The tide could turn against flash orders in the options industry in the wake of tremendous public pressure to banish these order types in equities. Flash orders have existed in options since 2004.
The Securities and Exchange Commission has not ruled out any action. "Market developments could cause us to seek rule changes across all markets," an SEC spokesman told Traders Magazine this week. Nasdaq OMX Group and BATS Exchange said yesterday they would eliminate flash orders on their equities markets by September, after Senator Charles Schumer of New York argued that the SEC should ban these order types.
A number of options exchange executives support flash orders. They make the case that these orders save customers money by enabling those customers to avoid higher access fees at another exchange. Flash orders are not believed to account for a significant amount of market share, although statistics are not available. Flashed orders that execute match the national best bid or offer available when the order is flashed. The flash period for exchanges that offer these orders is one second.
All exchange executives, however, may not fight efforts to eliminate flash orders in options. "Philosophically, if the SEC wants to get rid of it, we don’t have a big issue with that," said Will Easley, vice chairman of the Boston Options Exchange, which was the first exchange to offer flash orders in options. "This does good things for customers–that’s why we do it. A customer might otherwise have to pay an away market’s fees that could be higher than ours." BOX has maker-taker pricing for options in the penny pilot, but not for non-penny options classes.
Ed Boyle, who runs NYSE Euronext’s U.S. options business, said his company doesn’t approve of flashing orders in options and doesn’t do it at NYSE Arca Options or NYSE Amex Options. "We don’t agree with flash," he said. "We route out immediately if we’re not the best market. We don’t slow the order down and disclose it to participants."
Flash orders, in his view, run counter to the goal of transparency in the markets. "Flash orders disclose customer information to a select group of market participants, which effectively creates a two-tiered market," Boyle said.
The International Securities Exchange and the Chicago Board Options Exchange argue that flash orders benefit customers. "Customers like this functionality," said Boris Ilyevsky, managing director of the ISE Options Exchange. "They see a direct economic benefit."
He notes that flash order types in options are technically similar to those in equities, although the benefits are different. "Our market makers and members can match the away price through a flash auction," Ilyevsky said. "That gives the customer the away price without paying a take fee that could, on some markets, be 45 cents per contract. The customer fee on the ISE is zero." If there’s no response, the ISE’s primary market maker in that symbol seeks the best price through a linkage order.
The Chicago Board Options Exchange makes the same argument. Its flash order type is called HAL, for Hybrid Agency Liaison. "Prior to outbound routing, orders are flashed to market participants at the CBOE with the opportunity to match the NBBO and keep the order at the exchange," said Edward Tilly, executive vice chairman of the CBOE.
Tilly noted that the CBOE uses HAL when it’s not at the NBBO or doesn’t have enough size. "The best argument for [this order type] is economics, since we’re not employing maker-taker fees and many routing firms are involved in payment for order flow, which lowers costs further," he said.
BOX’s flash capability, called the "NBBO exposure mechanism," is primarily used to enable public customers to get a fill at the best price on BOX without having to route out any residual quantity. "We flash the residual quantity of a customer order we can’t completely fill at the best price," Easley said.
For instance, if his market has 20 contracts offered at the best price and a buy order for 50 contracts arrives, it would flash the remaining 30 to its entire subscriber base to see if anyone wanted to execute the remaining contracts at the best price. Easley noted that broker-dealers with public customer orders do not usually send flow to BOX if the exchange is not at the NBBO.
In options, exchanges have different market models and pricing structures. Exchanges with price-time priority for all participants and maker-taker pricing typically charge those executing against bids and offers a take fee. Traditional markets allocate a portion of incoming marketable customer orders to market-making firms on a pro-rata basis, and do not charge public customers a transaction fee. Those exchanges also have payment-for-order-flow programs.
Flash orders came about when more options trading took place on exchange floors than is now the case. "In the 2004 days, the NBBO in the options world still had a lot of floor quotes included in it that were unreliable," BOX’s Easley said. "Flashing an order could thus increase the likelihood of getting a quicker fill at the NBBO."
NYSE Euronext’s Boyle argues that times have changed. He notes that flashed orders can enable participants receiving the flashes to trade ahead of customers whose orders are flashed, either in the stock market or in options. "When an order is flashed, there’s often not a lot of contracts available at the best price," he said. "It’s when the market is moving fast that a customer is likely to be disadvantaged [by flash orders]." He added that flash orders proliferated in 2007 when the penny pilot began. Arca has price-time priority and maker-taker pricing for penny-quoted options.
Easley suggests that concerns about being traded ahead in options as a result of the information being flashed are minimal for a couple of reasons. First, he said, the other firm would have to take out all the volume at the best price in away markets, which could be costly. And second, orders that are flashed are typically for small size. Easley also notes that options prices do not move as quickly as the underlying price and are less sensitive to those movements in some cases. Even in penny names, it’s not a 1:1 move, he said.
Flash mechanisms in options are different from the price improvement auctions many exchanges have. Those auctions enable customers to seek price improvement over the NBBO in penny increments in options classes not quoted in pennies. Flash order types enable an exchange to match the best price on another market if it is not at the NBBO.