The options industry’s penny pilot is driving trades away from the exchanges.
According to an executive at one of the options industry’s largest market-making firms, large institutional trades in those options subject to the ongoing penny pilot are increasingly getting done over the counter and not on an exchange.
“Traders are having a very difficult time putting trades on the tape,” Kevin Murphy, a managing director in Citi’s derivative execution services group, said recently. “It is one of the unintended consequences of the penny pilot.”
Printing large trades on exchanges has become difficult for dealers, because penny ticks have made it easier for other traders to better their prices. And because exchange rules forbid dealers from trading through better prices, they are unable to print their negotiated institutional trades.
A dealer bringing a 1,000-lot trade down to the floor, for example, hoping to print it at $1.18 per contract, could be thwarted by a subsequent bid of $1.19 for, say, 10 contracts. If someone is willing to pay more than $1.18 per contract, then the dealer is prevented, under exchange rules, from trading at that price.
“That has become a big problem for the less-liquid larger institutional orders,” Murphy told attendees at the annual New York Equity Options Conference, sponsored by the Futures Industry Association and the Options Industry Council.
So, rather than take these large orders to the floor, dealers at Citi and other large trading houses are trading off-board, according to Murphy. The exec noted at the September conference that Citi has opened up “significantly more OTC derivative accounts in the past three months than in the past year.” The practice is not widespread, however, Murphy said.
Still, there is pressure to do more trading off-board. Sources tell Traders Magazine there is interest in setting up trade-reporting facilities in the options industry. These TRFs, which allow dealers to print without trading on exchanges, are permitted in the cash equities space. The exchange printing of trades done off-board is not permitted in the options industry because of rules set by the Options Clearing Corp., the industry’s clearing and settlement organization, owned by the six exchanges.
Trading in penny, rather than nickel, increments began in January with 13 classes. The program was recently expanded to another 22 classes. Now about 35 percent of industry volume is traded in smaller increments. In March, another 28 classes will be added. All told, those 63 classes will represent about half of the industry’s volume.
