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| Options at the Crossroads |
Note: This feature length story by Chris McMahon originally appeared in the February 2010 issue of SFO Magazine.
Link to original @ SFO Magazine
As U.S. regulators come to grips with the public perception that they have been asleep at the wheel while financial markets careened into chaos and lawlessness, there is legitimate concern that regulated markets, which have performed remarkably well, could be become victim to oversteering.
Public outrage is growing about seemingly rampant insider trading rings, enormous compensation packages for firms that have received bailouts and a string of hedge fund frauds and Ponzi schemes. Those issues, in conjunction with a new presidential administration and recently appointed heads at the Securities and Exchange Commission and the Commodity Futures Trading Commission have prompted a thorough reconsideration of what kind of markets Americans want and the consumer protections and regulation they need.
Although less volatile and upward trending markets have quelled demand to ban short selling, there is still a push for changes to tax laws and a proposed ban on flash orders for the equity and equity options markets that threaten the status quo.
“The options market is at a crossroads,” says Gary Katz, CEO of the International Securities Exchange. “Lawmakers and regulators are considering regulatory proposals that will change the future of the industry by altering market structure and imposing restrictions on exchange trading practices.” Exchange regulation is made up of complex, interconnected rules, he adds, and reversing rules without careful examination could have unintended consequences.
Last spring, we saw an example of this when it was again proposed to end the 60-40 tax break for options market makers and other market participants. The rule allows market makers to claim 60 percent of revenue as long-term gains, taxed at up to 15 percent, and 40 percent as short-term gains, taxed at 39.1 percent. An end to the tax incentive would require market makers to declare all revenue as income, and the expectation is that the increased costs would be passed on to traders or drive market makers out of the business.
In November, Representative Peter DeFazio of Oregon and others supported a per-transaction tax that would collect 0.25 percent of the notional premium per trade. “For people who make tons and tons of round-trip trades a day, this is a disaster,” says George Ruhana, CEO of OptionsHouse, adding that such a move would spell the end of high-frequency trading and hurt market makers.
He explains that, for example, on 100 shares of a $100 stock, there is $10,000 in premium and a trader would pay $25 in tax, which would overwhelm the potential profit of a business that already has razor thin margins. “It’s called the Wall Street pays for Main Street tax, and they say it could raise $150 billion; except if volume collapsed and there was no one there to pay it,” Ruhana says.
THERE’S A BATTLE OUTSIDE
One of the battlegrounds is the issue of flash trading. As per the SEC’s fact sheet, “A flash order enables a person who has not publicly displayed a quote to see orders less than a second before the public is given an opportunity to trade with those orders.”
In her comment letter to the SEC, Janet M. Kissane, senior vice president and legal and corporate secretary for NYSE Euronext, said that flashing contributes to wider market maker quotes, “because providing the national best price loses meaning when an order can be diverted into a flashing period rather than immediately routing to the best quoted price destination.”
NYSE also points out that when the flash trading rules were created, communications between exchanges were inefficient. An exchange receiving an order from another exchange had 20 seconds to report back a fill or cancel. “In that environment, flash orders were designed to avoid linkage and the inherent delays. Today, with highly efficient electronic systems, even the one-second flash period is much longer than the time required to route an order to an away market center at the NBBO [national best bid and offer] and to receive a response,” and therefore, “flash mechanisms in the options markets have the same fundamentally anti-competitive results as occurs in the equities markets.”
BATS Trading Inc. and NASDAQ OMX stopped offering flash orders in late summer. In his comment letter to the SEC, BATS attorney Eric Swanson argues that access to the flash order is exclusive to those with advanced technology and, therefore, contributes to a two-tiered market. He also observes that under Reg-NMS, protected quotes may not be traded through, but neither are they protected against another market trading at the same price, therefore the risk of being “traded at” creates a disincentive to post aggressive limit orders.
“During the period in which marketable orders are being exposed to a private network of users, those same orders are effectively priced at a locking price,” Swanson writes, and the U.S. regulatory structure is designed to avoid locked markets. Further, because flash orders are not included in the consolidated price tape, the tape no longer reflects the reality of the market and distorts the benchmark for best execution.
The idea that certain market participants would get a sneak peek at incoming orders before they are disseminated to the wider market is on the surface counter to just about everything good and right about free and open markets. The justifiable fear is that their widespread use could lead to a two-tiered market in which market participants hide their liquidity and drive up prices, and, to make matters worse, only high-frequency traders can afford the technology to see flash orders and respond to them.
A DIFFERENT SET OF RULES
Equity markets and equity options markets are different in many important ways, and it is noteworthy that the exchanges that oppose flash trading are those that grew as extensions of equity exchanges.
