The Evolution Of The Options Market: 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 remotelyfamiliar with the options market knows that the battle over paymentis far from over. The furor over this practice has deeply divided theindustry, 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 sofirmly entrenched and the SEC caught up in their penny obsession, thisfierce debate shows no signs of ending.

However, while the sniping mayhave abated, an interesting development has forced many combatants torethink their allegiances and old ways of doing business. I am speakingof course about the latest evolution of payment for order flow ñpreferenced trading.


Longing for the Days of Angry Gorillas
For those unfamiliar with the issues involved, hereís a brief historylesson. Back in the good old days of the options markets, people usedto actively compete for customer orders.

Groups of highly caffeinatedand angry men would fight to make the fastest and tightest markets fora customer order. The trader who made the best market would get as muchof the order as he wanted with the rest of the crowd parsing out thescraps.

It may not have been the most elegant way to conduct a transaction. Infact, more than a few observers likened it to watching angry gorillasfight at the zoo. However, it incentivized competition among liquidityproviders and gave the customers deep, liquid and reasonably tightmarkets.

But those days are finished. The dawn of multiple listing and the onsetof electronic trading have created a brave new world where tradingscreens have replaced the gorillas.

Transaction speed is no longerlimited to the snailís pace of the open outcry system. Instead, it islimited only by the bandwidth of your data feed and the processingpower of your computer.

The Evolution of Competition
However, these advances have created a new set of problems that can befar more insidious for market participants. Competition betweenindividual market makers has been replaced by competition betweenexchanges and large trading firms.

Although it was unthinkable only afew years ago, competing market makers and their specialists nowroutinely join forces when filling large orders.

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

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

In return for managing these competitive activities, the specialistsare rewarded with the lionís share of the volume in their particularproducts. This usually amounts to 20-40% of the order flow, although itcan be higher in certain products.

While many industry observers areoffended by this system of orchestrated bribery, it has functionedreasonably well for years. Granted, there were quite a few problems inthe early days, including rampant trade-throughs and bad fills.However, many of those problems were mitigated with the advent of thelinkage between the exchanges.

To Be Continued on Friday in "Preferenced Trading - Part Two..."

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