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December 1, 2012

Beauty Contest

Traditional exchanges beat newer rivals on four measures

By Peter Chapman

Mirror, mirror on the wall, who's got the best marketplace of them all?

According to recent statistics published by Tabb Group, that honor goes largely to the group of four traditional pro rata options exchanges. On average, they bested their newer, time-priority rivals in four categories that purport to measure market quality.

The common thread, industry executives tell Traders Magazine, is the fact that all four of the pro rata exchanges operate payment-for-order-flow (PFOF) schemes. Because the market makers on these exchanges are, indirectly, paying retail brokerages for their orders, they have an incentive to quote large size at tight spreads. That way, when the orders come streaming in, they are more likely to interact with them.

"Market makers make their living off of retail flow," explained Brian Donnelly, chief executive of market-making firm Volant Trading. "So they have a big incentive to quote tight markets on those exchanges where they interact with that flow, which, because of preferencing, tends to be directed to the pro rata exchanges."

Tabb publishes an "Options Liquidity Matrix" every month, detailing the market shares and execution quality of the industry's 10 exchanges. The data comes from Hanweck Associates, a vendor of data and risk analytics software.

The four pro rata exchanges the matrix covers are the Chicago Board Options Exchange, NYSE Amex, Nasdaq OMX PHLX and the International Securities Exchange. The six time-priority exchanges covered are the Nasdaq Options Market, BATS Options Exchange, BOX, Nasdaq OMX BX, NYSE Arca and C2, also operated by the Chicago Board Options Exchange.

Key market-quality statistics include the average bid-ask spread; the percentage of time the exchange is at both the best bid and offer; the average quoted size; and the average trade size.

In general, the pro rata exchanges, which allocate incoming orders to liquidity suppliers based on the size of their quotes, best the time-priority exchanges, which allocate incoming orders to liquidity suppliers based on their rank in the queue, in all four categories.

In October, the pro rata exchanges had the tightest spreads. They spent the most time at the inside quote. They quoted the most size. They reported the largest trades. Exchange operators and other industry players offered various reasons for the stark differences among the two exchange groups. The most consistent explanation was that the practice of paying for flow wedded the large market makers to the pro rata exchanges.