The flash trading debate has shown the derivatives market in a good light.

Position papers arguing against the proposed ban on flash trading of options, signed by the CBOE’s Bill Brodsky, Michael Simon of ISE and the Boston Options Exchange’s Tony McCormick, have dissected this issue with forensic precision.

All are anxious to avoid a regulatory clampdown that would hurt their interests, and which they maintain would also damage the market as a whole. Not just market intermediaries would suffer, they claim, but also end users of derivatives – in this case, retail investors.

So far, so familiar. Every time a law or regulation threatens companies’ freedom to make money, these are the terms in which they couch their opposition.

Strident protests of this kind were heard all summer in the US, over CFTC chairman Gary Gensler’s plans to impose position limits on commodity traders, especially in energy.

What makes the options exchanges’ complaints different from those of the commodity ‘investment’ industry is that as you read them, you gain a sense of clarity and understanding. Whether right or wrong, their arguments make sense.

The opposite was true of the evidence so many market participants gave to Gensler’s commodity hearings. The more you read or listened to that, the more you were befuddled with unanswered questions, unjustified assertions and rhetoric used to cover up the holes.

Promoting competition…

With flash trading, CBOE and ISE argued calmly that this practice is not a way of giving sophisticated market participants privileged access to the best pricing, to the detriment of ordinary investors.

Rather, they believe, it helps investors get the national best bid or offer (NBBO) price at the exchange of their choice.

When an order arrives that is marketable – that is, it could be executed at the NBBO price on one of the seven US options exchanges – but for which the NBBO is at a different exchange, the order may, at the choice of the submitter, be flashed to market makers on the receiving exchange.

For a fraction of a second, they have a chance to match or better the NBBO. If they do not do so, the order is routed away to the competing exchange.

Who loses out? Conceivably, market makers on the receiving exchange that are too slow to respond to the flash order. But without the flash, they would also miss out, as the order would go straight to the exchange with the NBBO.

The market maker that originally posted the NBBO at another exchange does miss out on an order, if the NBBO is matched or bettered at the receiving exchange. But this puts pressure on that market maker to quote more aggressively, and on all exchanges to make themselves attractive to customers so that they receive order flow.

Finally, the submitter could lose if market makers front run – that is, use the order as a cue to snap up the NBBO at the other exchange and then trade out, perhaps even to the original submitter.

As Professor Lawrence Harris points out in another submission to the SEC, this could be prevented easily, by forbidding market makers to take the NBBO of an order being flashed.

As far as CBOE and ISE are concerned, banning flash orders would harm competition by forcing orders to be routed to the exchange with the NBBO, without regard to the total cost of trading, including fees, which may be higher for customers at exchanges with maker-taker pricing, such as NYSE Arca.

…or stifling it?

Of course, there are two sides to every question. Getco, the electronic trading firm, submitted a detailed comment to the SEC – in favour of banning flash orders.

Getco’s paper is as detailed and thoughtful as those of CBOE and ISE. It believes, unlike them, that flashing orders has pretty well the same effect in the options market as in equities – which is to inhibit competition that would benefit the consumer.

Central to this is Getco’s view that flash trading is unfair – free-riding on the information supplied to the market by the NBBO market maker at another exchange; getting in between the customer and the best price; and discouraging market makers from quoting aggresively.

The firm points out another way the submitter could lose from flash trading – if the NBBO worsens during that fraction of a second, and the flash fails to match it.

This is presumably unusual – and anyway the submitter can opt out of flash trading. But Getco has a point that there is little oversight of this issue.

However, the most important issue separating the two camps is whether they favour maker taker pricing or the conventional payment for order flow (PFOF) method.

CBOE and ISE say market makers on maker taker exchanges can win orders by quoting more aggressively because of the fee rebate they get. The customer is then slapped with a fee that changes the economics of the trade.

For Getco, it is PFOF that distorts. While maker taker pays all liquidity makers and charges all liquidity takers, irrespective of who they are, PFOF is far less transparent, Getco contends, because fees are “aggregated and allocated to certain customers at the sole discretion of specialists according to their indivdual business interests”.

Transparent and democratic

Who is right and wrong in this debate matters, of course – but more important still is the picture it gives of a market that is hyper-disciplined, strictly controlled but still apparently highly competitive and efficient.

No market is perfect. Reading the submissions makes it clear how hard – perhaps impossible – it is to achieve complete fairness and transparency. As Lawrence Harris points out, in any effort to design a market, one must balance the desire to have several exchanges, competing to lower costs and improve service, with the recognition that the fiercest competition on the actual trading price would occur if there was only one market.

But the US equity options market is surely one of the most advanced and efficient.

Not only that – the regulator and market participants with different views and commercial interests are engaged in a constructive debate about how the market could be improved. Like the market itself, that debate is both technically sophisticated and accessible to the ordinary citizen.

Oil speculators, carbon emitters and credit default swap dealers take note.

Jon Hay +44 207 779 8372 jhay@fow.com