Options ‘Exposure’ Rules Under Assault

One of the bedrock principles of the nation’s options exchanges is starting to fracture.

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 proposals from exchanges 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 other 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" (see Traders Magazine, November 2009), but the pace has picked up.

NYSE Arca got the ball rolling in July, when it 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 controversial fee that critics charged 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 as the proposal concerns fees, but detractors are calling on 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 from the industry. Arca has not yet gotten approval for its rule change on the handling of solicitation crosses.

The options exchanges, which require all trades to be conducted on their facilities to be cleared by the Options Clearing Corp., have always faced pressure from members looking for a way to sidestep the competition inherent in exchange trading.

Market makers have sought ways to interact exclusively with orders sent to them by their retail brokerage customers. Institutional brokers have sought ways to bring crosses to the exchanges without the order being broken up.

With dealer profits under pressure from penny trading, and allotments capped at 40 percent, market makers are more determined than ever to win concessions from exchanges. Unlike in the equities business, there is no trade-reporting facility to support a pure internalization business. So, all trades must go to exchanges.

For their part, the exchanges want to remain in the good graces of the dealers to secure their trading and the institutional brokers who can easily trade and clear their large orders upstairs.

NYSE Arca tried to accommodate its market makers with a rule change. BOX is trying to do the same with a pricing change.

In BOX’s case, its critics charge, the exchange is trying to make the fee structure in its "Price Improvement Period" auction so unfair that only internalizing market makers who bring flow to the auction will benefit. The fee structure is skewed so that dealers who bring flow to the auction pay less than those dealers who might compete against them to trade the orders, they say.

"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."

According to the ISE in a comment letter to the SEC, BOX is "actively marketing these new fees as a way to avoid the breakup of PIP orders and internalize flow." The exchange added that at least one order-flow provider has shifted its business from the Chicago Board Options Exchange to the BOX to take advantage of the pricing.

NYSE 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.

Under the proposal, the dealers did not have to be quoting at the NBBO, but had to ensure the order was filled at the NBBO.

Although technically, the order was required to go through the usual trading process before landing in the dealer’s lap, critics charged that 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." NYSE Arca would not comment. It pulled the filing shortly after it was made public.

Arca’s other proposal to make it easier to conduct solicitation crosses–not facilitations, the dominant type of cross–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, an executive with Chicago market makers CTC, said in a letter to the SEC.