Options industry players are lining up against the International Securities Exchange’s controversial proposal to permit clean crosses.
In the past week several exchanges, market makers and institutional brokers have publicly voiced their support for a petition by the Chicago Board Options Exchange to require the Securities and Exchange Commission to reconsider the ISE proposal the regulator approved this summer.
The ISE’s so-called "qualified contingent cross" order type would permit institutional brokers to cross large options orders without exposing the trade to other exchange participants. Such "clean crosses" are considered "de facto internalization," by some in the industry, who contend they represent a drastic change to the way business is conducted in the options market.
The SEC actually approved the ISE proposal in August, but the CBOE won an automatic stay shortly thereafter. The ISE is eager to put the new rule in place, but must wait until the SEC decides whether or not to uphold the stay and reconsider the rule change. Organizations supporting the CBOE position include options exchange operators such as NYSE Euronext and Nasdaq OMX PHLX and market makers such as Wolverine Trading and Group One.
"This is a significant change to rules of priority which are designed to protect the interest of public customers," NYSE Euronext told the SEC in a letter. "Such a rule change should be approved only after a more thorough review."
NYSE Euronext’s letter follows comments made by its options chief Ed Boyle at an industry conference two weeks ago. "I’m not a fan," Boyle told the crowd at a conference jointly put on by the Futures Industry Association and the Option Industry Council. "This takes us towards the European structure where they do not have an onscreen customer market. [The order type] will continue to undermine the structure of the options business."
When the ISE’s proposal was first made public, the CBOE told the SEC that use of the order would be the first time crosses were allowed on an options market "without exposure to market participants and ahead of resting public customer orders." Ed Tilly, a CBOE executive vice president, said at a recent conference jointly sponsored by the Futures Industry Assoc. and Options Industry Council that the ISE’s move was "an all-out attack on current market structure."
Others echo CBOE and NYSE Euronext, arguing public customers will suffer if the ISE gets its way. Susquehanna Investment Group, an options market maker and brokerage, was an early critic of the proposal and recently reiterated its distaste for the ISE plan in a letter to the SEC.
Wolverine Trading, a market maker and brokerage, recently told the SEC the proposal represents a "material, transformative change" that "places the options industry squarely on a path that leads directly to broader forms of internalization."
Other exchanges have also expressed their concern. "We don’t like it," Tom Wittman, president of Nasdaq OMX PHLX, told the FIA/OIC crowd. "I’m sorry we did not comment against it."
Chris Nagy, a TD Ameritrade managing director responsible for order strategy, said it was "an attempt to create a de facto internalization model in the options market when maybe the options markets are asking for higher interaction rates."
The ISE’s proposed order type is similar to the exception to Regulation NMS’ trade-through rule for "qualified contingent trades." In that exception, certain stock orders whose executions are contingent on executions in the options or other markets are allowed to trade-through the market’s best quote.
The ISE qualified contingent cross order would permit a broker to cross the options leg of a qualified continent trade with a contra-side order "immediately upon entry." Like the qualified contingent trade of the equities world, the qualified contingent cross order would bypass orders on the book. The rule would only apply to orders of at least 500 contracts traded at the NBBO or better.
The SEC approved the ISE’s new order type despite reservations. The regulator agreed with the CBOE that it would "represent a change in certain long-held principles in the options market because it would permit the execution of a cross order without requiring exposure or customer priority."
The SEC based its approval, however, on the fact that the order type was similar to the Reg NMS exemption for qualified contingent trades, which it believes benefits the market as a whole. The SEC also liked the fact that the order type is limited to a minimum of 500 contracts and would be executed at the NBBO or better.
The order type’s detractors argue its approval could be merely the first step towards widespread internalization in the options market. Today, 500 contracts, they say; Tomorrow, 10 contracts.
"Suddenly, before you know it," NYSE Euronext’s Boyle said at FIA/OIC, "the rules have been watered down to the point where you’re completely internalizing the 10-lot order coming from the retail customer."
Nasdaq OMX PHLX’s Wittman said: "Trading like this probably belongs in an auction to get responses and maybe price improved. It’s a slippery slope. Whether its 500 or 200 lots. Even if it’s 500, we’re against it."
The ISE originally presented its proposal to the SEC as a replacement for a rule it was discarding. Previously, on the ISE, a trader got an exemption from the ISE’s trade-through rule if his order was for 500 contracts or more. The ISE discarded this block trade exemption this summer as the options industry moved to a uniform trade-through rule. The industry-wide rule contains no block-trade exemption. To make it possible for block traders to continue to trade through the NBBO, the ISE argued its qualified contingent cross order type was necessary.
At FIA/OIC, Gary Katz, the ISE’s president and chief executive officer, argued the order type was not a big deal and did not represent a significant change in the way business is done at exchanges. He said traders put up crosses all the time on exchanges and are not broken up. There are too few traders on the floors of exchanges to break them up, he said.
In the ISE’s filing, the exchange stated that the crosses would not usurp the priority nor otherwise put at a disadvantage the orders on the book because those orders would not be bidding and offering for the contingent trade. "Most people recognize it is very little change at all to how things are done today," Katz said.
