Breaking Down The Options Market: Payment For Order Flow

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A DIVISIVE ISSUE
Payment for order flow is the most divisive issue in the history of theoptions market. This untoward practice has set off a firestorm ofcontroversy and divided the options world into two angry camps.

Proponents claim that the practice is merely the natural evolution ofcompetition between the exchanges. Critics deride it as outrightbribery and claim that it has destroyed the integrity of the industry.

Unfortunately, there is little hope that the fight over payment fororder flow will end anytime soon. This divisive practice hasmetastasized throughout the entire industry, leaving little but outrageand bitterness in its wake.


AN OLD PRACTICE
Payment for order flow is not a new phenomenon. In fact, market makers,exchanges and trading firms have been buying access to orders fordecades. Back in the good old days, these payments were subtle andrarely, if ever, involved cash.

ìBefore payment for order flow, therewere trips to Puerto Rico. There were arrangements that firms made tobarter order flowî says Meyer ìSandyî Frucher, Chairman & CEO ofthe PHLX. ìIs all of that wrong? Some of it, maybe, but frankly youírenever going to eliminate payment.î

However, in the last five years, the payments to brokers have becomemuch more direct. Today, market makers, trading firms and exchangesexplicitly pay brokers an incentive fee for every contract that issteered their way. These payments are negotiated openly and are evenlisted in brokerage statements alongside commissions.

The explosive growth of payment for order flow has coincided with theexponential growth of competition in the options industry. With moreexchanges fighting for an ever-shrinking slice of the options pie, theincentive to ìbuyî orders increases. Since the options markets aretighter than ever, exchanges and specialists have a hard time competingon price alone.

As a result, payment for order flow has become an integral part of thecompetitive process. For example, if every exchange lists the same bidfor an option but one exchange pays a higher ìincentive feeî than itscompetitors, the brokerage houses are going to steer the bulk of theirorders toward that exchange.

Itís a simple fact of economics, but ithas outraged industry watchdogs for decades. These same criticscharge that the practice gives brokerage firms an incentive to violatetheir fiduciary responsibility.

After all, whenever the exchange with the highest incentive fee is notthe exchange with the best price, a conflict arises between thebrokerage firmís economic interest and the customerís economicinterest. Most reputable brokerage firms choose to honor theirfiduciary responsibility and route their order to the exchange with thebest price. Unfortunately, that hasn't always been the case...

To Be Continued In Part Two...
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