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April 3, 2008

Redoing Ties that Bind

Options exchanges revamp linkage

By Peter Chapman

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Trading large lots could get easier under a plan being put together by the industry's options exchanges. The International Securities Exchange and NYSE Arca, hoping to speed up trading in a marketplace that has become much more fragmented under the "penny pilot," are spearheading a redesign of the industry's Options Linkage Plan. The proposal is intended to make sweeping multiple exchanges faster for large-lot traders by incorporating elements of the equities market's Regulation NMS. "We have a consensus of all the exchanges to move forward and replace our current

linkage with a more Reg NMS-like linkage plan," says Mike Simon, the ISE's general counsel and chief regulatory officer. "I think one year from now, we will have it implemented."

The need to trade quickly on more than one exchange has become more urgent now that almost 40 percent of the industry's volume is trading in 1- or 5-cent ticks. The change to smaller increments in the past year has caused spreads to collapse and size to disperse to multiple price points across six exchanges. By the end of the month, a total of 63 options classes could be trading in the smaller increments, representing at least half of the industry's volume.

Riskier Market

While retail investors are thrilled with the sharp decrease in spreads wrought by penny trading, institutional investors are flummoxed by the equally sharp drop in size at the inside market. Where there might have been 10,000 lots offered top-of-book in near-term QQQQ contracts, now there may only be 1,000, as dealers rein in their quoting in the riskier market.

Also, the dispersion of that liquidity could be across as many as six (soon to be seven, when Nasdaq Options Market opens its doors) options exchanges. So while a trader might find the size he wants on the Chicago Board Options Exchange, he may have to trade against quotes on other exchanges if they are better priced.

That's because, like the equities market, the options market has an intermarket trade-through rule. It forbids traders from bypassing the market's best quotes, even if they are in a hurry.

And they are in a hurry. "The institutional trader is forced to wade through meaningless top-of-book prices to get to the quote he wants," says Tony Saliba, president and CEO of LiquidPoint, a unit of institutional brokerage BNY ConvergEx. "And by the time he does, due to linkage, the ultimate price he wants is gone."

While there is technology available to quickly sweep multiple exchanges-LiquidPoint offers something called DeepSweep-the sweep can still take precious seconds. That's because traders still wait for reports of fills to come back from other markets before trading at inferior prices. And, by rule, exchange dealers have three seconds to fill incoming orders. By the time the reports come in, that sizable quote could be gone.

The ISE and NYSE Arca submitted a plan to the Securities and Exchange Commission last September called the "Options Order Protection and Locked/Crossed Market Plan." If approved, it would replace the current linkage plan established in 1999. The current plan involves a set of rules governing order types and an order-routing system operated by the Options Clearing Corp. The plan is overseen by the Options Linkage Authority, which is made up of members from the six exchanges. (Nasdaq also attends meetings.)