Options exchanges typically strive to foster competition among members by requiring incoming orders to be exposed to all participants. Order exposure is a hallmark of the industry, but some recent exchange proposals call its longevity into question.
"Exposure is a key piece of the foundation, but we are seeing some fractures in that structure," said Ed Boyle, NYSE Euronext’s head of options markets, at a recent industry conference.
Boyle was referring to proposals from his competitors at the International Securities Exchange and the Boston Options Exchange. But ironically, two proposals coming out of NYSE Arca have also come under fire as anti-competitive.
All four proposals are meant to help the exchanges’ members get trades done without interference from other members. The ISE kicked off the trend last year with its plan to introduce a so-called "qualified contingent cross" but the pace has picked up.
In July, NYSE Arca proposed new procedures for its solicitation crosses, which critics charged would effectively take market makers out of the loop.
Then, in August, BOX proposed a fee that critics said would only benefit internalizing market makers and stifle competition. A day later, NYSE Arca proposed a rule change that critics also charged would benefit internalizing market makers at the expense of other traders.
ISE saw its proposal approved by the Securities and Exchange Commission at first, but later abrogated. BOX received automatic approval, but detractors are asking the Commission to renege and disallow it.
Arca withdrew its "NBBO Cleanup Guarantee," intended to benefit internalizing dealers, shortly after submitting it to the SEC, due to howls of protest. Arca has not yet gotten approval for its rule change on the handling of solicitation crosses.
The options exchanges have always faced pressure from members looking for a way to sidestep the competition inherent in exchange trading.
Market makers have sought to interact exclusively with orders sent them by their retail brokerage customers. Institutional brokers have sought to bring crosses to the exchanges without the order being broken up.
Arca tried to accommodate its market makers with a rule change. BOX is trying to do the same with a pricing change.
BOX, critics charge, is trying to warp the fee structure in its "Price Improvement Period" auction to advantage internalizing market makers who bring in flow. Under the plan, those dealers pay less than dealers who might compete against them to trade the orders.
"Pricing mechanisms that discourage competitive quoting are not healthy for the market," NYSE’s Boyle said at the annual conference held by the Futures Industry Association and the Options Industry Council.
BOX chief executive Tony McCormick disagreed. "The customer is getting more price improvement," he said at FIA/OIC. "That’s the bottom line. To economically induce brokers to bring in more customers into that process, that’s a good thing. The data doesn’t support it being non-competitive."
Arca tried to take a different tack to win more flow. It amended its order-handling procedures to include an "NBBO Cleanup Guarantee." It would’ve allowed market makers with contracts with order flow providers to fill any leftover portions of their orders before they were routed away to another exchange. The dealers did not have to be quoting at the NBBO, but had to ensure the order was filled at the NBBO.
Technically, the order was required to go through the usual trading process before landing in the dealer’s lap. But critics charged the move was tantamount to permitting complete internalization. Currently, preferenced dealers may trade against no more than 40 percent of an incoming order, per SEC rules.
"It would’ve created a TRF," said ISE executive Boris Ilyevsky. "A market maker with a deal with an order-flow provider could guarantee them the NBBO and basically create a trade-reporting facility."
Arca would not comment. It pulled the filing shortly after it was made public.
Arca’s other proposal for solicitation crosses ran into the same headwinds. By requiring market makers to respond to incoming crosses with their "final bids" and not providing them with size information, the proposal effectively eliminates dealer competition for the order, critics charged. "Essentially, the solicited party, or counterparty to the customer order and cross transaction, no longer has to compete with the floor-based trading crowd," Matthew Abraham, with Chicago market makers CTC, wrote the SEC.
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