Welcome to Futures Industry
Sherree DeCovny
Published 3/14/2008

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In the highly competitive world of U.S. equity options trading, some exchanges are experimenting with new models for setting transaction fees as a way to gain a greater share of the market. Two exchanges— NYSE Arca Options and the Boston Options Exchange—have implemented the makertaker model for pricing, and a third— Nasdaq—is preparing to do the same. Some say maker-taker pricing makes good economic sense for market participants, others say it does not. Here’s why.

The U.S. equity options industry currently has two pricing models: customer priority and maker-taker. Under customer priority, any account identified as “customer” goes to the front of the line with respect to priority of fill, and pays no transaction fees to the exchange. The exchange stays in business by charging market makers fees for transactions and payment for order flow. The payment for order flow is paid to brokerage firms as an inducement to send their orders to a given exchange.

Maker-taker was invented in 1997 by Island, an alternative trading system for U.S. equities. Under this approach, all trades are divided into two types of orders: price setter and price taker. Traders who want to buy or sell at a given price place a price setter order, and traders who want to interact with the bid or offer place a price taker order. Typically, the price setters get a rebate when their orders are executed and the price takers are charged.

The maker-taker model is now used by a number of equity markets, but it was not viewed as applicable to U.S. equity options trading until the industry, under pressure from the Securities and Exchange Commission, began implementing penny pricing in 2007.

At NYSE Arca Options, for example, the exchange implemented maker-taker pricing in January 2007 for the options classes included in the penny pilot, and it recently asked the SEC for permission to extend maker-taker pricing to the 25 most liquid non-penny pilot names. Registered market makers on NYSE Arca Options receive 30 cents per contract and non-market makers receive 25 cents per contract whenever their quotes are hit. Liquidity takers are charged 50 cents per contract. BOX, which implemented maker-taker pricing in September 2007, offers the same rebates to firms that provide liquidity, and charges 45 cents per contract for liquidity takers.

Kevin Fischer, manager, block execution services at Interactive Brokers, explains the economics behind maker-taker for his company. Interactive Brokers acts as a broker, but it also acts as a market maker under the name of Timber Hill. He estimates that the cost per contract for Timber Hill’s trades on maker-taker exchanges is roughly 70 cents lower than the cost on a customer priority exchange. That reflects not only the 30 cent rebate but also the elimination of roughly 20 cents in exchange fees and a 20-cent reduction in payment for order flow fees. Timber Hill calculates that this difference in cost gives it enough incentive to improve the quote by a penny or $1 per contract. By showing a better quote, Timber Hill can go to the front of the line and capture a greater share of the volume.

In contrast, there is little incentive to be the price improver on the customer priority exchanges. A market maker can tighten the market, but then a customer can come in behind and go to the front of the line, thanks to the priority rules. In fact, market makers often complain that the customer priority model gives professional traders an incentive to game the market by trading through a customer account. For instance, some proprietary trading firms have established affiliated “customer” hedge funds. They can stand outside of a market and wait for the market makers to send prices, then join those prices and go to the top of the book.

A customer cannot represent a two-sided market so these “customers” may join a bid for five seconds, cancel it and join the offer for five seconds, repeating this process all day long. Their hope is to interact with incoming order flow at a price that gives them a trading edge, which is augmented by payment for order flow from the market makers, and not reduced by exchange fees.

“As more firms take this approach, fewer market makers are left to bear the costs of running the exchange, and have less opportunity to interact with the order flow that their markets attract,” says Fischer. “As a result, some of these market-making firms have decided to post superior markets on the maker-taker exchanges in the hope of better interaction rates at reduced costs.”

What about the retail customer side of the business? On the maker-taker exchanges, customers typically have to pay a fee because generally they are taking liquidity, rather than providing it. All else being equal, one therefore would expect customers to prefer the traditional model. One would also expect their brokers to prefer the traditional model because of payment for order flow, which rewards brokers for bringing customer orders to a particular exchange. But in a best execution world, brokers are required to route orders to the best price. Supporters of the maker-taker model argue that if market makers can offer better pricing on the makertaker exchanges because of the economics of the pricing model, then maker-taker exchanges may well capture a larger share of trading, especially in the series that are priced in pennies. They also argue that the cost of paying fees for taking liquidity should be more than outweighed by the benefit of receiving a better price.

According to Scott Morris, CEO of BOX, the value of the maker-taker model is that it allows market makers to quote a narrower bid/offer spread. It also promotes liquidity because they receive a credit on each contract for which they provide liquidity.

“One of the problems we’ve seen with the penny pricing is the lack of liquidity on the inside book,” says Morris. “This incents people to not only tighten markets but also to add more size to their markets.”

Since all orders must be routed to the exchange with the best price, BOX hopes it can pick up market share by having the tightest market. So far the model has worked; the exchange says its market share is up around three percent since it implemented maker-taker pricing.

