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October 1, 2010

Bump in the Road

By Peter Chapman

Everything was going according to plan for the options industry's newest exchange until it wasn't. BATS Exchange launched in late February, completed its rollout by June and was steadily growing its market share. Then it stumbled.

Jeromee Johnson

In August, the exchange operator and some of its customers discovered BATS had overcharged those customers for orders routed to other exchanges. The aggregate amount was in the tens of thousands of dollars, said Jeromee Johnson, head of BATS's options exchange.

"We significantly overbilled some clients," Johnson said. "We gave ourselves a black eye."

The error, which took nearly three weeks to resolve, caused those firms affected to cease routing orders to BATS. That hurt. The exchange's options market share, which had reached 1.2 percent in July, fell to about a half percent in August. It remained there through mid-September.

BATS' original target was a year-end market share of 3 percent, a goal Johnson admits will now be tougher to reach.


A Price-Time Model

Besides the public relations gaffe, the options marketplace is extremely competitive with eight-soon to be nine-exchanges vying for order flow.

Making things even harder in this dealer-dominated industry is the preference of market makers for exchanges that allocate trades based on the size of their quotes, and not on their standing in the queue.

In contrast to the traditional price-size priority model, BATS launched a price-time model. First introduced four years ago by NYSE Arca, the model has never garnered more than 20 percent of industry volume. And that's despite attractive pricing for market makers.

Dealers have largely shunned it because they need to interact with their customers' order flow. And it's easier to be on the receiving end of those orders if they don't have to always be first in line.

Johnson is unperturbed. "The easiest way to have dealer-to-client interaction is to make sure the dealer is at the best price," he said.

Still, BATS is not aggressively seeking quoters. At 20 cents per 100 shares, its rebate is among the lowest, or least competitive, in the industry. By contrast, it has courted liquidity takers with a very competitive access fee. A coming price reduction for its outbound routing service will further encourage liquidity takers to check the BATS book.


Pleasing Black Box Users

Time priority does have its fans, of course, especially among those brokers catering to traders using high-frequency strategies. "Firms deploying high-volume black-box strategies are coming into the options space," said Jeff Wecker, Lime Brokerage's president and chief executive. "There's been significant growth in volume in the past few years." Lime is a minority investor in BATS.

Brokers serving less frequent traders also like having different exchange models to choose. Interactive Brokers, for instance, caters to do-it-yourselfers-they are active, but not overly. Kevin Fischer, in charge of options block trading at the firm, is happy with the choices that all the competition brings. “If you are a sophisticated broker and you have a sophisticated routing matrix, it works well for you,” he said.

The trading veteran added, however, that with BATS’s small market share and lack of liquidity, the exchange needs to do something to get on traders’ radar.


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