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December 8, 2008

2008 Review: Options Biz Gets Access-Fee Fight

Turbulent Times

By Nina Mehta

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A battle royale is brewing in the options world over exchange market models and fees. This year's big skirmish was set off in July by a rule-making petition Citadel sent the Securities and Exchange Commission.

In that appeal, Citadel asked the SEC to impose a 20-cent-per-contract cap on take fees at options exchanges. The request came on the heels of NYSE Arca Options' rule filing to increase its take fee for certain highly active options to 55 cents per contract, from 45 cents. Arca did that to increase its liquidity-provider rebates and thereby attract more-aggressive quotes to its market.

In response to Citadel's request, Interactive Brokers and others shot back that what's good for the goose is good for the gander. They argued that payment-for-order-flow programs sponsored by exchanges are also access fees in kind that market makers must pay to retail brokers. Arca's petition, wrote David Battan, an executive vice president at IB, "is deafeningly silent regarding private payment for order flow arrangements, which would remain completely uncapped, unlimited, unfettered, un-interfered with and off the books."

The take-fee fight is a consequence of the penny pilot, in which options under $3 are quoted in penny increments (which translates into a minimum $1 spread). Maker-taker pricing on price-time priority exchanges has enabled NYSE Arca Options, Boston Options Exchange and, more recently, Nasdaq Options Market to narrow the spreads in those names by offering participants incentives to make tighter markets.

However, that hasn't resulted in much additional market share: The three exchanges had 18.8 percent of overall options volume through October of this year, up from 17.9 percent for price-time markets last year. A big reason for this is that market makers on the traditional pro rata exchanges are able to match the better quotes on away markets to avoid routing flow out and paying the take fee on that market. But doing so crimps the profits of firms such as Citadel, the largest options market-making company.

Although Arca's proposed take fee is less than the minimum spread, Citadel argued that high take fees at "outlier" exchanges "could result in executions at prices materially different from the displayed quotations," and could lead to more locked markets. Citadel said an options fee cap would follow the lead established by the SEC in the equities market.

NYSE Arca Options, the Boston Options Exchange, GETCO, Wolverine Trading and IB penned comment letters opposing Citadel's position. They also opposed any limits on the take fees that exchanges charge for executions that remove liquidity from their books, as long as the fees don't exceed the spread.

IB didn't mince words: "Although clothed in the language of the public interest, Citadel's petition for a Commission-imposed cap on Take Liquidity fees is an attempt to strangle the Maker/Taker exchanges in their cribs by limiting the Take Liquidity fees that these exchanges can charge and therefore limiting the Make Liquidity rebates that these exchanges can pay to liquidity providers that narrow the NBBO." BOX argued that maker-taker exchanges encourage narrower spreads than pro rata markets.

Most critics of Citadel's petition agreed that if the SEC considers a cap, it should pull exchanges' payment-for-order-flow programs under the same umbrella. Both types of fees, they said, are inducements to send flow to a specific exchange.