The options industry is edging toward a fight over access fees and payment for order flow. This was kicked off by a letter Citadel Investment Group sent the Securities and Exchange Commission on July 15, petitioning the regulator to impose a cap of 20 cents per contract on access fees for non-members executing against displayed quotations on exchanges. That letter caused NYSE Arca Options and automated market maker GETCO to go on the offensive.
Citadel’s missive took aim at take fees on maker-taker exchanges. These exchanges charge liquidity takers for removing liquidity from their books and pay providers of liquidity. “Requiring broker-dealers to send their orders to the markets displaying the best quotations while also requiring them to ignore the fees associated with obtaining access to those quotations would allow markets to charge excessive fees, and could result in executions at prices materially different from the displayed quotations,” Citadel told the SEC. Brokers executing orders in the options industry, as in equities, are prohibited from trading through better displayed prices in the market.
Citadel added that it was imperative the SEC “address distortions in the options market caused by the excessive take fees that may be charged by options exchanges using maker-taker pricing.” The firm said a cap would “ensure the effectiveness of quotations in the options markets and address many of the same concerns that the Commission addressed in the equity markets when the Commission adopted Rule 610(c) of Regulation NMS to cap access fees in those markets.”
Last month, NYSE Arca Options and GETCO separately argued that the SEC should reject Citadel’s plea, charging that Citadel was skewing the debate by ignoring the presence of payment for order flow in the options industry. GETCO called payment for order flow programs a source of “enormous conflicts of interest” and said those payments to retail broker-dealers are the “true cause of price distortions in the options markets rather than the transparent taker fees charged on maker-taker options exchanges.”
The four traditional exchanges typically don’t charge public customers for executions. Instead, they impose transaction fees on broker-dealers and market makers. They also facilitate payment for order flow. Through exchange-sponsored programs, market makers executing against customer orders on those exchanges are charged a marketing fee, which goes into a pool controlled by the market maker assigned to that option. That market maker periodically allocates payments to broker-dealers that provided the order flow.
Arca said the SEC should squash Citadel’s petition because it is “too narrow in scope” and doesn’t foster fair and orderly markets or transparency. Instead, Arca said, the SEC should conduct a “comprehensive study not only of the fee structures of options exchanges but also of the financial inducements offered by such exchanges to attract order flow.”
At the heart of the current debate are the take fees charged by three exchanges for executions in option issues that are in the penny pilot. These maker-taker exchanges are NYSE Arca Options, which has 12 percent of the industry’s volume, Boston Options Exchange, and Nasdaq Options Market. In early September, all three charged 45 cents per contract to take liquidity in options that are in the penny pilot. (The minimum spread for penny names if $1, since the minimum price variation is based on the option’s premium, which is calculated on a per-share basis, while a contract is typically for 100 shares.) Maker-taker exchanges earn the spread between the take fee they get and the liquidity provider rebate they offer market participants.
Citadel’s letter was prompted by NYSE Arca Options’ July 11 proposal to increase its fee for participants taking liquidity from its book in 10 “highly active” penny pilot issues through the Intermarket Linkage System. The proposal, which must be approved by the SEC, raises the fee to 55 cents per contract, from the current 45 cents. The proposal also raises the liquidity-provider rebates. A sister proposal to increase the fees and rebates on orders sent directly to Arca, filed on July 14, was effective immediately on filing, but has not been implemented. Citadel, a week after its initial letter, advised the SEC to reject Arca’s planned fee hike for intermarket linkage orders and abrogate the fee change for orders sent directly to the exchange.
Gary Katz, president of the International Securities Exchange, told Traders Magazine that the ISE is in favor of a take-fee cap. “We support the idea of a cap at some level, but what’s more complicated is what’s the right level,” he said. “We like the 30-cent cap [for 100 shares] in equities, but it’s not based on scientific reasoning. It’s just what we’re comfortable with.” Katz stressed that in options, unlike in equities, the sheer volume of discrete securities requires market makers to provide a lot of the industry’s liquidity. Take fees, he said, cut into market makers’ ability to do that. The ISE quotes 285,000 puts and calls, compared to around 3,000 securities traded on the New York Stock Exchange, according to the ISE exec.
Katz also pointed out that pricing differences between the two options market models have led to more locked markets, which is generally seen as harmful to market quality. In his view, dueling market models have yielded a “valid economic argument” for locked markets, in which a bid on one exchange is at the same price as an offer on another. “If I’m offering on a maker-taker market at the same price another person is bidding at on a non-maker-taker market, I don’t want to go to him [because I want to earn the rebate] and he doesn’t want to come to me [because he doesn’t want to pay the take fee],” Katz said. “So we’re not trading, and the incidence of locked markets is compounded as the take fee goes up.”
Randy Frederick, director of derivatives at Charles Schwab, also supports the idea of fee caps. “Our position,” he said, “is that if this caps the fees we’d have to absorb ourselves or eventually pass on to our customers, we’d support the petition.” He added that he’s not sure what the right fee level would be, but that he doesn’t expect a cap to be as low as 20 cents.
For NYSE Arca Options, access fees and payment for order flow are two sides of the same coin. “When a liquidity provider pays for order flow, that’s a cost and it must come from some place,” said Ed Boyle, head of Arca’s options market. “That place is the spread in the market.” In a maker-taker model, in contrast, the liquidity provider gets a rebate, so the spread in penny names can often be tighter. “The customer pays to take liquidity, but the benefit he gets is a tighter spread,” Boyle said. “It’s a tighter spread because the people providing the spread have a revenue stream coming toward the rather than a revenue stream going out.”
Boyle noted that his exchange doesn’t object to fee caps if the SEC plans to level the playing field across maker-taker and traditional exchanges. “The Commission should study fees across all market venues and models,” Boyle said. “The Commission must understand the relationship between access fees and payment for order flow fees, and the relationship of those fees in each market model to price, before making a decision about capping fees in a single market structure.”
Larry Leibowitz, head of global execution and technology at NYSE Euronext, voiced the same idea in NYSE Arca Options’ September letter to the SEC. “Both models recognize that order flow has value,” he wrote. “The maker-taker model coupled with its price/time priority market structure, and the PFOF model coupled with its directed order flow market structure, are simply two methods to determine who pays for and who receives this value.”
The SEC is studying this topic but doesn’t expect to resolve the issue anytime soon. Elizabeth King, associate director of the Commission’s Division of Trading and markets, said at an options conference on September 9 that she expected the industry to be discussing this issue next year. “The cash equities market,” she noted, “had evolved a great deal more than the options market has when the Commission took action [about access fees].”
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