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February 18, 2010

C2 Will Combine Market Models

By Peter Chapman

The Chicago Board Options Exchange is offering details about the operation of its new options exchange.

Ed Tilly

C2, as the exchange is called, will allocate trades on a pro rata basis as well as a price-time priority basis, depending on the option being traded. It will not, as previously thought, be strictly a price-time priority exchange, as most new options exchanges are.

"C2 gives us the flexibility to try different things in different classes," Ed Tilly, a CBOE executive vice chairman, said at a recent press briefing. "On a class-by-class basis, we can try new [allocation] algorithms, new pricing structures and new models."

The guts of any exchange are its trade allocation rules, its pricing and the extent of market-maker participation. In C2's case, the CBOE hopes to encourage dealer participation as well as foster an environment where orders can meet orders without dealer intervention.

CBOE's flagship exchange uses the pro rata allocation model exclusively, which favors market makers quoting large size. Under the scheme, incoming orders are parceled out to quoters in relation to the size of their quotes.

With C2, the exchange operator hopes to apply the pro rata model to trading in some classes while using the price-time priority model in others. Price-time priority, which allocates trades to those first in line, generally works best in the more liquid names.

The rules of CBOE's flagship exchange also permit the exchange operator to vary the trade allocation model on a class-by-class basis, but, in practice, all options are traded on a pro rata basis.

With C2, both the pro rata and the price-time models can be modified with certain "overlays" that grant priority to different traders, such as customers and so-called market turners.

Tilly said some of C2's rules that favor dealers may be in jeopardy if the Securities and Exchange Commission decides to ban the options exchanges' use of step-up, or flash, orders. The regulator proposed a ban on the orders last year, but has yet to rule.

The SEC approved C2 in late December. The exchange is expected to go live this summer.


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