A Battle Between Two Market Structures
Nasdaq Options Market is choosing a price-time priority model, where whomever is there first, trades first and gets the entire order. This is more akin to what NYSE Arca and the Boston Options Exchange (BOX) are doing, but completely different from how the other options exchanges - International Securities Exchange, Chicago Board Options Exchange and the American Stock Exchange- work, says Nunes. In that more hierarchical market structure, customers go first in time priority, and then the specialist gets an allocation. Usually 40 percent of an incoming order is the standard allocation that the specialists get after customers step ahead, according to Nunes. Then other market makers receive a pro-rata allocation and then non-market maker firms get a piece of the order, he says. For example, If "you come in with 100 contracts sitting at the inside, by the time everyone has joined you, you're going to get 10 contracts," says Nunes.
"The key driver of that (price-time priority) model is penny pricing. In the current nickel world four-or-five or six exchanges are all on the inside bid and the inside-offer, he says. So all the exchanges are at the inside price, but what usually breaks the tie is payment for order flow. But if the minimum quoting increment in options is changed from nickels to pennies, instead of 20 price points, there will be 100 price points per dollar. Then, there is more incentive to drive the quote in the price-time priority world and if there are different market structures, there will be more competition, says Nunes.
Nasdaq executives contend that running two different types of market models for options trading could be a winning formula. "I do believe that having the two models puts us at a huge advantage over everyone else," says Concannon. In the traditional model, there is a hierarchy where customers get priority over market makers. "A customer order jumps ahead of someone who spent $1 million on a Google bin," says Concannon. "If I'm a dealer expecting to get 40 percent of every order and someone jumped ahead of me, my economics just changed," says Concannon.
While the price-time priority model is a bit new to the options market, there are indications that that's where the market is headed, says McPartland. "But that's not how the options markets were created," adds the analyst, noting that the AMEX, CBOE, ISE and PHLX are all pro-rata quote driven models, while the newer electronic options exchanges Nasdaq, Arca and BOX are all "make or taker" models which reward liquidity providers with rebates and charge fees to liquidity takers.
"We're talking about Nasdaq coming from the equities world and developing the options market in a very similar way," says McPartland. In options, exchanges usually charge 30 cents per 100 contracts to take liquidity and pay a rebate of 15 cents per 100 contracts to add liquidity, says McPartland. "Those incentives have worked in other markets, such as equities with BATS (ECN) and NYSA Arca Options has a similar model," notes McPartland. "That's one of their incentives," says the analyst, referring to Nasdaq OMX and the second incentive is their technology. Everything is built new and built for today's world."
But one options industry source, who requested anonymity, doesn't understand why Nasdaq-OMX would want to buy the PHLX trading floor when it costs far less to trade options electronically. "They were so far ahead of the curve and now they're taking a step background," says the options source, who is an options professional with over 20 years of experience in the industry.
"I don't think it makes a lot of sense to keep the Philly exchange there. I think there has to be something more to it than meets the eye," says the source.
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio