The Boston Options Exchange has become the latest exchange to reject the options industry’s traditional transaction pricing model in favor of that pioneered by the cash equities business. Following the lead of NYSE Arca Options, which switched to “maker-taker” pricing last January, BOX will now pay a rebate to suppliers of liquidity and charge liquidity takers a fee.
Both are counting on this pricing scheme to attract volume to their venues as the penny pilot underway at the six U.S. options exchanges expands to include more options classes. Both are also far from the industry’s largest exchanges.
Whether the rest of the industry follows the path of NYSE Arca Options and BOX is an open question. Because the industry gets half of its order flow from public customers who have trading priority and pay no exchange transaction fees, it would be difficult for the established exchanges, which have the vast bulk of liquidity, to change how they’re treated. But if maker-taker pricing succeeds in winning and sustaining market share, those exchanges may have to consider altering their market models.
Falling in Love
It’s very easy to fall in love with the idea of maker-taker incentives, but hard to think through the consequences in terms of what that means for how public customers trade and how our markets work,” says Michael Bickford, senior vice president in charge of options at the American Stock Exchange. Public customers are the non-broker-dealer clients of exchanges’ member firms.
Ed Tilly, executive vice chairman of the Chicago Board Options Exchange, refers to maker-taker pricing as the “reintroduction of customer fees” since public customers are primarily liquidity takers. But, he acknowledges, serious competition could affect how the established exchanges operate in the future. “Will the bigger exchanges ever add back customer fees in some classes?” Tilly says. “The answer has to be that ‘ever’ is a long time and probably. But when that occurs is a question.”
For BOX, the smallest options exchange, the pricing decision was easy. “Arca’s maker-taker pricing allowed them to create tighter markets [in the penny options classes] because they had an incentive for people to post additional liquidity,” says R. Scott Morris, the exchange’s chief executive. “We decided it was the best way to go, especially as the penny pilot is expanded.” BOX, which launched in 2004, had a market share of 5.6 percent in August.
NYSE Arca Options switched to maker-taker pricing for the pilot classes last January. “If you make the best price, [a trading firm’s] router must come to you whether you pay for order flow or not,” says Paul Adcock, executive vice president at NYSE Euronext and head of trading operations at NYSE Arca and its options market. “That model worked for us in the equities world, and it’s why we built an exchange with no cancellation fees that’s the fastest in the industry.” (Both Arca and BOX have standard transaction fees for non-penny names.)
NYSE Arca Options increased its market share in the penny options classes to 12.9 percent in August, from 9.7 percent in December 2006, before the pilot began. A large portion of that increase stemmed from activity in QQQQ and IWM, the two options on exchange-traded funds in the pilot. The exchange’s overall equity options market share in August was 12 percent. Last December, as a result of unusual volume, it had risen to 14.6 percent, although its 2006 average was 10.7 percent.
The goal of NYSE Arca Options and BOX-both price-time priority markets, in which orders at the national best bid or offer are executed in the order they were received-is to attract volume by encouraging liquidity providers to tighten the spread in a penny environment. “It’s a way to try to differentiate themselves from the other exchanges and build their marketplace,” says Tony Saliba, president and CEO of BNY ConvergEx LiquidPoint. “We’re in a quote-driven market and that’s an order-driven approach.”
The two largest options markets are the CBOE and the International Securities Exchange. The CBOE had 29.8 percent of the single-equity options market in August, while the ISE’s market share was 30.5 percent (these numbers exclude index options, most of which aren’t multiply listed). These two market leaders, along with Amex and the Philadelphia Stock Exchange, are quote-driven markets with traditional “pro-rata” models.
Primary market makers quoting at the inside market on these exchanges can cumulatively execute against up to 40 percent of each eligible incoming customer order, based on the size of their quote-or some variation on that model for certain options classes. In multiply listed classes, these exchanges don’t charge member firms transaction fees for orders from public customers. All primary market makers and broker-dealers pay per-contract fees for executions on quote-driven markets.