Ed Boyle, vice president at NYSE Arca Options, agrees with Morris. “With a makertaker model, the spreads are inherently tighter,” he says. “The NYSE Arca is four times more likely to have the best price than any other exchange. It is simply due to the fact that we’ve got a better pricing structure for the liquidity provider. We attract order flow because of best price, not because we can pay the most for it.”

Buy-side firms do pre- and post-trade analytics in order to forecast and assess results as well as ensure best execution. Boyle notes that the maker-taker model increases transparency because the fee structure is defined, and this makes best execution easier to measure.

While many stakeholders believe makertaker is better than customer priority, some market participants see significant drawbacks. One concern is that there are no rules in the equity options markets to prevent locked and crossedmarkets.Alockedmarket happens when the bid and offer are the same but no trade occurs. A crossed market is when the bid is higher than the offer but no trade occurs.

Historically, options markets were rarely if ever locked but it is becoming more frequent, particularly in active names such as the QQQ. According to TD Ameritrade, the market in the QQQ is locked about four percent of the time, sometimes for more than 10 seconds. Often, it is a maker-taker exchange locked against a customer priority exchange. In these situations, the quoted spread is zero or even negative, but the true spread may be large enough to discourage the trade because of the differences in the fee structures.

Chris Nagy, managing director of order routing, sales and strategy at TD Ameritrade, says his firm is concerned about the effect of this trend on the firm’s retail client base. Locked and crossed markets confuse retail clients, which leads to more calls into the call center, price dissatisfaction and other negative impacts on market integrity.

“We’ve been vocal about preventing the locking and crossing of one market versus the other,” says Nagy. “In the absence of these rules, maker-taker pricing could reward these manipulative practices.”

Citadel co-head Matt Andresen (and former CEO of Island) is another opponent of maker-taker pricing in the options markets. He warns that consistently rewarding market makers and punishing customers may be good in the short term, but in the long run it is a bad idea. He uses this analogy to explain his point: A shopping mall owner might be able to charge customers a cover charge for one day because everyone has already driven there, planned their day, and they are not going to go home. But they are not coming back.

He also is adamant that the taker charges for equity options on NYSE Arca and BOX are abusively high. By comparison, for a marketable limit order in the equities markets, exchanges can charge a maximum of 30 cents per hundred for taking liquidity and rebate liquidity providers up to 20 cents per hundred. Ultimately, either the taker charges in options have to be capped at a low rate— he thinks around 25 cents is fair—or internalization has to be permitted. That’s allowed in the equity markets, and it gives brokers a way tomatch customer orders without incurring the taker charges. “The current model [in which customers trade free] is the right one, which is why options volume is growing at 40% per year,” says Andresen. “We have something that is clearly working very well, and the incredibly rapid adoption of this product by institutional and retail customers is evidence of those correct incentives.” Some market participants are worried that one effect of the maker-taker model is that retail brokers will have less of an incentive to support educational initiatives that promote equity options trading and expand the market. Prior to 1999, retail brokerage commissions in the options markets were considerably higher than they are today. When payment for order flow programs started after 1999, it created a strong incentive for retail brokers to increase their order flow by reducing commissions and providing more value added services and education tools to their customers. Retail brokers warn that they will have fewer resources to support such programs if maker-taker become the dominant model. Others feel there is no relationship between payment for order flow and education, and predict that there will be educational money available in a maker-taker environment. As BOX’s Morris points out, the Options Industry Council holds over 100 seminars a year to educate investors about options. These efforts are funded by the exchanges and the Options Clearing Corp., not the brokerage firms. It is likely that the customer priority and maker-taker models will continue to coexist for the foreseeable future. From a retail broker’s perspective, multiple models allow for more competition, which increases price transparency and levels the playing field for retail and institutional investors. “In the equity markets you’ve got multiple models and multiple price points,” says Nagy. “So the likelihood that you see multiple models at multiple price points in the options world is pretty strong.”

That may be why both NYSE Euronext and Nasdaq plan to use both models. NYSE Euronext bought the American Stock Exchange and will continue using the traditional pricing model on that exchange. Nasdaq bought the Philadelphia Stock Exchange and said it will run that exchange in parallel with a new exchange, now awaiting SEC approval, that will use maker-taker pricing.

Interactive’s Fischer notes that the two models can coexist to the extent that different trading firms find value in each model and the exchanges that sponsor each can make enough money to keep their doors open. Since floor exchanges are the most expensive to run, and favor the customer priority model, they ultimately depend on finding enoughmarketmakers willing to bear the cost of payment for order flow.

But he also predicts that as the pool of market makers dries up when they decide to trade as customers, the financial burden on the remaining market makers will become too onerous. If maker-taker exchanges show tighter markets, the remaining market makers on customer exchanges will still be held to the standard of the NBBO, so per trade profits will wane.

“This is an industry full of smart people who will figure out how to game any system faster than the exchanges and regulators can stop it,” he says. “In the short run, any model can exist, but economics will ultimately determine which model survives.”

Sherree DeCovny is a journalist specializing in finance and technology. Her work has appeared in leading U.S. and U.K. trade journals. She is also the author of several books and reports in her field.
 
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