According to the famous poem 'If’ by Rudyard
Kipling, a sign of true maturity is the ability to keep your
head while all around you are losing theirs, and blaming it on
The US equity options market should consider adopting this as a
While the credit crisis has unleashed a frenzy of recrimination
aimed at derivatives, the exchange-traded equity options market
has not only kept its head – it has
Trading of US equity and index options reached 2.58bn contracts
in the first eight months of the year, according to the Options
Clearing Corp, a rise of 7% on the same period last year. That
puts the market on track for another annual record, beating
2009’s total of 3.63bn contracts, itself 1% up on
2008’s haul, despite the crisis.
Such slight growth was very unusual – over the past
decade, options volumes have increased more than
At the heart of the boom is the belief that options are a
toxic-free way of expressing long or short views, mitigating
risk and accessing leverage. Amid soaring popularity, the CBOE
Volatility Index of options volatility has entered
mainstream financial argot, attaining unrivalled status as Wall
Street’s fear gauge.
Competition turns fierce
But in the nature of capitalism, an efficient market –
such as US options seems to be – is rarely the result
of harmony. In fact, once you are inside the options market,
many of the players seem more like Kipling’s bad
examples – blaming and mistrusting each other in an
all-out scramble to gain advantage.
The introduction of penny pricing, and attendant tightening of
bid-offer spreads, have fuelled growth and spurred intense
competition among exchanges, which sit at the centre of a
rapidly evolving regulatory environment. In response, they have
launched a welter of initiatives designed to grab market share
and attract new money.
The key battlefield in the war for market share is pricing
models, and exchanges have this year bombarded customers with
pricing structure tweaks, fee rebates and commission
increments, all designed to boost transaction flow.
Meanwhile, exchange executives have fought an unseemly war of
words, each claiming to offer the best and cheapest customer
experience, while maligning competitors’
In recent weeks the backbiting has come to a head, with angry
letters fired off to the US Securities and Exchange Commission,
contesting the legality of practices at rival
"We have eight exchanges operating in a hyper-competitive
environment, all trying to attract order flow, and using
pricing models as incentives," says Andy Nybo, principal and
head of derivatives at Tabb Group, the Massachusetts-based
research and strategic advisory firm. "With a ninth exchange
set to start trading in October, the situation is only going to
continue to get more complex, and we may come to a point where
the regulator steps in to dictate fee revenues for
Smaller exchanges catch up
As exchanges have experimented with new pricing models and
protocols, market share has swung back and forth almost
However, putting aside squabbles over how contract share is
measured, the established exchanges have lost ground over the
In August, the Chicago Board Options Exchange had 27.2% of the
options business, according to the Options Clearing Corp,
compared with 32.5% in the same month last year. International
Securities Exchange, owned by Deutsche Börse, had 18.3%,
down from 27.4% a year ago.
The gainers are the exchanges owned by Nasdaq OMX and NYSE
Euronext. Nasdaq OMX PHLX now has a 23.4% market share, up from
15.5% in August 2009, while the smaller Nasdaq Options Market
has grown from 3.3% to 4.6%.
NYSE Amex Options, which only took 6.1% of trading last August,
is now getting 11.8%, a shade more than NYSE
Arca’s 11.7%, up from 10.9% last year.
Among the smaller players Boston Options Exchange (Box) has
suffered a market share drop from 4.4% to 2.7%, while Bats
Options Exchange, which only began trading in February, has
captured a 0.4% slice of the action.
Us and them
On pricing, the eight exchanges can broadly be divided into two
camps. The traditional or classic pricing camp (comprising
CBOE, ISE, PHLX, Amex and Box) uses a system called payment for
order flow, designed to keep costs for 'customers’
to a minimum. Customers are defined as end users who bring
orders to the exchange through brokers.
The exchange’s costs are borne by market makers,
defined as professional participants that quote prices
continually for large swathes of options, and are willing to
take orders at those prices.
The exchange assigns a certain portion of incoming orders to
market makers, which compete to offer the best price. The
better their prices, the more of the incoming order flow they
get. They pay fees for completed trades, part of which are used
to reward brokers for bringing customer orders to the
The alternative camp (Arca, Bats and Nasdaq Options Market)
uses a price-time priority pricing system alongside a so-called
maker taker model of pricing.
This system is more similar to what prevails in the cash equity
market. Maker taker pricing appears to have gained a slight
advantage in the public debate in the past year, though its
gains on the ground, in terms of actual market share, have been
Under this system, orders are executed at the best available
price in the order in which they were received. The fee is
charged to the broker (and hence the customer), and the party
that receives a rebate is the market maker.
