As you read this column, a life-or-death struggle is being waged in the option trading pits across the U.S. At the heart of this conflict is a controversial practice known as trade crossing. Trade crossing occurs in two distinct forms. The first takes place when a brokerage house becomes the counterparty to its customer's order. Alternatively, brokerage houses can also arrange for customers to become
order counterparties. In either scenario, the transactions are arranged prior to reaching the exchange and involve little or no market maker participation.
Trade crossing has sparked a fierce debate. Opponents of the practice – primarily market makers – believe it is a direct usurpation of their role as liquidity providers. Supporters of the practice – primarily brokerage houses and exchanges – believe that trade crossing brings in more revenue, increases trading volume as well as customer satisfaction. As with most debates, the most reasonable position is in the middle.
Here's how trade crossing works: Brokerage houses, looking for counterparties for their orders, show the orders to other customers. This is a practice known as shopping. Since it is time-intensive, it was initially done on a very limited basis. However, as competition intensified, many firms began to look for alternative sources of revenue. The double commissions generated by trade crossing, as well as the customer goodwill fostered, made it an irresistible lure. Today, most large option orders are repeatedly shopped before they ever reach the trading floor.
According to most market makers, early access to critical information is a primary benefit of exchange membership. Exchange members are usually the first to learn about significant orders and the first to see trends develop. However, these benefits vanished when brokerage houses began showing their orders to other customers. Order shopping gave non-members access to order information before it was revealed to market makers and other exchange members.
Over time, the tracking of customer and brokerage positions, a necessary function for market makers, was obscured by the large volume of shopping and crossing activity. It became virtually impossible to determine which side of a trade represented the customer; whether the customer was opening or closing positions and who took the other side of the trade. As a result, it became difficult to identify trends and inefficiencies in the marketplace. In addition, since crossed trades are counted as regular volume in the daily volume reports, option traders can no longer distinguish true customer activity from "fake" crossing activity. Many traders have put on positions in products only to discover that the bulk of that product's volume is crossed off the trading floor.
The options exchanges had always tolerated trade crossing as a way to facilitate customer transactions. Nevertheless, they took steps to regulate the practice. Trades could not be crossed on the bids or offers disseminated by the market makers. Brokerage houses had to provide the market makers with a chance to participate in the trade.
Heated Battle
But, with the advent of multiple listing in 1999, options exchanges soon found themselves locked in a heated battle for trading volume. All trades, including crossed trades, were fought over bitterly. The exchanges even began to pay member firms to route orders to their trading floors. The Designated Primary Market Maker (DPM) system was also adopted by the exchanges. The DPM system decentralized the functions of the exchanges, making DPMs responsible for most of marketing, trading and regulation activities in their products.
Consequently, old restrictions on trade crossing were tossed aside as individual DPMs struggled to attract more business. Soon, trades could be crossed on the bid or offer prices as long as the market makers received a chance to participate.
This stipulation sounded good in theory, but it fell apart in practice. Most brokerage houses shopped their orders repeatedly before they routed them to a particular exchange. As a result, many of their orders arrived at the trading pits with counterparties already attached. This left little room for the market makers, floor traders or DPMs to participate. If the exchange members protested or tried to block the trade, the order was routed to a more lenient exchange with a DPM that needed the volume. Market makers and floor traders, armed with precious little leverage, found themselves in an increasingly untenable situation. They could remain silent and allow the transactions to take place without participating, or block the trades and risk losing a significant percentage of their trading volume.
Despite these difficulties, most market makers do not mind surrendering a portion of their volume to facilitate legitimate customers. Market makers know that customer facilitation generates the repeat orders that are the lifeblood of their business. However, a recurring complaint among trade crossing opponents is that the practice blurs the line between legitimate customers and competing traders. Legitimate customers are rightfully afforded order priority on every major options exchange. However, in their rush to generate crossing revenue, many brokerage houses began to shop orders to their proprietary trading desks, as well as to other trading firms and even market makers. Exchange market makers were then expected to step aside while these "customers" took the other side of their trades.
This put the exchanges in an unenviable position. They were obligated to protect their members from predatory trading practices. On the other hand, they also had to defend their businesses during a period of unprecedented change in the options industry. Crossed trades account for one-third to one-half of the average daily volume in some products. No exchange can afford to lose that business. Exchanges begrudgingly accepted the fact that a significant portion of their volume was taking place without market maker participation.
Trade crossing has been both a boon and a bane to the options industry. Options orders that never would have been filled a decade ago are now finding counterparties. Customers are also receiving better prices on many of their transactions. Crossed trades have also provided a steady source of revenue for the brokerage houses and exchanges during an otherwise tumultuous period.
Still, trade crossing has greatly diminished the revenues of floor traders and market makers. This change is indicative of a fundamental shift in the options industry. Market makers are no longer the sole providers of liquidity in the marketplace. By crossing a significant portion of their order flow, brokerage houses have become major liquidity providers. The outcome of this shift is still impossible to predict. Some industry analysts believe that the growth of trade crossing will lead to tighter bid/offer spreads and, therefore, to greater liquidity in the marketplace. Other analysts believe that the resulting loss of experienced trading firms and professional market makers will lead to wider markets and an overall loss of liquidity.
Mark Longo is an options trader and a former member of the Chicago Board Options Exchange.