The Chicago Board Options Exchange and International Securities Exchange are fighting a regulatory push to ban flash orders in the marketplace. Their argument is that flash orders lower costs for retail brokers. The orders do this, the exchanges argue, by enabling traditional pro rata exchanges to match the price on exchanges with price-time priority models and maker-taker pricing, but without charging retail brokers a fee.
A change to flash orders could have a "significant impact on the options industry," said Ed Provost, executive vice president at the CBOE. Speaking at a Security Traders Association conference in October, he said: "We are very concerned about the Securities and Exchange Commission tinkering with the ability of an exchange to step up to a price even if we’re not showing the best price on the screen at the time we receive the order."
The SEC in September proposed a rule that would eliminate flash orders on securities exchanges. The regulator, reacting to harsh criticism of the practice in the cash equities industry, is concerned that flashing marketable orders to those receiving an exchange’s market data feed could create a two-tiered market. But it asked market participants to comment on how the elimination of flash orders could affect exchanges in the options industry.
The CBOE, ISE and other pro rata options exchanges use flash order mechanisms to keep orders at their exchanges. This functionality, Provost noted, allows market makers to step up and improve the price, "just like we do in open outcry every day." Flash orders are marketable orders sent to an exchange that is not quoting the market’s best price. Those orders are flashed briefly to the exchange’s participants in the hope that market makers will trade against the orders at the industry’s best price. If that doesn’t happen, the exchange routes the order to the market quoting the best price.
Gary Katz, CEO of the ISE, has stressed to SEC commissioners in visits to Washington, D.C., that flash orders in the options marketplace work differently than they do in cash equities because of the competing market models in options. On the cash equities side, all market centers operate price-time priority markets, typically charging liquidity takers and rebating liquidity providers. On the options side, public customer orders do not get charged for executions. They also trade ahead of other participants.
Price-time markets tend to have better prices than pro rata exchanges about 10 to 15 percent of the time, Katz said. He noted that in those cases the fee on maker-taker exchanges is less than the price improvement they provide, which benefits customers. But he added that allowing pro rata exchanges to offer flash mechanisms provides an even better deal for those customers.
NYSE Arca, a price-time exchange with maker-taker pricing, argues that its market and pricing model are more transparent than pro rata models that operate payment-for-order-flow programs. In its view, an exchange quoting the best price alone should get marketable orders because it established the best market.
To service and attract public customer flow, both the CBOE and ISE pay some or all of the take fee when orders that can’t be matched in their markets are routed to maker-taker exchanges. Enabling retail brokers to get cheaper executions helps ensure that public customer orders come through the exchanges’ doors to seek executions. Flow from public customers is considered attractive flow to market makers.
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