From the Archives: The Shadowy World of Trade Crossing
For over a quarter of a century, the options industry has relied uponits proven transaction system to meet the demands of the financialmarketplace. At the heart of this system are the brokers, market makersand exchanges that execute option trades. However, in recent years, anew transaction system has emerged that threatens to reshape the entireindustry. This system is known as trade crossing.
WHAT IS IT?
Tradecrossing (a.k.a. internalization) occurs in two distinct forms. Thefirst form occurs when a brokerage house becomes the counter party totheir customerís order. Alternatively, brokerage houses can alsoarrange for their customers to become order counter parties. In eitherscenario, these transactions are arranged prior to reaching theexchange and involve little or no market maker participation.
Tradecrossing has sparked a fierce debate within the options industry.Opponents of the practice, primarily market makers and floor traders,believe that it is a direct usurpation of their role as liquidityproviders. Supporters of the practice, primarily brokerage houses andthe exchanges, believe that trade crossing expands the industryísrevenue stream, increases trading volume and improves customersatisfaction. Which viewpoint is correct? As with most debates, theanswer lies somewhere in the middle.
WHY THEY DO IT
Tradecrossing came about in an effort to improve customer satisfaction andincrease brokerage fill rates. On any given trading day, a large numberof option orders remain unfilled. This is due to a variety of factorsincluding price, size, market movement and the complexity of the order.Each unfilled order represents lost revenue for the brokerage houses,exchanges, market makers and clearing houses. It also represents anunsatisfied customer.
To reduce this problem, brokerage housesbegan to cross their partially filled orders. Since this serviceentailed additional labor and risk for the brokerage house, it wasusually reserved for the accounts of loyal customers. However, thebenefits of this service were believed to outweigh the costs. Tradecrossing improved customer satisfaction, increased brokerage fill ratesand generated additional commission revenue. Many industry analystsbelieved that trade crossing was a good idea whose time had come.Unfortunately, as often happens with good ideas, it soon took on a lifeof its own.
Tradecrossing soon began to drastically affect other established practiceswithin the options industry. The first change came in the way thatorders were handled inside the brokerage houses. Under normalcircumstances, the specifics of options orders remained confidentialuntil brokers announced them in the trading pits. Any market makers ortraders who violated this confidentiality faced steep fines and evencriminal charges. Confidentiality was strictly enforced to preventadvanced knowledge from moving the markets and adversely affecting thecustomerís order.
Nevertheless, order confidentialitygradually slipped away as trade crossing became more prevalentthroughout the industry. In order to cross their trades, brokeragehouses needed to find counter parties for their customerís orders. Thiscould only be done by showing their orders to other customers, apractice known as shopping.
Sinceorder shopping is a time intensive process, it was initially done on avery limited basis. But, as competition intensified within thebrokerage industry, many firms began to look for alternative sources ofrevenue. The double commissions generated by trade crossing, as well asthe customer goodwill engendered by the service, made it anirresistible lure. Order shopping quickly became widespread as brokerscompeted to cross their order flow.
Today, virtually allsignificant options orders are repeatedly shopped before they everreach the trading floor. The expansion of order shopping has helped tofuel the raging debate over trade crossing. In the eyes of most marketmakers and floor traders, early access to critical information is aprimary benefit of exchange membership. Exchange members are usuallythe first to learn about significant orders and the first to see trendsdevelop in the marketplace. However, these benefits vanished whenbrokerage houses began revealing their orders to other customers.
Ordershopping gave nonmembers access to order information before it wasrevealed to market makers and other exchange members. Over time, thisdisparity of information flow had a significant impact on the dynamicsof the marketplace. The tracking of customer and brokerage positions, anecessary function for market makers, was obscured by the large volumeof shopping and crossing activity. It became virtually impossible todetermine which side of the trade represented the customer, whether thecustomer was opening or closing their positions and who took the otherside of their trade. As a result, it became difficult to identifytrends or inefficiencies in the marketplace. Additionally, marketmakers had to fend off front-running attempts by proprietary tradersattempting to exploit their early access to order flow.
Manymarket makers turned to the exchanges to address their concerns overtrade crossing. The options exchanges had always tolerated tradecrossing as way to facilitate customer transactions. However, in orderto protect their members, they had also taken steps to regulate thepractice. Trades could not be crossed on the bid or offer pricesdisseminated by the market makers. A brokerage house had to provide abetter price for their customer if they wanted to cross a trade. Inaddition, they also had to provide the market makers with a chance toparticipate in the trade. These regulations worked well until theadvent of multiple listing for equity and index options in the late1990s.
The options exchanges soon found themselves locked in aheated battle for trading volume. All trades, including crossed trades,were fought over bitterly. The exchanges even began to pay their memberfirms to route orders to their trading floors. They even adopted aspecialist system similar to their equity counterparts as a way tofurther their competitive efforts.
RISE OF THE SPECIALIST
Thesespecialists, also known as Designated Primary Market Markers (DPMs)decentralized many of the functions of the exchanges. DPMs becameresponsible for the lionís share of the marketing, trading andenforcement activities in their particular option products. The oldrestrictions on trade crossing were gradually relaxed as individualspecialists struggled to attract more business. Crossing trades on thedisseminated bid or offer prices was allowed as long as the marketmakers received a chance to participate.
This stipulationsounded good in theory, but it fell apart in practice. Most brokeragehouses shopped their orders before they routed them to a particularexchange. As a result, many of their orders arrived at the trading pitswith counter parties already attached. These orders were essentiallyfilled before they ever reached the trading floor. This left littleroom for the market makers, floor traders or specialists to participateon the trade.
If the exchange members protested or tried toblock the trade, the order was routed to a more lenient exchange with aspecialist that needed the volume. Market makers and floor traders,armed with precious little leverage, found themselves in anincreasingly untenable situation. They could either remain silent andallow the transactions to take place without participating or block thetrades and risk losing a significant percentage of their tradingvolume.
To be continued in Part 2...
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