With this month’s extension by the Securities and Exchange Commission of the pilot covering trading in penny increments the battle has begun anew over whether to expand penny trading or not.
Three exchanges–NYSE Arca, International Securities Exchange and Chicago Board Options Exchange–have submitted proposals covering the pilot. Supporters of one plan or the other have made their cases to the SEC. The regulator is expected to make a decision before the extension ends on Oct. 31.
The pilot is now over two years old and the industry is divided over whether the current number of options trading in pennies should be increased. Many participants are eager to take the pilot to the next level.
NYSE Arca is one of them. The exchange is now driving the agenda with its June proposal to expand penny trading at its exchange by another 300 classes. That would bring the total number of options classes trading at NYSE Arca in pennies to 363. The plan is unchanged from a previous NYSE Arca proposal to require penny trading in all options that cost less than $3. Those costing $3 or more would trade in nickel increments. Certain ETF options would have no breakpoint.
If all exchanges adopted this plan, trading in pennies would account for between 85 percent and 90 percent of all volume. Today, trading in pennies accounts for about half of all volume.
NYSE Arca’s proposal has both supporters and detractors. The Chicago Board Options Exchange and the International Securities Exchange are in the opposing camp. They would prefer to reduce the number of options trading in pennies.
The two recently submitted proposals of their own calling for an expansion of penny trading, but recommended a $1 breakpoint. Only those options trading for less than $1 would trade in pennies. Under the CBOE’s plan, all other options would trade in nickel increments. Under the ISE’s proposal, options trading from $1 to $3 would trade in nickels. Options trading for more than $3 would trade in dimes.
The two exchanges’ proposals would reduce the number of series trading in pennies, leaving about one-third of volume subject to penny trading. The exchanges want to curb trading in pennies because the pilot has resulted in less size at the top of the book, which has driven block trading to the over-the-counter market.
ISE and the CBOE point out that most retail volume occurs in the series trading for less than $1 anyway. Both exchanges note that retail customers, presumably the SEC’s target, tend to trade the cheaper options.
"The case for trading options over the counter has gotten stronger as a result of the move to pennies," Boris Ilyevsky, managing director of the ISE’s options exchange, tells Traders Magazine. "Two years ago, the spread was at least a nickel wide and there was more liquidity on the screen. Spreads were wide enough that market makers were more willing to take the risk associated with posting large size quotes."
The Securities Industry and Financial Markets Association and at least one big options broker also want to see a rollback of the pilot by reducing the breakpoint to $1. "Executing larger client orders in Pilot options has been more difficult due to decreased liquidity at the inside market," executives from UBS told the SEC in a letter. "To compensate for the loss of liquidity, UBS more frequently facilitates the other side of larger options orders."
NYSE Arca does have its supporters. TD Ameritrade, the large retail brokerage, recommended the SEC keep the $3 breakpoint in a letter to the regulator. TD Ameritrade noted that while most volume occurs in options that trade under $1, most trades occur at or below $3.
TD Ameritrade recognizes that market makers have become reluctant to supply as much liquidity as they used to in the penny names. As an incentive to do so, the firm suggests the SEC and the exchanges increase the size of market makers’ allotments from 40 percent to 60 percent. Current exchange rules cap the portion of any trade in which a market maker may participate at 40 percent.