"The maker taker model is a lower cost model for the market
maker because of the fee charged to customers," says Ed
Ditmire, an analyst at Macquarie Group in New York. "That
enables the market maker to offer tighter quotes and is why the
system has taken a good chunk of the market and is growing
Proponents of the two models are equally adamant that theirs is
the right method. Payment for order flow (PFOF) supporters say
it enables customers to get the best price and terms of
Maker taker fans insist their way is more transparent, because
all 'makers’ of liquidity (the market makers) are
rewarded fairly, while all 'takers’ of liquidity
(those sending in orders) are charged fairly. In PFOF, they
claim, exchanges and brokers can allocate payments in obscure
ways to suit their commercial ends.
Surrounding these two basic methodologies, however, is a tangle
of price offerings from all the exchanges, often combining the
two systems. The terms and special offers can vary from month
to month and often from customer to customer.
Among such variations, different access fees may be charged for
individual option classes or market participants, as well as
according to the size of orders. There are varying fees, with
minimum trading increments, different order types and auctions,
individual option series and even time periods.
That is aside from numerous "blue light specials" like
discounted access for professional customers. So prolific are
the changes that in the first quarter of this year listed
option exchanges submitted some 22 fee-related filings in 24
Not surprisingly, this constantly changing array of prices has
raised the hackles of some investors, who question the benefits
of a menu that is at best excruciatingly complex. At worst,
they complain, it could hinder broker-dealers from living up to
their best execution responsibilities.
"While competition fosters innovation, listed
option exchanges have increasingly competed through ever more
complex fee structures that do not bring the value normally
associated with innovation," said Anthony Saliba, CEO of
trading system provider LiquidPoint, in a letter to the SEC in
July. "This level of activity does not serve the interests of
any market participant – except the exchanges. Market
participants cannot reconcile the amount of fees they are
charged and it places an enormous burden on development of
trade routing and execution technology."
Still, the exchanges are unperturbed. In the
view of some market participants, they would rather throw
brickbats at each other than simplify fee structures.
Transaction fees remain the most incendiary
point of combat. ISE this August wrote to the SEC complaining
of what it termed "anticompetitive and discriminatory" fees
charged by three of its rivals, which it said had the effect of
locking out rivals.
"Box introduced a fee schedule which made it
cheap to trade for the initiating broker but extremely
expensive for anybody else, which makes the probability of
price improvement almost impossible," says Boris Ilyevsky
(pictured right), managing director of ISE in New York. "The
differential was so outrageous we had to comment."
The CBOE and PHLX had imposed separate
financial barriers with the same effect, Ilyevsky
Executives at rival exchanges have reacted
furiously to ISE’s claims, saying that ISE itself
routinely exceeds SEC caps on fee differentials, and branding
the accusations "unfounded" and "slanderous".
"We tend to operate a little bit differently,"
says Edward Tilly (pictured below), CBOE’s
executive vice-chairman. "Rather than firing shots at what they
have developed we take the lead – we would rather
innovate than take the opposite approach."
Fees 'too high’
Concern over access fees was first raised by Kenneth
Griffin’s Citadel, the Chicago-based options
market maker and hedge fund manager. In July 2008 Citadel asked
the SEC to limit the 'take’ fees options exchanges
can charge non-members for access to quotations to $0.20 a
Requirements that brokers buy and sell securities for clients
at the best available quote in the marketplace may encourage
venues to charge "excessive" fees to access their systems,
masking the true cost of trading, Citadel said.
managing director of order routing strategy at TD Ameritrade in Omaha,
says fees continue to exact a punitive tax on retail investors.
"The fees issue is not resolving itself on its own and the cost
of trading is far too high. There should be a cap or a system
like in Europe where the fee is tied to notional trade
A punitive tax may seem a strong description for necessary fees
that have not prevented huge growth in the market. But there is
no doubt many agree with Nagy, and the debate has now broadened
to include all fees.
The SEC has yet to lay down the law on fees, but is moving
toward doing so. In April it published proposed amendments to
Rule 610 under the Securities Exchange Act, in which it
proposed setting a fee limit at $0.30 a trade, mirroring the
cap in equity markets.
"In the Commission’s preliminary view, limiting
access fees to $0.30 per contract would promote intermarket
access, standardization of quotations, and the
Commission’s goals for an effective and efficient
linkage between and among the options exchanges," the SEC said
in its draft. "The proposed fee limitation would place all
options exchanges on a level playing field in terms of the fees
they can charge for the execution of incoming options orders
against their best bid and offer."
Some exchanges (presumably those favouring a PFOF pricing
model) might choose to charge lower fees, so as to be more
attractive to order routers, the SEC said, while others
(operating maker taker pricing with rebates) might charge the
full $0.30 fee and rebate a substantial portion to liquidity
Competition between the exchanges would ultimately decide which
pricing model was most successful, the SEC opined.
The proposed rule changes have been cheered by brokers, some of
which have called for the cap to be set at an even lower level,
but booed by the exchanges, which plead that transaction fees
are their most important source of revenue.
