The International Securities Exchange’s recent big win in convincing the Securities and Exchange Commission to publicly notice its request that high-frequency trading by public customers get mandatory treatment as “professional orders” came as the ISE successfully ushered a “voluntary professionals” category past the SEC.
In May 2006, the ISE asked the SEC to allow it to mandate that broker-dealer members identify orders from certain public customers as “professional orders.” Those active, high-volume customers executing 390 or more trades per day (one trade per minute) would meet that definition and have their orders treated as broker-dealer orders with regard to execution priority and transaction fees. The SEC published that filing for comment in February, after a 20-month delay, and after the ISE in January filed an amendment to the original request, clarifying its plans.
Then, in March, the ISE won approval for the new “voluntary professionals” class of customers it has sought since May 2007. It did this as a compromise to allow active individuals and trading firms that are public customers to avoid paying cancellation fees. The rule change, which went into effect immediately, enables member firms to apply the voluntary-professionals designation to customers who elect to be treated as broker-dealers for purposes of trading priority and exchange transaction fees. However, if the mandatory category rule change is approved, this one will fall by the wayside, said Boris Ilyevsky, head of options business development at the ISE.
In early April, the Chicago Board Options Exchange expected SEC approval for a similar voluntary-professionals category it had requested in January. That rule filing replaced an earlier one from November.
All four quote-driven options exchanges impose fees on cancellations from member firms’ public customers. These customers get execution priority and typically pay no transaction fees. The options exchanges charge cancel fees to curtail trading behavior by some public customers that resembles market making. Broker-dealers, however, aren’t dinged for cancel fees since they pay for transactions. The ISE’s recently approved filing therefore offers an alternative for some high-frequency traders who are willing to have their orders treated on a more level playing field with broker-dealer orders and market-maker quotes, allowing them also to avoid the cumbersome cancel fees.
“We started charging cancel fees to recover transaction fees from participants we felt were sophisticated and not really retail investors,” said Ilyevsky. “Some are former market makers who came off the floor…and traded very actively, mimicking the activity of broker-dealers and market makers. One characteristic of their activity is canceling and replacing a lot of orders.”
The quote-driven exchanges’ member firms pay fees for their customers’ cancels beyond a set monthly allotment or monthly ratio of cancels to executions. The ISE in March raised its cancel fee for public customer orders to $1.75 from $1.50.
“Certain customers, particularly those categorized as high-frequency traders, are looking for greater flexibility in placing and canceling orders without encountering cancellation fees,” said Ed Tilly, vice chairman of the CBOE. “This type of customer will go into this class voluntarily to get coverage in a few names.”
Kevin Fischer, manager of block execution services at Interactive Brokers, believes interest in the new designation may be scant. “It’s the worst of both worlds,” he said. “These traders won’t pay cancel fees, but they will pay transaction fees, they won’t get customer priority, and they won’t be able to make two-sided markets.” However, there could still be converts. “If some professional customers value the ISE’s order flow and want to interact with it on a pro rata basis and are willing to post large-size orders, then priority is not as important,” Fischer said.
According to Fischer, the ongoing issue with cancel fees cuts to the heart of what a “customer priority” exchange is. “The only way a customer-priority exchange can survive is if some entity is willing to pay the bills to keep the lights on,” he noted. “Market makers will pay exchange and transaction fees if they can interact with customer order flow that’s profitable for them. However, if a pseudo customer is interacting with that flow ahead of the market maker, then the market maker won’t be willing to pay all the exchange fees.” In Fischer’s view, the “customer-priority market structure could really be in jeopardy without a change.”
The voluntary designations at both the ISE and CBOE can be rescinded by customers at any time. The ISE’s Ilyevsky said non-broker-dealer traders using the ISE can choose to be deemed voluntary professionals on a trade-by-trade basis. By opting for this classification, customers don’t have to pay cancel fees and they swap the execution priority and lack of transaction fees granted public customers for the transaction fees and pro rata allocations of broker-dealers.
In contrast to the predicament faced by quote-driven markets concerning the high level of cancellations, options markets with maker-taker pricing do not need to differentiate between participants. On NYSE Arca Options, the Boston Options Exchange and Nasdaq Options Market, all users pay to take liquidity and get a rebate for providing liquidity. Public customers don’t trade for free. However, the cost of taking liquidity on those markets may detract from their appeal for some traditional public customers.
(c) 2008 Traders Magazine and SourceMedia, Inc. All Rights Reserved.
http://www.tradersmagazine.com http://www.sourcemedia.com
