Three options market-making firms have petitioned the Securities and Exchange Commission to require the four options exchanges that operate floors to expose large block trades to all market participants-both on-floor and off-floor-electronically.
Susquehanna International Group, Citadel Securities and Chicago Trading Company argue in their petition that investors are often hurt when firms execute large block orders-those of 500 contracts or more-on the floors of exchanges. That’s because the number of floor traders has decreased in recent years as electronic trading has taken hold.
With fewer traders on the floor, those orders that do hit the floor are subject to less price competition, the dealers argue. The floor exchanges need to expand their systems to allow competition from off-floor registered market makers to make up for this loss of liquidity on the floors.
“The exchanges can easily equip their systems to include an electronic block auction mechanism and give access to off-floor market makers,” Jerry O’Connell, Susquehanna’s chief compliance officer, told Traders Magazine. “It’s not that the floor exchanges are unable to provide the service, it’s that they lack the motivation to do so.”
Susquehanna et al. want the SEC to require all exchanges operating floors to steer their large block trades into so-called electronic facilitation systems accessible by off-floor traders. The greater level of competition that is expected to result would help ensure the customer gets the best price possible.
The three firms that authored the petition are all longtime options dealers that conduct a significant amount of their trading from their offices, rather than on the exchange floors. According to their petition, “less than 20 percent of overall market maker liquidity is now available for quoting in-person in the vast majority of floor trading crowds.”
Four options exchanges run open outcry auctions on physical floors: the Chicago Board Options Exchange operates a floor in Chicago; NYSE Amex Options runs one in New York; NYSE Arca Options runs one in San Francisco; and Nasdaq OMX PHLX runs one in Philadelphia.
In their petition, the dealers estimate that more than 30 percent of industrywide volume is comprised of trades of 500 or more contracts. These are typically done on exchange floors. The rest is traded electronically and automatically against dealer quotes. Most dealer quotes are large enough to accommodate trades of up to 500 contracts.
By and large, most trades manually executed on the floors involve large institutional orders that have already been matched with an off-floor liquidity provider before introduced on the floor.
A sparse trading crowd lets the brokers execute the trades relatively free of competing bids, which helps preserve the economics of the trade, which is often hedged with stock.
Brokers contacted by Traders Magazine would not speak to the issue.
Among the exchanges, the petition has its supporters and detractors. Gary Katz, president and chief executive of International Securities Exchange, is in favor. “It’s the right thing for the customer. It’s the right thing for the industry. And it’s the right thing for the market makers,” he told attendees at this year’s options industry conference in Las Vegas. “More and more of the business is being done away from them.”
ISE already operates an electronic facilitation system. It does not operate a floor.
At NYSE Euronext, operator of two options floors, Steve Crutchfield, head of options trading, is skeptical of the need for such a change. “We don’t believe investors are being disadvantaged,” he told reporters at a media briefing. “Plus, there is no evidence that investors would receive a better execution experience if everything was broadcast electronically. So, it’s not obvious to us that there is a problem to which this is a solution.”
Others disagree. Tom Wittman, head of Nasdaq OMX Group’s options exchanges, told conference attendees that empty floors are no different from dark pools that permit institutional brokers to trade against their customers’ orders without fear of competition.
Wittman said he was a proponent of electronic trading but still frets that any move to force exchanges to broadcast their block orders could hurt the institutional brokers and others that risk capital when bringing those orders to the floor in the first place.
“Any rule has to strike a balance that would preserve liquidity by not deterring firms from deploying capital to facilitate a contra-sided order,” Wittman told conference-goers.
Critics of the market makers argue that they could participate in the large block trades if they placed individuals on the floors or increased the size of their quotes. Dealers say privately that it would be prohibitively expensive to staff all the crowds on all four floors. The market makers’ petition notes that quoting in greater size exposes them to greater risk.
Upon receipt of a petition for rulemaking, the SEC is not held to any timetable. Public comments are permitted, however. Under Rule 192 of the regulator’s Rules of Practice, the SEC must only acknowledge receipt of a petition and notify the petitioner of any action it decides to take. The SEC has received about one petition per month over the last five years.
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