Eyes on Arca
Maker-taker pricing is predicated on a penny-increment environment. As the penny pilot expands-to another 22 options classes last month and 28 more in March-the industry has seen volumes increase in the penny names at a much faster clip than in non-penny options classes. Spreads have decreased in the pilot names and liquidity at the NBBO has shrunk, in some cases dramatically. The quote-driven markets have warned the Securities and Exchange Commission that the changes to liquidity for all but the most liquid classes could hurt the options industry generally.
In the meantime, the established exchanges are analyzing how broker-dealers and customers are responding to maker-taker pricing. “It’s probably too soon to tell if the model is working,” says Gary Katz, president of the ISE. “Algo trading is anticipated to grow, but whether that grows with or without a maker-taker model or is spurred on by that model has yet to be seen.”
Katz stresses that the options and equities markets have different structures and their products trade differently. “There isn’t as much liquidity in any one options product as there is in stocks, so this will be a different experience [with pennies],” he says. “Algo traders and customers will see what works for them.”
BNY ConvergEx’s Saliba notes that algorithmic traders usually take liquidity from exchanges instead of posting bids and offers. “So the maker-taker model wouldn’t lend itself to that group,” he says. “They’d take more liquidity than they add and have to pay increased exchange fees.”
In adopting a price-time priority market model and shifting to maker-taker pricing for the pilot options, NYSE Arca Options and BOX have challenged the market by eliminating the ability of public customers to jump to the head of the line and to trade for free. They’ve done so by utilizing an ECN-like incentive structure.
Adam Nunes, head of the new Nasdaq options market, notes that the traditional trading model in options grants public customers a “property right to priority.” In contrast, he says, maker-taker pricing in a strict price-time priority market provides a “property right based on what [participants] do.” Nasdaq plans to launch its options exchange in December with a first-in-first-out model and aggressive maker-taker pricing.
In contrast to quote-driven systems, NYSE Arca Options and the other maker-taker markets are counting on new, high-frequency participants to attract liquidity to their venues. “There’s a set of clients that like price-time priority and no cancel fees,” Adcock says. “We’ve created a new class of customers with this model-they’re liquidity providers acting like market makers remotely.”
Other industry trends are abetting the development of this new options class of aggressive liquidity providers. BOX’s Morris notes that portfolio margining, coupled with maker-taker pricing in a penny environment, will enable nontraditional and smaller liquidity providers to compete with larger market-making firms to tighten markets. Portfolio margining permits trading firms and liquidity providers to gain some of the cross-margining advantages available to traditional market makers, thereby reducing their cost of capital.
Market participants have mixed opinions about how well this may work. George Ruhana, an options trader at trading firm PEAK6 in Chicago, agrees that maker-taker pricing is a bid to attract volume through aggressive quoting. If exchanges with that type of incentive pricing “post markets that are tighter because they have more liquidity providers on their exchange, then people will be forced to go there because they have the better price,” he says. However, that may not happen as planned. “What tends to happen, especially for small size, is that exchanges match better prices elsewhere,” he notes.
In Ruhana’s view, maker-taker pricing helps statistical arbitrage and black-box trading firms that are continually in the market electronically. “This gives them incentive to do that more because they get paid to do it,” he says. Ruhana adds he expects incentive pricing to draw volume to Arca in penny options classes-and that “if anybody knows about doing this well [based on the equities-market experience], it’s Arca.”
For the CBOE and other quote-driven exchanges, the changes wrought by the maker-taker markets spell competition not just for market share but for their market models. In a penny setting, they must ensure they’re at the NBBO to hold on to their volume. If they do that, customers will be able to choose which market will receive their flow. And those accustomed to paying no fees, if given a choice, are expected to continue to avoid paying exchange fees by trading on quote-driven exchanges when markets are tied at the NBBO.
BNY ConvergEx’s Saliba says it’s unlikely a public customer would want to hit a bid or take an offer on a maker-taker market if that person has a choice of execution venues. “They’re charged more, so they’ll clear the other markets first,” he says. “Being a liquidity provider on those exchanges could be the last bastion of liquidity provision.”
