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July 1, 2010

Cover Story: Reversal of Fortune

Options Market Makers Catch a Break on Fees as Customers Pick Up More of the Tab

By Peter Chapman

The rules of the game are changing.


For most of their history, ever since the Chicago Board Options Exchange was created in 1973, the nation's options exchanges have looked to market makers for their revenues. In return for a dominant role at the exchanges, market makers paid the lion's share of the fees. Customers, on the other hand, traded for free.


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That arrangement is now breaking down. Market makers pay exchanges less often to trade. And when they do pay, the fees are lower. To make up the shortfall, the exchanges are looking to the industry's customers--by way of their brokers--to pay.

"In the past, market makers were making enough money that they could afford to bear the costs," said Slade Winchester, a director in Citigroup's U.S. equity derivatives division. "But markets have tightened up to a level where market makers can't continue to bear the cost and make tight markets. So the costs are shifting."

The shift is significant. The exchange structure was founded on the principle of giving the customer the advantage in his dealings with the marketplace. To allay fears that the options market was a rigged game, the industry gave customers priority over all other traders; plus, it let them trade for free.

In addition, the industry adopted the practice of paying brokers for their orders. Exchanges collect a "marketing" fee from market makers every time they trade against a customer order. Then, once a month, the exchanges distribute those fees to retail brokers. According to the brokers, the practice benefits the customers: It keeps commissions low and allows the brokers to improve their services.

Tom Wittman, Nasdaq

All of this is being upended because market makers are making less money. Both the switch to trading in penny increments in January 2007 and stepped-up activity by high-frequency traders have cut into dealer profits. That has made the dealers less willing to shoulder the entire burden of supporting the exchanges.

Almost 90 percent of industry volume is now being traded in options subject to the "penny pilot." With the minimum trading increment down from 5 cents to 1 cent in the most active options, competition has cut dealer spreads dramatically.