The results of the SEC-mandated options "penny pilot" and the increased presence of institutional investors in the market could change the U.S. equity options trading landscape, raising the possibility of more-ECN-like models.
It seems likely that options exchanges will define their operations based on their response to the fundamental question, "Can the options market continue to grow and function efficiently with the current quote-driven, 'pro-rata' model, the predominant way of doing business in options exchanges today?"
In the pro-rata model, market makers, which are assigned, pay a fee to gain the responsibility to maintain liquidity in the market by providing quotes on a specified group of options. Customers respond to these quotes with buy or sell orders. Options markets determine the order of execution priority based on the largest volume order at a given price. Liquidity is expressed by the number and volume of quotes on an option.
In contrast, in the equities market, orders are executed on a price-time priority model -- the first order entered at the most competitive price is executed first, regardless of size. Liquidity is expressed by the number of matches between the bid and ask prices on a stock.
As new exchanges and institutional investors enter the options market, the question is, Could the industry better serve investors by switching to an order-driven, price-time priority model? Additionally, to what degree should options classes be quoted in penny increments?
Purchasing Order Flow
The penny pilot was a trial period that ran from January through June 2007 during which 13 equity options, representing about 15 percent of the overall market, changed their quotation intervals from $0.05 minimum increments to $0.01 increments. The goal was to reduce the practice of payment for order flow, in which market makers offer rebates to their customers in exchange for orders.
Market makers fund payment for order flow through the margins on options transactions. The pilot's concept was that reducing the minimum available margin between a bid and ask price will lower the amount of potential funds available to pay for order flow, and thus curtail the practice.
Payment for order flow has attracted retail brokers and much liquidity to the market and has been extremely lucrative for market makers, according to Brad Bailey, author of a May 2007 Aite Group report on options trading. However, the practice tends to artificially attract orders to market makers that are offering the highest rebates but not necessarily the best price.
But while the industry is growing -- the compound annual growth rate in options from 2002 to 2006 was 27 percent -- its constituency is changing. According to the Aite Group report, "The U.S. Equity Options Landscape: More Options Than Ever!," in 2006 institutional options trading volume was equal to retail volume for the first time. While retail volume dominated the market previously, the report predicts that institutional volume will rise to 54 percent and retail volume will decline to 46 percent by the end of 2007.
Unlike retail investors, institutions with fiduciary best-execution obligations to their clients may not be as inclined to participate in payment for order flow because, although they would get a rebate, they would not necessarily be getting the best price. Additionally, about 33 percent of the options market is hedge funds, which are accustomed to high-frequency, highly leveraged electronic trading in the equities world. As a result, some of the institutional market participants favor a trading model similar to the price-time priority model of the equities market, as compared to the quote-driven model that currently dominates options trading.
As for penny pricing, Bailey refers to the impact penny trading had in equities. He says that if the options market were to switch to penny quotation, it's likely traders would experience a drop in displayed liquidity at the National Best Bid and Offer (NBBO). The market makers would not have as much incentive to amass large offers in a single location, and thus control the course of trading in a given class, he explains. More smart-routing technology and execution algorithms would enter the market, and fragmentation of liquidity across multiple exchanges, alternative trading systems and ECNs would occur, which could make large block orders more difficult to transact, Bailey continues.