Equities markets are order driven, whereas in options, 98 percent of the quoted market comes from market makers, professionals with an obligation to buy or sell, while maintaining a firm bid and offer price.
Further, the equity options market is dispersed across more exchanges and the liquidity is spread out not among 7,000 stocks, but rather puts, calls and multiple strikes of perhaps 3,000 names. And although there are 40 million stock transactions per day, there are only 750,000 options trades.
Finally, the structures of the markets are substantially different.
Although seemingly arcane, these issues are directly related to who pays for what and when. A decision to ban flash orders could favor some exchanges over others and increase trading costs for retail traders.
FROM THE SHADOWS TO THE MARKET
“Today there are two distinct fee structures in options. There is the maker-taker market, and there is the classic fee market,” Katz explains. “In the maker-taker, market makers get paid to provide liquidity, and when you send in an order and hit a bid or an offer, you pay a taker fee. That taker fee is today 45 cents.” In a classic market, such as the ISE, Chicago Board Options Exchange and Boston Options Exchange, market makers are charged and customers trade for free.
Because market makers receive a rebate on maker-taker exchanges, they are able sometimes to make more aggressive markets than traditional exchanges. If an order comes to the exchange and it does not have the best market, the exchange can then route the order to the maker-taker market, or flash the order to the members of the exchange, offering them an opportunity to step up to the order.
Flash orders are embedded in the price improvement mechanisms that exist at the traditional options exchanges, says Tony McCormick, CEO of the Boston Options Exchange. There are the Price Improvement Process at BOX, the Price Improvement Mechanism at the ISE and Automated Improvement Mechanism at the CBOE. “All of those mechanisms use an exposure for price improvement. Where you have established an NBBO, the order is stopped at the NBBO, and there’s an instantaneous auction that can occur,” he says.
HER PROFESSION’S HER RELIGION
Given the degree of connectedness between the exchanges and market participants, the profit motive and the differences in fee structures at the various exchanges, it is not a huge surprise that many sophisticated traders have found ways to make those differences into an edge.
“Certain participants that post liquidity in the maker-taker world are also participants trying to get customer priority in the traditional model, so they are trying to have their cake and eat it, too,” McCormick says. “It’s pretty easy to see how you could game that to the disadvantage of other participants.”
An argument could be made that market flow would be internalized; however, he says that would be detrimental to transparent, competitive markets for retail customers.
If that trend were allowed to continue, market makers at traditional exchanges would likely give up their entitlements and obligations and become customers, depriving the exchange of liquidity and further fragmenting the markets.
“A lot of people want to be customers on the most liquid front-month stuff and the at-the-money strikes,” Ruhana says. “But there are strikes across the board on this thing, and we need fair and orderly markets in all of them.”
In response, as of Jan. 1, CBOE will implement a mandatory professional customer designation. “What we are doing is for the sake of our algorithms,” says Ed Tilly, vice chairman of the Chicago Board Options Exchange. “We recognize those customers as acting very much like our liquidity providers in certain series, without the obligation. Therefore, we are going to treat them as professionals when it comes to the matching algorithm.”
The ISE put into place a similar mandatory professional customer designation in October.
While CBOE is taking steps to protect the integrity of the traditional CBOE structure, it is also hedging its bets. CBOE has announced that, upon authorization of the SEC, it will launch a second options exchange, called C2. Tilly maintains that the final decision has not been made or announced, but most expect it to use the maker-taker fee schedule and allocate order flow on a first in, first out algorithm rather than on a pro-rata customer priority basis.
“A lot of it is going to be determined based on regulatory issues,” Tilly says.
Such an arrangement would not be unusual. NYSE Euronext owns both the NYSE Arca Equities Exchange, which also trades options, and NYSE Amex. NASDAQ has the Philadelphia Stock Exchange and NASDAQ OMX.
“It’s difficult to determine whether rule makers really appreciate the role of regulated markets—which worked well amidst the credit crisis of late 2008 and early 2009—and how structural changes to these markets might adversely affect investors,” says Bill Brodsky, CBOE chairman and CEO.
“While the proposed legislation for financial reform acknowledges the lack of regulation in OTC markets,” he says, “there continues to be a disproportionate focus on tinkering with specific rules within regulated markets and less resolve to bring unregulated markets onto regulated platforms. Clearly, Congress needs to set its sights on the big picture, the perils of systemic risk, not the minutia of regulated markets, which provide investor safeguards, such as transparency, price discovery, certainty of execution and protection against counterparty risk through centralized trading and clearing.”
Chris McMahon is a Chicago-based business journalist, specializing in markets and technology. He is editor of the JLN Metals Edition and contributing editor to MarketsWiki.com. In addition, he is a frequent guest lecturer at the Medill School of Journalism and other colleges in Chicago on journalism and economics.
Public outrage is growing about seemingly rampant insider trading rings, enormous compensation packages for firms that have received bailouts and a string of hedge fund frauds and Ponzi schemes. Those issues, in conjunction with a new presidential administration and recently appointed heads at the Securities and Exchange Commission and the Commodity Futures Trading Commission have prompted a thorough reconsideration of what kind of markets Americans want and the consumer protections and regulation they need.
Although less volatile and upward trending markets have quelled demand to ban short selling, there is still a push for changes to tax laws and a proposed ban on flash orders for the equity and equity options markets that threaten the status quo.
“The options market is at a crossroads,” says Gary Katz, CEO of the International Securities Exchange. “Lawmakers and regulators are considering regulatory proposals that will change the future of the industry by altering market structure and imposing restrictions on exchange trading practices.” Exchange regulation is made up of complex, interconnected rules, he adds, and reversing rules without careful examination could have unintended consequences.
Last spring, we saw an example of this when it was again proposed to end the 60-40 tax break for options market makers and other market participants. The rule allows market makers to claim 60 percent of revenue as long-term gains, taxed at up to 15 percent, and 40 percent as short-term gains, taxed at 39.1 percent. An end to the tax incentive would require market makers to declare all revenue as income, and the expectation is that the increased costs would be passed on to traders or drive market makers out of the business.
In November, Representative Peter DeFazio of Oregon and others supported a per-transaction tax that would collect 0.25 percent of the notional premium per trade. “For people who make tons and tons of round-trip trades a day, this is a disaster,” says George Ruhana, CEO of OptionsHouse, adding that such a move would spell the end of high-frequency trading and hurt market makers.
He explains that, for example, on 100 shares of a $100 stock, there is $10,000 in premium and a trader would pay $25 in tax, which would overwhelm the potential profit of a business that already has razor thin margins. “It’s called the Wall Street pays for Main Street tax, and they say it could raise $150 billion; except if volume collapsed and there was no one there to pay it,” Ruhana says.
THERE’S A BATTLE OUTSIDE
One of the battlegrounds is the issue of flash trading. As per the SEC’s fact sheet, “A flash order enables a person who has not publicly displayed a quote to see orders less than a second before the public is given an opportunity to trade with those orders.”
In her comment letter to the SEC, Janet M. Kissane, senior vice president and legal and corporate secretary for NYSE Euronext, said that flashing contributes to wider market maker quotes, “because providing the national best price loses meaning when an order can be diverted into a flashing period rather than immediately routing to the best quoted price destination.”
NYSE also points out that when the flash trading rules were created, communications between exchanges were inefficient. An exchange receiving an order from another exchange had 20 seconds to report back a fill or cancel. “In that environment, flash orders were designed to avoid linkage and the inherent delays. Today, with highly efficient electronic systems, even the one-second flash period is much longer than the time required to route an order to an away market center at the NBBO [national best bid and offer] and to receive a response,” and therefore, “flash mechanisms in the options markets have the same fundamentally anti-competitive results as occurs in the equities markets.”
BATS Trading Inc. and NASDAQ OMX stopped offering flash orders in late summer. In his comment letter to the SEC, BATS attorney Eric Swanson argues that access to the flash order is exclusive to those with advanced technology and, therefore, contributes to a two-tiered market. He also observes that under Reg-NMS, protected quotes may not be traded through, but neither are they protected against another market trading at the same price, therefore the risk of being “traded at” creates a disincentive to post aggressive limit orders.
“During the period in which marketable orders are being exposed to a private network of users, those same orders are effectively priced at a locking price,” Swanson writes, and the U.S. regulatory structure is designed to avoid locked markets. Further, because flash orders are not included in the consolidated price tape, the tape no longer reflects the reality of the market and distorts the benchmark for best execution.
The idea that certain market participants would get a sneak peek at incoming orders before they are disseminated to the wider market is on the surface counter to just about everything good and right about free and open markets. The justifiable fear is that their widespread use could lead to a two-tiered market in which market participants hide their liquidity and drive up prices, and, to make matters worse, only high-frequency traders can afford the technology to see flash orders and respond to them.
A DIFFERENT SET OF RULES
Equity markets and equity options markets are different in many important ways, and it is noteworthy that the exchanges that oppose flash trading are those that grew as extensions of equity exchanges.
Equities markets are order driven, whereas in options, 98 percent of the quoted market comes from market makers, professionals with an obligation to buy or sell, while maintaining a firm bid and offer price.
Further, the equity options market is dispersed across more exchanges and the liquidity is spread out not among 7,000 stocks, but rather puts, calls and multiple strikes of perhaps 3,000 names. And although there are 40 million stock transactions per day, there are only 750,000 options trades.
Finally, the structures of the markets are substantially different.
Although seemingly arcane, these issues are directly related to who pays for what and when. A decision to ban flash orders could favor some exchanges over others and increase trading costs for retail traders.
FROM THE SHADOWS TO THE MARKET
“Today there are two distinct fee structures in options. There is the maker-taker market, and there is the classic fee market,” Katz explains. “In the maker-taker, market makers get paid to provide liquidity, and when you send in an order and hit a bid or an offer, you pay a taker fee. That taker fee is today 45 cents.” In a classic market, such as the ISE, Chicago Board Options Exchange and Boston Options Exchange, market makers are charged and customers trade for free.
Because market makers receive a rebate on maker-taker exchanges, they are able sometimes to make more aggressive markets than traditional exchanges. If an order comes to the exchange and it does not have the best market, the exchange can then route the order to the maker-taker market, or flash the order to the members of the exchange, offering them an opportunity to step up to the order.
Flash orders are embedded in the price improvement mechanisms that exist at the traditional options exchanges, says Tony McCormick, CEO of the Boston Options Exchange. There are the Price Improvement Process at BOX, the Price Improvement Mechanism at the ISE and Automated Improvement Mechanism at the CBOE. “All of those mechanisms use an exposure for price improvement. Where you have established an NBBO, the order is stopped at the NBBO, and there’s an instantaneous auction that can occur,” he says.
HER PROFESSION’S HER RELIGION
Given the degree of connectedness between the exchanges and market participants, the profit motive and the differences in fee structures at the various exchanges, it is not a huge surprise that many sophisticated traders have found ways to make those differences into an edge.
“Certain participants that post liquidity in the maker-taker world are also participants trying to get customer priority in the traditional model, so they are trying to have their cake and eat it, too,” McCormick says. “It’s pretty easy to see how you could game that to the disadvantage of other participants.”
An argument could be made that market flow would be internalized; however, he says that would be detrimental to transparent, competitive markets for retail customers.
If that trend were allowed to continue, market makers at traditional exchanges would likely give up their entitlements and obligations and become customers, depriving the exchange of liquidity and further fragmenting the markets.
“A lot of people want to be customers on the most liquid front-month stuff and the at-the-money strikes,” Ruhana says. “But there are strikes across the board on this thing, and we need fair and orderly markets in all of them.”
In response, as of Jan. 1, CBOE will implement a mandatory professional customer designation. “What we are doing is for the sake of our algorithms,” says Ed Tilly, vice chairman of the Chicago Board Options Exchange. “We recognize those customers as acting very much like our liquidity providers in certain series, without the obligation. Therefore, we are going to treat them as professionals when it comes to the matching algorithm.”
The ISE put into place a similar mandatory professional customer designation in October.
While CBOE is taking steps to protect the integrity of the traditional CBOE structure, it is also hedging its bets. CBOE has announced that, upon authorization of the SEC, it will launch a second options exchange, called C2. Tilly maintains that the final decision has not been made or announced, but most expect it to use the maker-taker fee schedule and allocate order flow on a first in, first out algorithm rather than on a pro-rata customer priority basis.
“A lot of it is going to be determined based on regulatory issues,” Tilly says.
Such an arrangement would not be unusual. NYSE Euronext owns both the NYSE Arca Equities Exchange, which also trades options, and NYSE Amex. NASDAQ has the Philadelphia Stock Exchange and NASDAQ OMX.
“It’s difficult to determine whether rule makers really appreciate the role of regulated markets—which worked well amidst the credit crisis of late 2008 and early 2009—and how structural changes to these markets might adversely affect investors,” says Bill Brodsky, CBOE chairman and CEO.
“While the proposed legislation for financial reform acknowledges the lack of regulation in OTC markets,” he says, “there continues to be a disproportionate focus on tinkering with specific rules within regulated markets and less resolve to bring unregulated markets onto regulated platforms. Clearly, Congress needs to set its sights on the big picture, the perils of systemic risk, not the minutia of regulated markets, which provide investor safeguards, such as transparency, price discovery, certainty of execution and protection against counterparty risk through centralized trading and clearing.”
Chris McMahon is a Chicago-based business journalist, specializing in markets and technology. He is editor of the JLN Metals Edition and contributing editor to MarketsWiki.com. In addition, he is a frequent guest lecturer at the Medill School of Journalism and other colleges in Chicago on journalism and economics.