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July 1, 2008

Stung, Options Market Makers Send Out SOS

By Peter Chapman

Traders in the options industry, under siege from structural changes, are calling on exchanges and regulators to change their rules so that they can survive in the rapidly changing business.

New developments such as pennies, access fees and hidden orders are taxing market makers' ability to get trades done, as well as cutting into their profits. They can adapt, they say, but need rule reform to make it possible.

"There will have to be significant rule changes," said John Smollen, a managing director and institutional options trader at Goldman Sachs. "Facilitation rules, solicitation rules, the 40 percent [order allocation] guarantee....All must be challenged and changed before the industry adjusts." Smollen was speaking at a recent Securities Industry & Financial Markets Association conference.

Most of the changes hitting the options industry these days comes from the switch to trading in penny increments. The initiative, driven by the Securities and Exchange Commission, has flattened spreads and scattered liquidity. That's benefited retail orders, but made it harder to get large trades done and cut into dealer profits.

The net result of the switch to pennies, which now account for about half of all contract volume, has been to reshape the options market along the lines of the cash equities market. According to TABB Group: "Slowly but surely, options trading is transitioning from a quote-driven market where liquidity is provided by market makers to an order-driven market with liquidity being provided by natural market participants."

Pennies have also led to the adoption by exchanges of pricing schemes used in the equities market. Their "take" charges have hit some market makers hard in the pocketbook when they are forced to send their orders away to those exchanges.

The practice of so-called maker-taker' exchanges to charge traders access fees has prompted calls for SEC action to outlaw or cap the fees. "In the options market, there is a linkage mandate to route out to an exchange based on their displayed price," Matt Andresen, president of market maker and wholesaler Citadel Execution Services, told the SIFMA crowd. "But there is no access-fee cap as there is on the equities side. Access fees can literally be half the spread. Clearly, something has to break. The easiest and quickest partial fix is to introduce the same kind of cap we have in equities."

Andresen's cry for fee caps, however, pales in comparison with his questioning of the sacred cow of the options industry: mandated exchange prints. Unlike equities, all trades must be brought to the floor of an options exchange. In other words, brokers are banned from internalizing, or trading against their customers' orders in-house. They must expose them to competition on exchanges.

But with the options market starting to function more like the equities market, Andresen wonders if the time is ripe to permit brokers to move some of their business in-house.

"If we are so far down the road to make options look like equities, what is the reasoning not to just make it exactly like equities?" Andresen asked. "Why not go all the way and make internalization the stated, as well as the implicit, role of the markets?"

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