locked and crossed markets. Access-fee caps would reduce the incentive for that behavior, he said.

"We've seen a major spike in the frequency and duration of locked and crossed markets in options," Andresen told Traders Magazine. "It seems to be driven predominantly by quoters on Arca." In a locked market, a trader posts a contra-sided order at the same price as the national best bid or offer. In a crossed market, the trader posts a bid that's higher than the best offer or an offer that's lower than the best bid.

Locked and crossed markets are "one of the most distortive effects of rogue pricing," according to Andresen. In his view, the high fees to take liquidity on Arca and the Boston Options Exchange--50 cents and 45 cents per contract, respectively--subsidize high rebates, which creates an economic incentive for traders to find ways to earn that rebate.

An Arca spokesperson noted that "it's not uncommon for competing market models to occasionally bump up against each other as markets move." He added that NYSE Arca Options uses private routing instead of the intermarket linkage system, "which provides our platform with a faster linkage turnaround with significantly less delay. NYSE Arca will never lock a market using an order routed to us."

Kevin Murphy, head of U.S. broker-dealer sales at Citi, also observed that some market participants are now playing a "rebate game." Spurred by high rebates for providing liquidity, they can profit by breaking even on their trading, as long as they earn a rebate on their executions. "Options is a quote-driven market" and those traders "don't add much value," he said.

Andresen believes market structure changes in options could force the SEC to implement fee caps in the options market, as it did in equities in Regulation NMS. "We've seen this movie before, and if the SEC has the same reaction as in equities, we'll soon have fee caps," he said. Locked and crossed markets are frowned on by market centers and regulators.

According to Chris Nagy, who oversees order routing, sales and strategy at TD Ameritrade, the issue about access fees is part of a broader set of concerns. "The issue of whether make-or-take pricing or capping access fees is good or bad is irrelevant," he said. "The real issue is that two disparate fee structures coexist in the market with no rules to prevent manipulation and promote fair and transparent markets for the benefit of the options investor."

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