"Capping fees is a mistake and they shouldn’t do
it," says Ed Boyle, executive vice-president of NYSE Euronext
in New York. "Any time regulators get into the business of
capping fees it’s anti-competitive. If we had a
monopoly it might be a reason for a fee cap, but options is
competitive so regulators have no business coming in dictating
The CBOE is also up in arms, describing the proposals in a
letter to the SEC as an "extraordinary step", and saying that
access fees accounted for 73.8% of its revenue in
Flash without the
A further complication for the
traditional exchanges is the potential knock-on effects of any
fee cap, for example on the use of 'step-up’ or
'flash’ orders. These are offered by four
exchanges and are also the subject of proposed SEC
Flash orders emanated from the
SEC’s creation of a national market system for
securities and options. All the US options exchanges are
interlinked, and by law, each exchange must route away to
another exchange any incoming order which could be executed at
a better price on that exchange.
Under this system, exchanges were
allowed to give participants on their own exchange an
opportunity, for a short period, to "step up" to the National
Best Bid or Offer (NBBO) price quoted on a different exchange.
This "flash" functionality gives exchange participants a tiny
window of opportunity to match or beat the best price available
on another exchange, before the order is sent away.
In 2009, there was a burst of public
anxiety that sophisticated high frequency trading (HFT) firms
and banks were taking advantage of slower-footed investors. HFT
players, which use algorithms to dip in and out of markets
hundreds of times a second, are thought to generate as much as
60%-65% of total trading volume at options exchanges, according
to an estimate by Tabb Group.
The practice has been branded unfair by
US politicians and is subject to a review by the SEC.
Opposition crystallised around flash orders, which critics say
give the HFT firms an advantage because they are the only ones
that can react in time to fill the orders.
The SEC launched a consultation about
banning flash orders in both the equity and options
The great divide
In the options world, whether you
support or oppose a ban on flash trading tends to come down to
whether you favour PFOF or maker taker pricing.
Maker taker exchanges stand to benefit from a ban on flash
orders, because some of the time, their market makers,
emboldened by the prospect of fee rebates, quote more
aggressively than those on PFOF exchanges. If flashes were
banned, more orders would probably be routed automatically from
the PFOF exchanges to the maker taker ones.
The other camp hate this idea, saying that routing orders to
the NBBO does not necessarily give customers the best price,
because they may then be landed with an access fee at the maker
Therefore the CBOE and ISE oppose
a ban on flash orders, pointing to the system’s
role in lowering trading costs, while Nasdaq OMX and NYSE
Euronext – both of which operate one maker
taker market and one using PFOF – support
"Open access to the best displayed
prices fosters order interaction, price discovery and market
efficiency, while restricted access creates order isolation,
price opacity and inefficiency," says Tom Wittman, president of
Nasdaq OMX PHLX. "Flash mechanisms create disincentives for
market makers to provide their best market, and we support the
elimination of flash orders."
There are weaknesses in both sides of
the argument. Although flash orders can cause aggressively
quoting market makers to be disappointed, it is hard to see how
it disincentivises them.
However, one of the key arguments in
favour of flash orders is that, besides protecting customers
from paying to trade, they counterbalance excessive option
fees. The problem for supporters of flash orders is that if
fees are capped, one of the strongest arguments in their favour
Getco, a market maker and high
frequency trader, might be expected to oppose flash trading in
its role as a liquidity provider, while as a leader in HFT, it
might prefer to maintain the system.
In fact, as a strong proponent of maker
taker pricing (and part owner of the Bats exchange) it has come
down against flash orders, opposing what it calls a "two tier
market", and seemingly swimming with the tide on an issue that
the SEC is likely to resolve sooner rather than later.
As the SEC considers its options, the
battle for market share rages on. CBOE celebrated in July the
success of a four year legal action to prevent ISE from
offering options on the S&P 500 Index and the Dow Jones
Industrial Average – a market that CBOE now enjoys
Meanwhile, Nasdaq has tweaked its maker
taker offering and Box has opened talks with four retail
brokerages about selling an equity stake.
Meanwhile, yet another exchange is set
to launch in October, when CBOE opens a second platform called
C2. It will be an all-electronic alternative to CBOE, aimed at
reclaiming some of the market share lost to maker taker
exchanges, with what the exchange calls a "modified price/time
The move will bring CBOE in line with
Nasdaq and NYSE, which already have separate exchanges offering
both pricing models, and ISE, which offers, for a select group
of liquid contracts, a choice of formulas on its one
With so many offerings on the table,
and hybrid pricing mechanisms proliferating, executives say
there is little chance of the options market mimicking its cash
cousin, where one price-time pricing model is now standard.
Part of the reason is that exchange-traded
options are not subject to the internalisation processes that
have changed the equity markets, where banks and brokers absorb
order flow, filling trades from their own books rather than
passing them on to market makers. In effect, they act as
In options, business has so far stayed on
exchanges, fuelling competition in pricing. "We might see some
maximum level where one system [PFOF or maker taker] holds more
market share than the other, but the competition we see is part
and parcel of the special dynamics of the options market," says
Jeromee Johnson, head of Bats Options. "It is here to