Sometimes the best intentions are misplaced. Take the attempts to introduce the $1 coin, the videodisc and the attempt in the U.S. to convert to the metric system. The same might be said for the current “pilot” program in listed options. As of January 26, the industry began offering quotes in 1-cent increments in options on 13 underlying
securities-“penny quoting,” if you will. While the regulators may believe they have found an answer to the “cost” of bid-ask spreads by displaying penny increments, in reality the cost is just being re-allocated elsewhere, and will eventually be borne by users anyway. The only thing novel about this plan is that these prices are displayed for all to see.
First, let’s dispel some of the myths:
Options were not trading in pennies before this pilot program.
Options have actually been trading in pennies for just over three years. The Boston Options Exchange launched PIP, its penny-trading program to improve prices, in February 2004. Other options exchanges soon replicated it. The BOX claims that customers have saved over $100 million through price improvement over the last three years. I have no reason to doubt that.
Some brokerage firms like Interactive Brokers, optionsXpress and my firm, LiquidPoint, already offer the benefits of penny quoting to their customers via these price improvement mechanisms and posted penny prices on their trading applications. They have done so for quite some time. These mechanisms work with the exchange facilities to bring together customers’ orders and the liquidity providers willing to improve displayed prices. Allowing market participants-rather than regulators-to decide which securities are traded in pennies increases efficiency in the options market. These digital auction capabilities are already in place
Penny quoting will eliminate payment for order flow (PFOF).
One of the key drivers for penny quoting is the SEC’s desire to eliminate the practice of payment for order flow. Payment for order flow is a transaction-based rebate from the Liquidity Provider Organizations (LPOs) at various exchanges to those supplying the order flow. Those funds are supposed to either go back to the customer or subsidize the cost of routing. The irony is that the PIP and its clones could have altered or even eliminated that payment process already, but these innovations have not been well publicized and not all firms have chosen to hook up to them.
The theory goes that if the markets are tighter, it will squeeze out the ability of the LPOs to subsidize the order flow. But just because options are quoted in pennies does not mean that the bid/ask spread will be narrowed. I have so far seen a lot of “5-up,” 4-cent wide series. Not the kind of stuff that’s going to entice the growing, serious user of the product.
Instead of redoubling efforts to educate customers about innovations in the delivery system that are already in place, the SEC intends to remove the impact of PFOF by substituting penny quoting. The result will be a wildly expensive infrastructure paid for by the customer, while possibly leaving a vacuum for a less desirable (or unregulated) form of PFOF to manifest.
Alternative Minimum Tax
Those paying attention have witnessed an explosion of options activity over the past seven years. A potent cocktail of technological advances combined with minimal consumer education and a few rule changes has made the derivatives market as accessible-and usually more competitive-than the cash market. End-user access, including the penny-trading facilities, rivals any other marketplace.
Along with the trading activity came an even greater explosion in quote traffic-data, including a tremendous spike in the number of cancellations. That quote traffic competes with order-flow for power and bandwidth, which negatively impacts execution quality. The penny-quoting concept ignores the extraordinary cost to the liquidity providers, whose risk-taking provides the lubricant for our celebrated markets. Liquidity providers are saddled with the ever-increasing costs of maintaining pricing engines and high-speed connections that are up to the task.
Quoting a single stock issue requires a fraction of the systems, infrastructure and risk needed to quote hundreds of options series simultaneously. Only in the most strained analogy is quoting options similar to quoting in the underlying stock. And the difficulties in producing, distributing and maintaining those quotes are exacerbated by having to sustain them in pennies. Add to all of that the hair-trigger sensitivity that quoting in pennies mandates and you have an exponential increase in quote traffic.
In order to keep up with delivering these increased levels of data, every firm and exchange charged with processing option orders has been forced to invest in obscene amounts of servers, routers, storage and other hardware and software components. The requisition of more telecom services, lines and other facilities add tremendous expense to the message delivery infrastructure. (Is there a successful telecom lobbyist at work behind the scenes in Washington?) These suppliers are licking their chops at the untold millions of dollars that will be spent by exchanges and brokers as part of this mandate.
Additionally, forcing the LPOs to quote in pennies will probably result in bifurcated quotes, and therefore less liquidity. That liquidity will be less transparent than before, as was the case in equities post-decimalization. The smaller-size market in pennies and the larger “size” markets hidden at various other prices will end up doubling the amount of quotes and will spread the real liquidity over multiple prices.
Because of all this, it will become critical to display the layers of multiple quotes and the associated depth. Some exchanges are moving to do so now, but at what cost? And how effective will the exchanges’ depth display be? Algorithmic functions, increasingly popular today (like simple sweeps and more-complex dependent strategies) will not function if true size is hidden by the chaff of 3-lot penny quotes.
Some would call this “trade friction”-the incremental costs per transaction that create a more-expensive trade, a veritable “tax” on each order. So who will pay for this “Alternative Market Tax”? Surely the answer is the end-user, the intended beneficiary of all these changes.
If the goal is to make the listed options market more efficient and free from the LPO subsidies, the effort might be better spent on further educating end-users. This will lead to users who understand the impact of PFOF and demand the benefits it is supposed to bring from their brokers. Quoting in pennies may be a lot of “noise” without this understanding.
Trade activity in the options market is and has been more efficient than the underlying securities they are based on for some time now. Best Execution is measured in millisecond metrics and all six exchanges are brought together seamlessly on one screen. Today’s options customer has terrific advantages over even some of the professionals when it comes to making trade and routing decisions; speed, total transparency, no off-floor crossing and WYSIWYG quoting are just a few examples.
It is imperative to understand how customers will be impacted if liquidity becomes more hidden. As average order sizes get bigger, fragmenting the liquidity among different prices won’t help. Will the result be a liquidity “pool” that is effectively darker and less transparent? Before we foist this new cost on market participants, perhaps we should take a step back and determine what the value is in manufacturing these additional tiers of granularity.
Tony Saliba is the President and CEO of LiquidPoint, LLC, which offers an options front end that provides execution for investors and professional options traders. Mr. Saliba has been an active participant in the options industry for almost30 years.