There once was a time when public customers were the kings of the options marketplace. Their orders immediately jumped to the top of every order book, leaving market makers and other professionals to choke on their dust. Fortunately (or unfortunately, depending on your opinion), the days of priority for public customers’ orders are now coming to an end.
In today’s marketplace, customer orders are essentially left to the wolves. Two exchanges-NYSE Arca and the Boston Options Exchange (BOX)-now treat them the same as every other order that flows into their marketplace. However, this development undoubtedly represents the beginning of the death of the public customer.
The Gospel
How did it come to this? Until recently, customer priority was a fundamental tenet of the options markets. The belief that options customers needed special privileges to facilitate their trading was held as gospel. That rationale made a great deal of sense in the first few decades of the options business.
In those days, public customers had to overcome enormous hurdles just to participate in the options markets. For the typical one-lot retail customer, the trading pits were almost completely inaccessible. This prompted a genuine concern that small orders would be lost or manipulated by opportunistic brokers and market makers.
Granting priority to customer orders was seen as the only way to guarantee the accessibility of the marketplace and increase the industry’s user base.
But all of that changed with the recent rise of electronic trading and the onset of multiple listing. These were knockout punches for customer priority in the options markets. As multiple listing erased options margins and deprived liquidity providers of access to order flow, many of these professionals turned to the dark side.
Envious of the priority and access that was granted to customers, they created their own customer accounts and used this newfound priority as a competitive weapon. These wolves in sheep’s clothing have made many in the industry wary of customer orders. “The customer is no longer what it was,” said Timothy Brennan, executive vice president of equity options for Automated Trading Desk. “The customers of today are actually the market makers of yesterday. There is an entire class of professional and semi-professional customers lurking out there that you have to be aware of. Those who ignore these sophisticated customers do so at their own peril.”
Perhaps the most infamous example of professional traders taking advantage of customer priority occurred on the Chicago Board Options Exchange in 2000. At the time, the CBOE routed most of its public customer orders through its Retail Automated Execution System (RAES).
This system was designed as a way to facilitate small customer orders that didn’t warrant open-outcry execution. These small customer orders were automatically executed at the exchange’s disseminated prices and then assigned to a participating market maker. However, a handful of former market makers and other “professional customers” soon found their way onto this system and began abusing it in ways that were never anticipated.
RAES Banditry
Some examples of these abuses included planting one-lots in the book at ridiculous prices and then automatically executing trades at those prices. They also used RAES’ rapid execution to take advantage of any quirks in the exchange’s auto-quote system. If a particular product’s auto-quote began to lag behind the market, a relatively common occurrence during fast market conditions, then the consequences could be disastrous. Market makers suddenly found deep in-the-money options hitting their accounts at prices no sane person would ever contemplate.
The culprits behind these exploits eventually became known as “RAES bandits,” a title, no doubt, borrowed from the name given to rapid electronic traders who picked off market makers on Nasdaq’s Small Order Execution System (SOES): the so-called SOES bandits.
On RAES, the number of opportunistic trades was so prolific that it prompted many exchange members to boycott the RAES system entirely. Although the problem was eventually fixed, that experience opened the industry’s eyes to the dangers of customer priority in the modern era.
The emergence of the RAES bandits and other “professional customers” has also prompted a debate over the definition, and relevance, of a customer. In this era of electronic execution, is the public customer designation even relevant anymore? With so many professional-level tools at the disposal of the retail customer, the argument that they need priority to effectively participate in the options markets is moot.
If retail customers no longer need priority, then is there anyone left who should still qualify for this exalted privilege? As the RAES bandits proved, the world of electronic trading makes it all but impossible to determine who is a retail customer and who is a professional trader. By giving all public customers priority, the exchanges have handed trading pros a clear advantage over the true retail investor, who, in effect, now has to compete for the same fills.
Despite its dangers and looming irrelevance, there are still those in the industry who subscribe to the gospel of customer priority. “When it comes down to it, customers love being on the top of the book,” said Jay Knopf, vice president of SLK Hull Derivatives at Goldman Sachs. “Unfortunately, we’ve had some problems with people pretending to be customers just to gain that priority, and we’ve had to deal with that. However, I’m loath to do anything that hurts the customers. Eliminating priority definitely falls into that category.”
Dwindling Ranks
Although some in the industry still champion customer priority, their ranks are rapidly dwindling. All of the recent entrants to the options marketplace have seen fit to abandon customer priority in favor of price-time priority systems. Both the BOX and the revamped NYSE Arca Options have adopted variations of this approach.
The notion of a flat and open marketplace, where every order can compete on equal footing, may sound idealistic, but the markets are moving inexorably toward that goal. “Our goal is to create a level playing field for all participants,” said Scott Morris, the new CEO of BOX. “Unfortunately, many of our competitors still see fit to grant certain aspects of their customer base special privileges. We just don’t see why anyone should receive priority or special privileges in this day and age.”
The looming adoption of penny pricing may be the final nail in the coffin of customer priority. As the quoting increment narrows, liquidity will spread across a wide variety of price points. This will make it far more difficult for customer orders to get filled at a single price. It will also provide a strong incentive for customers and traders to improve their prices regularly. If they fail to do so, they risk being left behind by the rapidly shifting market.
In such an environment, many customers may simply opt for immediate execution rather than take their chances in the book. “If the markets move to pennies, then I think the days of the average retail customer working limit orders will simply disappear,” said Peter Bottini, executive vice president of trading and customer service for optionsXpress. “Even with all the priority in the world, it just wouldn’t be worth it for them. They will get pennied consistently and never get filled.”
At the end of the day, pennies may be the impetus that forces the industry to embrace the concept of price-time priority. In a penny market, it makes much more sense for exchanges to incentivize price improvement rather than reward a legacy system whose time has long since passed.
The views in this column are those of the author and do not necessarily reflect the opinions of Traders Magazine. The author welcomes comments and questions. He can be reached at mark.longo@sourcemedia.com
