Trips to exotic resorts and bottles of fancy wine were once offered in the options industry in exchange for order flow. It was a practice familiar in the equity trading markets. And sadly, it was an accepted cost of business. Call it shady. Whatever it was called, this was once part of the controversial system known as payment for order flow.
But if you think this practice is now history, think again.
Payment for order flow is bigger than ever before. Indeed, it may be one of the most contested issues in the options business today. In a few short years, it has divided the options world. In one corner, proponents claim that the practice is still merely a natural evolution of competition between the exchanges. In the other corner, critics describe payment for order flow as outright bribery.
David Johnson, a managing director at Morgan Stanley, once famously referred to payment for order flow as "the devil itself." Strong words from a powerful industry captain. But unfortunately, there is little hope that the fight over these payments will end soon.
Market makers, exchanges and trading firms have been buying access to orders for decades. Back in the bad old days, of course, these payments were subtle and rarely, if ever, did they involve cash. There were other ways to compensate order flow providers, recalls one exchange official.
"Before payment for order flow, there were trips to Puerto Rico. There were arrangements that firms made to barter order flow," says Meyer "Sandy" Frucher, Chairman and CEO of the Philadelphia Stock Exchange. "Is all of that wrong? Some of it, maybe, but frankly you're never going to eliminate payment."
Indeed, recently the practice has become more blatant. Today, market makers, trading firms and exchanges explicitly pay brokers an "incentive" fee – say $2 a contract – for every contract routed to them. It is part of the "marketing" costs. These payments are negotiated openly and listed in brokerage bills alongside commissions.
The explosive growth of payment for order flow has coincided with increased competition in the options industry. And since the options trading markets are tighter than ever, exchanges and DPMs now have a difficult time competing on price alone.
So payment for order flow has become an integral part of the competitive forces. For example, if every exchange lists the same bid for an option, but one exchange pays a higher "incentive fee" than its competitors, brokerage houses are more likely going to route most orders toward the exchange with the best incentive. It's a simple fact of economic life, but it has critics up in arms. These same critics charge that the practice gives brokerage firms a reason to violate their fiduciary responsibility.
After all, whenever the exchange with the highest incentive fee is not the exchange with the best price, a conflict can arise between the brokerage's and customer's economic interests. Most reputable brokerage firms should choose to honor their fiduciary responsibility: Route orders to the exchange with the best price. But, as some market makers will tell you, this is not always the case.
Still, technology could catch up with the deceptive practices. For instance, the recent electronic linkages between the exchanges seem to have helped reduce the payment arrangements. However, this reduction is not enough to quiet the critics. Some of these critics have sent the Securities and Exchange Commission examples of brokers allegedly violating their fiduciary responsibility in return for actual cash payments. Unfortunately, the SEC has been slow to issue a firm ruling in this controversial area, some of these critics charge.
"This is so deeply imbedded in our business that, absent something that is really earth-moving, whether it is Mr. Spitzer or somebody else, I don't think there is going to be a lot of change, because the SEC doesn't feel that they have the capability," says Bill Brodsky, Chairman and CEO of the Chicago Board Options Exchange.
Brodsky compared attempts at eliminating payment for order flow to putting your finger on a balloon. "You press on one side and something is going to come out the other side," he says.
The SEC says it is aware of the issue. John Heine, a spokesman, pointed out to Traders Magazine that the agency published a concept release examining payment for order flow, about 12 months ago. And it then followed up with some specific recommendations.
In an earlier study, the SEC's Office of Compliance Inspections and Examinations concluded that payment for order flow did influence where trades were routed. However, brokerage firms were not passing along the benefits to investors, according to the SEC study.
The critics of payment for order flow are not satisfied. "The SEC feels that they've addressed the issue by disclosure, but they have actually done a very poor job in dealing with the issue," says Brodsky. However, banning payment for order flow is like tilting at windmills. "Any time there are multiple manufacturers trying to sell product down a limited number of distribution channels, there are going to be incentives offered," says Kenneth Leibler, Chairman and CEO of the Boston Options Exchange. Leibler says the BOX is exceptional because it does not "pay" for orders. His competition is presumably paying attention. But Leibler admits, "I don't think that you will ever eliminate these incentives."
Frucher, who agrees, says, "What you really have to do is define it, control it and make sure it's transparent."
The issue of transparency has become problematic. Many firms and exchanges know how to dress up the incentives. Payments of cash are frequently compounded with other, less explicit incentives. One popular method is to allow brokerage houses to cross, or internalize, a larger percentage of volume. This allows brokerages to gain double commissions and generate position profits without any cash changing hands. The combination of internalization with direct payment has likely hampered the SEC from issuing a cast iron rule banning, or dramatically curbing, payment for order flow.
"Part of the problem is that the SEC has been unable to differentiate these things sufficiently," says Brodsky. He says the SEC, for example, is unable to legally separate out the differences between tickets to a ballgame and internalization.
To be sure, it may seem ironic to listen to the heads of U.S. options exchanges condemn a practice which some of their members sanction. But Frucher says some of the blame is misdirected. "The finger gets pointed at the options industry as though it were the only one that does payment for order flow and that it has been eliminated by pennies in the equity industry," says Frucher. "That's just not true."
Frucher noted that "payment for order flow" is prevalent in the equities markets through complex, but perfectly legal, liquidity rebates. "Virtually every order that is sent to Arca or the Nasdaq is an order that is paid for in one form or another," he says.
So what's the best advice on all of this? Learn to live with payment for order flow because it's not going away. Buyside equity traders need to watch the relationships between their brokerage firms and options exchanges as well as trading houses. If the brokerage firm accepts cash incentive payments in return for trades, then be sure to check your fills and make sure you are getting the best prices.
Mark Longo is an options trader and a former member of the Chicago Board Options Exchange.