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January 30, 2008

Dark Fight in Midst of Options Battle

Nasdaq wins few friends in the options world

By Nina Mehta

Also in this article

Nasdaq's plan to incorporate hidden orders in its proposed options exchange has enraged many of its competitors, who claim the idea will undermine the progress they have made in growing the business. Those exchange executives contend that by encouraging internalization, dark liquidity has hurt the equities market and shouldn't be allowed across the threshold of the options industry.

The latest fracas over dark, or hidden, liquidity emerged in the run-up to Nasdaq's planned December 7 launch of its Nasdaq Options Market, which was scheduled to include

various types of non-displayed liquidity. However, that launch was scuttled in early December, since the Securities and Exchange Commission had not approved Nasdaq's proposal in time.

The industry "should not move wholesale toward a market structure that destroys something all of us have been working toward," insisted David Krell, president and CEO of the International Securities Exchange, in November. In his view, dark liquidity undercuts price discovery and compromises the transparency that has contributed to the options industry's tremendous growth over the last seven years.

Strong Reaction

Executives at the Chicago Board Options Exchange, Philadelphia Stock Exchange and American Stock Exchange also expressed strong reservations about dark liquidity at the Futures Industry Association Expo in late November. They spoke on a panel that included the heads of the seven options exchanges.

One of several controversial components of Nasdaq's options exchange filing, which was submitted to the SEC a year ago and updated in April, was the introduction of what Nasdaq termed a "price-improving order" for options. That order type would enable a Nasdaq Options Market participant to submit a penny-priced order to the exchange for an option with a nickel-minimum increment. If the price were within the increment, the order would be held in Nasdaq's book for potential matching against an incoming contra-side order, but would be displayed publicly at the allowable nickel increment.

Nasdaq's filing included both hidden and reserve orders. Currently, only NYSE Arca Options allows reserve orders, although the ISE has asked the SEC to allow reserve orders in its market as well. No options exchange has hidden order types that allow participants to conceal their best prices or to execute automatically against existing liquidity within the quoted spread. The options industry also does not allow brokers to internalize orders, which is a common practice in equities trading. This has prevented crossing platforms, ECNs and broker-dealers from competing with the listed displayed markets at options exchanges.

Adam Nunes, head of the Nasdaq Options Market, said in December that Nasdaq's proposed price-improvement process is "both fairer and faster" than existing mini-auction processes at other exchanges, which currently enable executions within the spread. "Nasdaq's system allows for price improvement of all incoming orders and our system does not delay the execution of the incoming orders," he added. Nunes said Nasdaq is confident its options exchange will be approved with its price-improving orders, and that the exchange will launch early this year.

Kevin Murphy, head of U.S. broker-dealer sales at Citi, observed that Nasdaq's price-improving orders represent a big change from the current tools available on options exchanges. "If this gets approved, it will be a major change in market structure in the options industry," he said in November.

The First Domino