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January 31, 2008

Making Crosses Work

Price improvement doesn't always drive trading decisions

By Kevin Fischer

In the November issue, Traders Magazine reported on comments made at a recent industry conference regarding the effect of penny price increments on institutional trading. One options executive stated that large trades in penny option classes are increasingly executed over the counter and not on an exchange.

Although the same person later noted that the practice is not widespread, the thought that tradingexchange-listed options in penny price increments may drive trades to the OTC market is surprising, especially given the recent market turmoil created in large part by problems stemming from the OTC market. Such turmoil illustrates investors' lack of confidence in a market without evident competition. That turmoil also vividly demonstrates the lack oftransparency within both the trading and position marking process in the OTC market.

Penny pricing is certainly a hot-button issue for options traders, and it is used by its detractors to conjecture all manner of unintended consequences. Many times these predictions provide valid insight into the speaker's real agenda. An analysis of the comment that "Traders are having a very difficult time putting trades on the tape" may suggest that the real issue is upstairs dealers' desire to keep the most lucrative crosses in-house, not any flaw in existing crossing mechanisms.

As option spreads began to tighten after multiple listing in 1999, it became more difficult for market makers to remain profitable. Some of these firms found that it made sense to pay brokers in order to get the first look at customer order flow and be named as contra on the crosses. Brokers profited because they could now bill both sides of the order.

Electronic Speed

By rule, a human floor broker with instructions to cross an option order must first request a verbal quote from the trading crowd, and then try to cross the order inside the best of the combined verbal and electronic quote. Since penny pricing has dramatically tightened options quotes, and these narrower markets update at electronic speed, a human broker may not be able to create the required audit trail and get the cross on the tape before the market moves away from his predetermined price.

Given the slow speed of manual crossing on exchange floors, one would think that these brokers would use the ISE's electronic crossing mechanism instead. While the ISE certainly speeds up the process, its crossing mechanism presents a new challenge to cross-only order flow.

The problem for upstairs dealers is that they cannot attempt a cross electronically without exposing a customer's order to the price-discovery process via a three-second auction. Some floor brokers may simply inquire whether a cross can occur at a given level without actually exposing a customer order to the price-discovery process. If they find that other (non-paying) traders want to participate, the broker shops the order to different floors until he can find one where he can do the largest portion of the cross.