Trading large lots could get easier under a plan being put together by the industry’s options exchanges. The International Securities Exchange and NYSE Arca, hoping to speed up trading in a marketplace that has become much more fragmented under the “penny pilot,” are spearheading a redesign of the industry’s Options Linkage Plan. The proposal is intended to make sweeping multiple exchanges faster for large-lot traders by incorporating elements of the equities market’s Regulation NMS. “We have a consensus of all the exchanges to move forward and replace our current
linkage with a more Reg NMS-like linkage plan,” says Mike Simon, the ISE’s general counsel and chief regulatory officer. “I think one year from now, we will have it implemented.”
The need to trade quickly on more than one exchange has become more urgent now that almost 40 percent of the industry’s volume is trading in 1- or 5-cent ticks. The change to smaller increments in the past year has caused spreads to collapse and size to disperse to multiple price points across six exchanges. By the end of the month, a total of 63 options classes could be trading in the smaller increments, representing at least half of the industry’s volume.
Riskier Market
While retail investors are thrilled with the sharp decrease in spreads wrought by penny trading, institutional investors are flummoxed by the equally sharp drop in size at the inside market. Where there might have been 10,000 lots offered top-of-book in near-term QQQQ contracts, now there may only be 1,000, as dealers rein in their quoting in the riskier market.
Also, the dispersion of that liquidity could be across as many as six (soon to be seven, when Nasdaq Options Market opens its doors) options exchanges. So while a trader might find the size he wants on the Chicago Board Options Exchange, he may have to trade against quotes on other exchanges if they are better priced.
That’s because, like the equities market, the options market has an intermarket trade-through rule. It forbids traders from bypassing the market’s best quotes, even if they are in a hurry.
And they are in a hurry. “The institutional trader is forced to wade through meaningless top-of-book prices to get to the quote he wants,” says Tony Saliba, president and CEO of LiquidPoint, a unit of institutional brokerage BNY ConvergEx. “And by the time he does, due to linkage, the ultimate price he wants is gone.”
While there is technology available to quickly sweep multiple exchanges-LiquidPoint offers something called DeepSweep-the sweep can still take precious seconds. That’s because traders still wait for reports of fills to come back from other markets before trading at inferior prices. And, by rule, exchange dealers have three seconds to fill incoming orders. By the time the reports come in, that sizable quote could be gone.
The ISE and NYSE Arca submitted a plan to the Securities and Exchange Commission last September called the “Options Order Protection and Locked/Crossed Market Plan.” If approved, it would replace the current linkage plan established in 1999. The current plan involves a set of rules governing order types and an order-routing system operated by the Options Clearing Corp. The plan is overseen by the Options Linkage Authority, which is made up of members from the six exchanges. (Nasdaq also attends meetings.)
In a letter to the SEC, the ISE argued the Linkage Plan was under strain. Average daily volume had grown from 2.6 million contracts at the time the Plan was put into place in 2000 to 10.8 million contracts today. The increased volume made it more difficult for market makers to comply with “complex” Linkage rules, the ISE stated
Complicated Requirements
The specialized sets of rules make it “cumbersome” to route to away-markets, according to the ISE’s Simon, and need to be discarded. The ISE told the SEC the order types involve “a complicated set of requirements as to who may send such orders and under what circumstances.”
The new plan would largely cherry-pick certain aspects of the SEC’s Regulation NMS governing intermarket competition, which went into effect in the equities market last year. Most importantly, it includes a new trade-through rule complete with an accompanying exemption for so-called intermarket sweep orders, or ISOs.
Of the 13 exemptions or exceptions to the Reg NMS trade-through rule, the one for ISOs is the most widely used. An ISO is an order that trades against quotes priced worse than the market’s national best bid or offer (NBBO). It can be used as long as the trader simultaneously sends out other orders to trade against the NBBO quotes.
ISOs allow traders to quickly grab the quotes they want while taking out the often smaller NBBO quotes that stand in their way. The need for the ISO exemption reflects the sped-up nature of equities trading in a decimalized and electronic environment.
As the options market begins to take on characteristics of the equities market, options exchange executives believe they need an ISO of their own. “ISOs are a much faster way to search out liquidity,” says Phil Slocum, the CBOE’s executive vice president of trading operations. “You can hit those away-market NBBO prices and then print the balance at the exchange that has the original order. That gives more certainty and speed to the block-size order.”
Private Routing
A new trade-through rule with an accompanying exemption for intermarket sweep orders is the most prominent feature of the proposal. But allowing exchanges to use private routing networks to route out orders, rather than the OCC’s linkage system, is also key.
Like the now-abandoned Intermarket Trading System (ITS) technology used by the equities exchanges until last year, the OCC’s central system has its share of critics, too. “Private routing is a much more efficient model,” says Ed Boyle, NYSE Arca’s senior vice president. “It’s much faster.”
NYSE Arca is the only exchange currently using a private network to ship out orders. The exchange, Boyle says, “nearly always” offers sub-second turnaround times, fully three to four times faster than the OCC system.
Under the ISE-Arca proposal, exchanges would have three choices as to how they route out orders. They could go in through exchanges’ “front doors,” sending their orders directly to other markets by using homemade or vendor-supplied technology. They could allow their members to establish their own routing arrangements. Or they could stick with the OCC’s system.
Foot the Bill
If only one exchange decides to stick with the OCC network, then all exchanges will be required to connect to it to accept inbound orders. Those exchanges that choose to continue using the OCC network to route away, however, will be required to foot the bill for the system. The others won’t have to anymore.
NYSE Arca has already made its choice. The others haven’t decided. The CBOE is investigating all the possibilities, according to Slocum. That includes forming a broker-dealer to do the routing itself (exchanges must contract with a broker-dealer for routing) or outsourcing the work to an independent broker-dealer.
In the end, competition may end up dictating the exchanges’ decisions for them, as customers gravitate to the most efficient routers. “The strong will survive,” Slocum says. “Whoever is the fastest and the cheapest will attract the flow.”
Any plan to revamp linkage requires SEC approval. Each exchange must submit its own plan, something that was considered imminent as Traders Magazine went to press. SEC official Dan Gray has publicly acknowledged the problem institutional traders face and said that the ISE-Arca proposal is at the top of the regulator’s to-do list.
At this year’s Security Traders Association of Chicago conference, Gray said the proposal was pending before the commission. “I can’t comment right now on what the commission will do,” he said, “but it is worth noting that equities and options markets differ in important respects. You can’t just assume that equity market structure will be fully equippable in an options market context. The options exchange proposal recognizes these differences, though, and attempts to tailor Reg NMS to options market reality.”
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