Breaking Down the Business: Preferenced Trading

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A (Relatively) New Front in the Payment War
Although the guns have been silent lately, anyone who is even remotely familiar with the options industry knows that the battle over payment is far from over. The furor over this practice has deeply divided the industry, creating a schism that grows larger every year.

Advocates for both sides ceaselessly fire broadsides at one another, leaving the average trader caught in the crossfire. With both sides so firmly entrenched and the SEC caught up in their penny obsession, this fierce debate shows no signs of ending. However, while the sniping may have abated, an interesting development has forced many combatants to rethink their allegiances and old ways of doing business. I am speaking of course about the latest evolution of payment for order flow ñ preferenced trading.


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Longing for the Days of Angry Gorillas
For those unfamiliar with the issues involved, hereís a brief history lesson. Back in the good old days of the options markets, people used to actively compete for customer orders. Groups of highly caffeinated and angry men would fight to make the fastest and tightest markets for a customer order. The trader who made the best market would get as much of the order as he wanted with the rest of the crowd parsing out the scraps.

It may not have been the most elegant way to conduct a transaction. In fact, more than a few observers likened it to watching angry gorillas fight at the zoo. However, it incentivized competition among liquidity providers and gave the customers deep, liquid and reasonably tight markets.

But those days are finished. The dawn of multiple listing and the onset of electronic trading have created a brave new world where trading screens have replaced the gorillas. Transaction speed is no longer limited to the snailís pace of the open outcry system. Instead, it is limited only by the bandwidth of your data feed and the processing power of your computer.

The Evolution of Competition
However, these advances have created a new set of problems that can be far more insidious for market participants. Competition between individual market makers has been replaced by competition between exchanges and large trading firms. Although it was unthinkable only a few years ago, competing market makers and their specialists now routinely join forces when filling large orders.

This is all done in the hope of attracting more volume to their trading crowd or electronic trading bin.  Unfortunately, with many equity options trading in nickel or even penny increments, there is precious little room to compete on price. How, then, do exchanges, specialists, DPMs, trading firms and others compete for customer orders? The answer is payment.  

The Nitty Gritty
How does payment work? Currently, most options exchanges collect funds from individual members and member firms in the form of supplemental fees. These fees are then deposited into accounts that are administered by the specialist firms. The specialist firms then use the funds to buy order flow for their particular products.

In return for managing these competitive activities, the specialists are rewarded with the lionís share of the volume in their particular products. This usually amounts to 20-40% of the order flow, although it can be higher in certain products. While many industry observers are offended by this system of orchestrated bribery, it has functioned reasonably well for years. Granted, there were quite a few problems in the early days, including rampant trade-throughs and bad fills. However, many of those problems were mitigated with the advent of the linkage between the exchanges.

To Be Continued on Thursday in Preferenced Trading - Part Two...

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