NYSE Arca Comes Up a Winner in Penny Trading

Maker-Taker Model Model Makes Options Debut

If the penny pilot now under way in the options market is viewed as a referendum on NYSE Arca’s unique market structure, it would be hailed as a victory for the exchange. NYSE Arca has seen its market share in the 13 options classes subject to trading in penny increments jump from 8 percent in January, before most of the pilot launched, to 12 percent in mid-April. In the same period, the respective market shares of the five other exchanges have declined or remained unchanged. “We thought the penny pilot was a good opportunity to try a new market model that rewards those people who provide liquidity at very tight spreads,” says Jon Werts, a New York Stock Exchange vice president for derivative products. “Early indications are that the results are very positive.”

At 12 percent, NYSE Arca now has the third-largest market share in the 13 penny classes. It trails only the Chicago Board Options Exchange and the International Securities Exchange, which dominate options trading. Overall, NYSE Arca ranks fourth, with 11 percent of total equity and index contract volume.

Of the six options exchanges, NYSE Arca is the only one to pay rebates to traders who provide liquidity and to charge fees to those who take it. This so-called maker-taker model is popular in the equities trading industry, but brand new to options trading.

Specialists’ Privilege

The other exchanges reward liquidity providers-mostly specialists or market makers-by guaranteeing them a large chunk of any incoming order. To qualify for a typical 40 percent allotment, specialists must show considerable size at the market’s best prices.

That model may be coming under pressure with penny trading. Spreads have shrunk because of fierce competition between traders, making it more risky and less rewarding for specialists to be at the inside.

Options with strike prices of $3 or less per contract now trade in penny increments, and not nickels. Those with higher strikes trade in nickel increments, not in dimes.

The penny pilot was not, of course, intended as a referendum on NYSE Arca’s business model. The Securities and Exchange Commission largely prodded the industry to reduce its trading increments in order to narrow spreads and, it’s hoped, reduce payment for order flow.

NYSE Arca, formerly the Pacific Exchange and now reinventing itself under new management, chose to introduce the maker-taker model to the options world for two reasons. First, it has had success with the model in the equities industry. Second, it may be more attractive to market makers in an environment of declining spreads.

The penny pilot, launched by the six options exchanges, has led to a 50 percent drop in spreads in the selected classes.

Narrowing Spreads

By some accounts, average spreads in the 13 classes were 12 cents before the pilot and are 6 cents today. Some of the more active names are down around 2 cents or 3 cents. For those options, that translates into a $2 or $3 gross margin per contract for specialists.

The smaller gross makes a 30-cent rebate-the amount NYSE Arca is paying specialists per contract-enticing. The exchange also eliminated two standard exchange charges, a 25-cent levy on market makers used to pay retail brokers for their order flow and an average 20-cent transaction charge. That brought the marginal benefit to trading on NYSE Arca up to 75 cents.

While the pilot doesn’t end until June, NYSE Arca’s success is prompting other exchange officials to reconsider their models. The open question is whether or not the maker-taker model will be adopted by NYSE Arca’s competitors.

“We think maker-taker has merit,” says Scott Morris, chief executive of the last-placed Boston Options Exchange, or BOX. “I think the BOX and other exchanges will have to look at the maker-taker model and consider it.”

The BOX initially launched with much fanfare in 2004 with a radical business model of its own, opting for a more egalitarian construct devoid of specialists and based on strict price-time priority.

So Unkind

It also created a so-called “price-improvement period,” or PIP, that allowed traders to quote and trade within the 5- and 10-cent spreads during special auction sessions.

The BOX captured order flow almost immediately, but then just as quickly plateaued with a market share of about 5 percent.

And the penny pilot has not been kind to BOX. Its market share in the 13 classes shrank from about 6 percent in January to 4.5 percent in mid-April, according to the Options Clearing Corp.

Its PIP was expected to suffer in penny trading, because there would be less need for trading in between the spread if the spread narrowed significantly, and those expectations were on the mark. PIP volume has declined by about two-thirds, according to Morris.

“We’re in sixth place,” he says. “We need to do something to get moving.”

Morris won’t say whether or not BOX will adopt the maker-taker model. One reason BOX and other exchanges have been shy about trying the model is the fear that retail brokerages, the source of most options flow, would reject it.

Not Really

The customers of retail shops could balk at paying a fee on top of commissions for taking liquidity. Plus, the brokerages themselves may not be able to institute such pricing.

“Frankly, maker-taker is not something retail customers like at all,” says Randy Frederick, Charles Schwab & Co.’s director of derivatives. “Customers want a simple model they can understand.”

NYSE Arca’s success may be fleeting. Some observers believe the new spreads do not reflect economic reality. They speculate that market makers are still experimenting with their pricing and will soon quote less aggressively.

“People are trying to figure out whether this narrowing of spreads is sustainable,” says David Fisher, president of optionsXpress, another retail brokerage.

“Everyone is playing around with the new pennies, testing their systems. Many people believe there is some artificial quoting going on that is not sustainable.”

Defying Logic

The BOX’s Morris notes that some spreads on options with nickel increments declined from about 10 cents to a nickel, something that could have happened without a penny pilot.

“It defies logic,” he says. “I am sure the end result will be a tightening of spreads, but I would be very surprised if they end up being as tight as people expect.”

The level at which spreads ultimately settle will play a big role in determining the success or failure of the maker-taker model, but a bigger factor may be whether the pilot is expanded to encompass more options.

About 200 options classes out of a total 2,000 see the most trading. If all of those started trading in pennies, the impact on exchange market share could be considerable, sources maintain.

“You are absolutely going to see an expansion,” NYSE Arca’s Werts says. “The pilot has been a huge success. The industry did a good job. There will be heated debates when the pilot ends, but the benefits [of penny trading] to the customers and the industry cannot be ignored.”

Size Declines

Based on NYSE Arca’s performance to date in the 13 penny options, an expansion of the pilot could lead to an expansion of NYSE Arca’s market share.

Yet factors besides the decline in spreads give other market participants pause. Quoted size dropped about 80 percent at the inside market in the 13 penny options, a troubling bit of news for some.

“The magnitude of the decline in liquidity is worrisome,” says optionsXpress’ Fisher. “If that level holds, there is a concern that volume will decrease. Certainly, from an institutional standpoint, they get very scared when they see such a decrease in liquidity.”

Fisher believes the drop in depth at the inside warrants a cautious approach to expanding the pilot. He also notes that overall volume did not pick up in the 13 penny classes. “There has been zero increase in volume,” he says. “That is not the best thing you would hope for.”

NYSE Arca Levels Playing Field

For many options traders, the playing field is stacked against them. That’s the view of Nitin Gambhir, chief executive of Tethys Technologies, a vendor that has been monitoring the penny pilot.

Gambhir believes NYSE Arca’s maker-taker pricing model is an improvement over traditional exchange models and will give players such as non-member broker-dealers more opportunities.

“The NYSE Arca model is extremely intuitive,” Gambhir says. “Most exchange models are extremely complex. They are especially cumbersome for non-member broker-dealers. They have these onerous charges to trade at most exchanges.”

He says the simpler structure at NYSE Arca combined with its low latency will make it an attractive venue for non-member broker-dealers to post liquidity.

For many options traders, the playing field is stacked against them. That’s the view of Nitin Gambhir, chief executive of Tethys Technologies, a vendor that has been monitoring the penny pilot.

Gambhir believes NYSE Arca’s maker-taker pricing model is an improvement over traditional exchange models and will give players such as non-member broker-dealers more opportunities.

“The NYSE Arca model is extremely intuitive,” Gambhir says. “Most exchange models are extremely complex. They are especially cumbersome for non-member broker-dealers. They have these onerous charges to trade at most exchanges.”

He says the simpler structure at NYSE Arca combined with its low latency will make it an attractive venue for non-member broker-dealers to post liquidity.