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June 1, 2012

Walls Coming Down?

By Peter Chapman

Should a firm's options market makers be allowed to work together with its stock market makers?

Options exchange rules explicitly bar the sharing of information between a brokerage firm's options and stock market-making units, but some executives question whether the rules are outdated.

Recently, the options committee of the Securities Industry and Financial Markets Association took up the issue. "In some cases, the information barriers that separate equities and options market makers are appropriate," Jim Boyle, head of the SIFMA options committee and a UBS executive, told the crowd at this year's Options Industry Conference. "But in other cases, these two businesses are actually complementary and operate as one. We're going to take a look at that."

Exchange rules require firms to keep their stock and options market-making units physically separate and to develop procedures that prevent the sharing of "material non-public" information. The goal has been to prevent either department from gleaning order flow information from the other that could be used to the advantage of the dealer over his customers.

The rules date to the days when trading took place on exchange floors. A specialist or market maker stood in the center of a crowd swirling with information, giving him advantages others didn't. The fear was that a New York Stock Exchange specialist, for instance, could place a phone call to his counterpart in the pits at the Chicago Board Options Exchange-or vice versa-and relay important order flow information. His counterpart could use that information to reprice his merchandise to his advantage. "Can you imagine?" said a source. "He would run everybody over."

The rules were generally accepted, and firms with both stock and options market-making units structured themselves accordingly. Some firms maintain two broker-dealers-one housing the options dealing unit, the other housing the stock trading. Others, maintain a single broker-dealer, but segregate their trading desks into "aggregation units."

The shift away from floor trading to making markets electronically on upstairs desks in recent years has changed the picture, the proponents of change claim. Because the crowd is diminished and upstairs desks are isolated, dealers have considerably less information than they used to. That makes them less of a threat.

Others note that there is still plenty of activity on exchange floors-especially in the CBOE's index pits. Therefore, the rules governing information sharing should not be discarded altogether. Some sort of bifurcation between on-floor and off-floor trading may be appropriate.

Either way, some argue, market makers will be able to make better markets for their customers if they can coordinate their stock trading with their options trading. "Who's in a better position to be a market maker in the underlying than the guy with the options position? And vice versa?" one dealer asked. "A delta is a delta."

Simultaneously receiving an order for shares in Apple from one customer and options on Apple stock from another is no different from receiving two orders for Apple shares from two different customers, the trader said. Either way, the market maker is required to give his customers best execution. He is not allowed to use the information gained from the first customer to the disadvantage of the second.

If the two desks were freed to cooperate with each other, a firm would gain at least two advantages. First, it could more efficiently manage its exposure to a company by netting its stock and options positions throughout the day. Second, it could more efficiently fund those positions. Rather than separately fund two books, it could simply manage one, a source said.

Any rule change could result in the merger of a firm's options desk with its stock desk. It could even lead to a single individual making a market in both a company's stock and the options on that stock. At least one exchange executive says he is amenable to working with SIFMA on the issue. "We are certainly eager to modernize where doing so would help our participants," Amex chief executive Steve Crutchfield said at a recent press briefing.

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