Nasdaq’s plan to incorporate hidden orders in its proposed options exchange has enraged many of its competitors, who claim the idea will undermine the progress they have made in growing the business. Those exchange executives contend that by encouraging internalization, dark liquidity has hurt the equities market and shouldn’t be allowed across the threshold of the options industry.
The latest fracas over dark, or hidden, liquidity emerged in the run-up to Nasdaq’s planned December 7 launch of its Nasdaq Options Market, which was scheduled to include
various types of non-displayed liquidity. However, that launch was scuttled in early December, since the Securities and Exchange Commission had not approved Nasdaq’s proposal in time.
The industry “should not move wholesale toward a market structure that destroys something all of us have been working toward,” insisted David Krell, president and CEO of the International Securities Exchange, in November. In his view, dark liquidity undercuts price discovery and compromises the transparency that has contributed to the options industry’s tremendous growth over the last seven years.
Strong Reaction
Executives at the Chicago Board Options Exchange, Philadelphia Stock Exchange and American Stock Exchange also expressed strong reservations about dark liquidity at the Futures Industry Association Expo in late November. They spoke on a panel that included the heads of the seven options exchanges.
One of several controversial components of Nasdaq’s options exchange filing, which was submitted to the SEC a year ago and updated in April, was the introduction of what Nasdaq termed a “price-improving order” for options. That order type would enable a Nasdaq Options Market participant to submit a penny-priced order to the exchange for an option with a nickel-minimum increment. If the price were within the increment, the order would be held in Nasdaq’s book for potential matching against an incoming contra-side order, but would be displayed publicly at the allowable nickel increment.
Nasdaq’s filing included both hidden and reserve orders. Currently, only NYSE Arca Options allows reserve orders, although the ISE has asked the SEC to allow reserve orders in its market as well. No options exchange has hidden order types that allow participants to conceal their best prices or to execute automatically against existing liquidity within the quoted spread. The options industry also does not allow brokers to internalize orders, which is a common practice in equities trading. This has prevented crossing platforms, ECNs and broker-dealers from competing with the listed displayed markets at options exchanges.
Adam Nunes, head of the Nasdaq Options Market, said in December that Nasdaq’s proposed price-improvement process is “both fairer and faster” than existing mini-auction processes at other exchanges, which currently enable executions within the spread. “Nasdaq’s system allows for price improvement of all incoming orders and our system does not delay the execution of the incoming orders,” he added. Nunes said Nasdaq is confident its options exchange will be approved with its price-improving orders, and that the exchange will launch early this year.
Kevin Murphy, head of U.S. broker-dealer sales at Citi, observed that Nasdaq’s price-improving orders represent a big change from the current tools available on options exchanges. “If this gets approved, it will be a major change in market structure in the options industry,” he said in November.
The First Domino
Nasdaq’s price-improving orders could also be the beginning of a broader shift. Other exchanges would likely feel compelled to offer similar order types, to prevent Nasdaq from getting an edge over their markets, according to Joseph Sellitto, marketing director for listed options at Susquehanna International Group. The industry would be “encouraging people not to show their hand,” but to hide their quotes and liquidity, he said.
Anthony McCormick, vice president of equity options at Charles Schwab & Co., criticized Nasdaq’s plans. He said the potential of having a resting penny-priced order in a name restricted to a nickel increment would confuse customers. Customers who placed such orders on the Nasdaq Options Market wouldn’t understand why their better-priced orders weren’t filled if displayed orders elsewhere, priced at the increment, got executed instead, he explained.
At the November conference, Nunes pointed out that the options industry “really can’t have [automated] price improvement without dark liquidity” for options whose minimum spread is a nickel. Nasdaq’s price-improving orders, he said, provide a “tool for institutions to get size done” without showing their hand. “Even if we’re not the preferred destination,” Nunes said, institutions could check Nasdaq’s market for liquidity within the spread before routing to other exchanges.
Check Here First
The idea that customers seeking price improvement should route to Nasdaq first, when other markets are displaying orders at the national best bid or offer, didn’t sit well with the other exchange leaders. “We think that is absolutely the wrong way to go,” said the ISE’s Krell about using dark liquidity as an enticement to win order flow in the options market. “Now we’re moving backwards.”
In Krell’s view, Nasdaq’s argument reflects the comfort in the equities market with internalization, which is not allowed in options. He added: “We think, philosophically, that’s the wrong thing to do.” Unlike in equities, all options trading must take place on an exchange, with orders exposed to the crowd for price improvement. In options, Krell said, “everything is done not opaquely, but transparently.”
Michael Bickford, senior vice president in charge of options at Amex, added that “hidden liquidity opens up an opportunity for gaming.” He also feared that Nasdaq’s plan would encourage people to “send in IOCs [immediate-or-cancel orders] for no reason.” Those IOC orders would add to the rush of options message traffic, which exchanges are currently trying to limit.
Others were less sanguine about dark liquidity more generally. “Dark pools on either side–equities or options–are a train wreck waiting to happen,” said Meyer “Sandy” Frucher, CEO of the PHLX. He added that competition and technology push markets in that direction, but said the SEC should rethink what he called its “laissez-faire” attitude toward dark liquidity. So far, the SEC has not put significant limits on hidden liquidity in the equities market.
SEC Dialogue
Frucher recommended that the SEC have a “dialogue” with exchanges about dark liquidity. Bill Brodsky, CBOE’s chairman and chief executive, agreed. “The issue of dark pools hasn’t had a good vetting,” Brodsky said. “I would urge the SEC to take the dark pool issue as seriously as they’re taking the [penny] pilot.” Based on what has transpired in the equities world, he added, not having “a full vetting of the issues is absolutely irresponsible.” He also noted that in a regulatory system where an exchange’s every move requires a rule filing, “this issue shouldn’t evolve amorphously.”
Brodsky said this despite the fact that his exchange in April proposed a rule to allow “price-improvement” orders akin to those in Nasdaq’s proposal for options whose minimum spread is greater than a penny. The filing said market makers would be able to provide firm “indications of interest that are superior to their own [displayed] quotations in increments no smaller than 1 cent.” The CBOE’s filing, like Nasdaq’s, had not received a yea or nay from the SEC by mid-December.
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