PEAK6, a market maker on NYSE Arca Options, trades on all the options exchanges and incorporates exchanges’ pricing schemes into its trading decisions. When the firm is posting liquidity, Ruhana says, it would be glad to post on Arca because of the explicit pricing benefits, “but when we have to take liquidity, we will look for depth at the best price, and then factor the exchanges’ cost profiles into our decision.”
It’s possible, though, that maker-taker pricing could alter the mix of flow that executes in those markets. After NYSE Arca Options switched to maker-taker pricing, for example, Citadel Derivatives Group says it noticed a difference in the order flow on Arca. According to Matt Andresen, co-head of CDG, the firm found its experience on Arca in the pilot names disappointing.
“The flow on Arca changed dramatically,” Andresen says. “Because of the new fees on customer orders, those orders fled for other exchanges. What was left was more toxic proprietary trading flow.” Citadel Derivatives Group makes markets on all six exchanges and routes approximately 1 million contracts per day to exchanges on behalf of retail brokerages.
Andresen, who says the firm continues to quote on Arca but not as aggressively, thinks Arca hasn’t yet found the right market model with which to compete with the CBOE, ISE and PHLX. He adds that he expects NYSE Arca Options to move toward a model that “more directly incents customer flow to come to their exchange.”
Andy Kolinsky, head of sales and client services at Citadel Execution Services, also notes that some “professional traders dabble when there’s a new market structure.” In his view, part of Arca’s gain this year may have resulted from those players. “Without customer order flow, however, it is not a sustainable model,” he predicts.
For now, the options exchanges are in a heated battle over which market structure is likely to work best in a changing trading environment. In the penny names, success hinges in part on being at the top of the market. If maker-taker pricing enables an exchange to tighten the spread, the other exchanges must be able to compete with those who better the price.
“We’re all very competitive with the two exchanges that are maker-taker,” CBOE’s Tilly says. “That’s the pressure we’re under-it’s not turning [improving] the market first, though that’s great, but making sure that if it’s turned in another market, our liquidity providers can make the NBBO.” To facilitate that, the CBOE is now examining its pricing tiers for primary market makers for 2008.
For quote-driven markets, the challenge posed by maker-taker pricing is also intimately linked to the breadth of the “public customer” definition. Over the last few years, public customers as a class of traders have expanded past retail customers to include professionals, sophisticated algorithmic players and trading firms. By treating all of them identically and giving their orders priority over those of market makers’, an exchange creates potentially stiff competition for its market makers, who have additional obligations that high-frequency liquidity providers classified as public customers don’t have. A quote-driven market also loses out on transaction fees associated with that class of customers.
The issue is that “public customers” aren’t always pure customers. Meyer (“Sandy”) Frucher, chairman and CEO of the Philly, quips that “old market makers never die-they become customers.” Amex’s Bickford agrees that it’s a serious issue “when people used to work on the trading floor and then go upstairs to trade.”
The CBOE’s Tilly is clear about what his exchange will consider in an increasingly competitive environment. “We have to make sure CBOE posts the best markets in the country,” he says. “If maker-taker [pricing] jeopardizes our ability to do that, we have to look at different schemes such as changes to our matching algorithm, maker-taker pricing or the reintroduction of a customer fee.”
None of the quote-driven markets are keen to reintroduce customer fees-and they are not permitted to differentiate between entities that qualify as non-broker-dealer customers. However, given the competition their market makers now face, efforts are underway to come up with novel ways to segment the range of customers.
In August, the ISE asked the SEC for permission to create a new “voluntary professional” category. (A previous attempt by the ISE, in May 2006, to create a new category of professional traders was deep-sixed by the regulator.) Under the new proposal, self-identified professional customers would get some of the benefits broker-dealers have, such as no cancellation fees for orders, but would agree to forfeit other advantages accorded public customers such as execution priority and no trading fees. So far the SEC has not ruled on the filing. Other exchanges say the ISE’s effort is an innovative response to issues that are becoming increasingly pressing in a penny environment.