A New Front In The Penny War

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A New Front In The Great Penny War
It is no secret that penny pricing is a divisive issue in the options business. As you read this, the debate over penny pricing continues to rage throughout the options industry. Retail brokerages continue to trumpet the savings that pennies have brought to their customers. At the same time, institutional brokerages argue that pennies are disguising liquidity and harming their customers' executions. Given the heated opinions on both sides of this issue, it doesn't appear that the conflict over pennies will end anytime soon.

To make matters worse, a new front recently opened in the the great penny war. This new front has redrawn the traditional battle lines of the options debate. Instead of retail vs. institutional, the new debate pits order flow providers (primarily retail) against the liquidity providers and the options exchanges that process their orders.




Maker-Taker Widens The Rift
At the core of this new battle is the growing prominence of the maker-taker fee structure (read "Breaking Down Maker-Taker" for more information on maker-taker pricing).

The options world was initially organized around a transaction system that gave priority to customer orders. Since customers were the primary drivers of options volume, it was taken as gospel that they were the lifeblood of the industry. Therefore, anything that could possibly benefit the customer was universally viewed as good for the business. Any effort that might lower customer transaction costs or reduce friction was given priority, even if it damaged other aspects of the industry in the process (read Death To The Tax Man for some of the unintended consequences of customer priority).

The "customer priority" gospel began to fall apart in recent years as a new class of professional customer emerged in the options market. This professional customer class expertly manipulated customer priority and routinely used it to prey on liquidity providers.

The onset of the Penny Pilot also strengthened the growing opposition to customer priority in the options market. With penny pricing dramatically reducing spreads in many classes, something needed to be done to incentivize liquidity providers in those products. NYSE Arca was the first exchange to copy the equity world's maker-taker model and adapt it for the penny options environment. So far, the results have been nothing short of astounding (see Breaking Down The Exchanges & The Rise of NYSE Arca for more information on NYSE Arca's exploding market share).

The Boston Options Exchange (BOX) also jumped on the maker taker bandwagon recently (see Options Insider Radio Episode 10 for more information on BOX and its maker-taker program) and more exchanges are expected to follow suit in the near future.

At the core of the maker-taker pricing model is the rebate that is paid to options liquidity providers. This rebate incentivizes market making in products that have experienced dramatic spread reductions as a result of penny pricing. Although this rebate has gone a long way toward improving liquidity in the Penny Pilot classes, it has also raised transaction costs in many of those products. In an industry that still views passing fees along to the customer as anathema, the question remains:

"Who Should Pay These Fees?"


Continued In:  "Are The Days of Cheap Options Commissions At An End?""

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