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December 14, 2009

2009 Review: Penny Pilot Expanded

Washington Strikes Back

By Peter Chapman

As it was in the cash market, so it will be in options.

The Securities and Exchange Commission in September approved a plan by NYSE Arca to expand trading in penny increments to nearly 400 options classes. The move, which prompted the other six options exchanges to follow Arca's lead, will affect trading in options accounting for nearly all industry volume.

From late October/early November, the seven options exchanges have promised to roll out 75 options classes every three months until next summer. That would increase the current total of 63 classes traded in pennies to 363 over the period. Today, trading in pennies accounts for 50 percent of traded contract volume. When the rollout is completed, penny trading will account for about 85 percent of volume.

The switch to pennies, begun in January 2007, was largely driven by the SEC. Arca, however, has always been a strong supporter of the move, as it has hoped to profit from a business model that differs significantly from that of the traditional exchanges.

How much more business Arca and its ilk--with their price-time priority, maker-taker pricing models--will gain under the expansion of the "penny pilot" is not clear, though. While Arca's market share in penny names is higher than its total market share of about 12 percent, it has not benefited in proportion with the growth in penny-traded volume.

About 82 percent of industry volume is still traded on traditional platforms. That figure has actually risen in the past year from 79 percent.

Still, the traditional exchanges aren't remaining complacent. Both Nasdaq OMX and NYSE Euronext operate both market models. The Chicago Board Options Exchange is expecting to win approval soon from the SEC for its C2 exchange, which is likely to incorporate maker-taker pricing.

"Nobody really knows whether classic market model will be the survivor or whether the maker-taker model might actually end up growing in the future," Ed Provost, a CBOE executive vice president, said at this year's Security Traders Association national convention.

Behind the inertia on the maker-taker side, industry sources contend, is the fact that retail brokerages are reluctant to send their trades to maker-taker exchanges as trades there would cost them more. While some observers are expecting volume to eventually split 50-50 between traditional exchanges and maker-taker platforms, others believe the share of the traditional markets will drop to no less than 70 percent.

The switch to trading in pennies by the options industry follows a similar switch by the cash equities industry in 2001. The impact in cash equities was transformative. The move collapsed spreads, drove market makers out of business and generally accelerated the move to electronic trading. To a large extent, human traders were replaced by machines.

On the options side, the toll on market makers has also been harsh. Spreads have collapsed, benefiting the strongest and most technologically sophisticated dealer firms. Electronic trading is gaining in popularity, but so far, market makers are holding on. There simply isn't as much liquidity in options as there is in equities to do away with dealer services entirely.

The expansion of the penny pilot--it is still under SEC review in "pilot" form--means options trading for less than $3 will trade in pennies. Those trading for $3 or more will trade in nickels.

NYSE Arca's plan was opposed by many traders and exchanges. The Chicago Board Options Exchange and the International Securities Exchange, for instance, wanted to see a rollback of the pilot so that fewer options traded in pennies. The move to pennies has reduced displayed liquidity at the inside, making it harder to get large trades done, NYSE Arca's detractors argued.

Supporters argued that retail investors have gotten better fills in those names trading in pennies and thus the pilot should be expanded. TD Ameritrade, for one, supports expansion of penny names.

Behind the SEC's approval of the NYSE Arca proposal, the regulator said, was the fact that "allowing market participants to quote in smaller increments has been shown to reduce spreads, thereby lowering costs to investors." The penny pilot, which began in January 2007, ended on Oct. 31. The SEC approval order extends it to Dec. 31, 2010.


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