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Large specialist firms have long been a powerful force in the options business. These firms maintain presences on every exchange and are responsible for managing the payment programs and competitive activities across a wide array of products. As a result, they have a firm grip on the market share and the purse strings of the exchanges. If a firm decides that it is not worth their effort to compete in a particular product on a certain exchange, their decision can have a devastating impact on the exchangeís bottom line.

Sharing Power
Since exchanges are not accustomed to sharing power, the relationship between the exchanges and the specialists has always been tense. The dramatic expansion of the option specialistís role over the last decade has only served to exacerbate this situation.

While clashes between large firms and exchanges are nothing new, these struggles for power lie at the heart of the preferenced trading movement. Proponents of preferenced trading claim that it breaks the stranglehold of the specialist firms and increases the level of competition in the marketplace.

Ground Zero
The PHLX is ground zero for the preferencing movement. While other exchanges hemmed and hawed over the feasibility and viability of preferenced trading, the PHLX jumped in with both feet. They call their preferencing system a "directed order flow program," and it has raised more than a few eyebrows.

As usual, their outspoken CEO Meyer ìSandyî Frucher has a few words for the programís critics. ìSome people think that preferenced trading has a negative effect on the industry by decreasing the level of competition,î Frucher responds. ìHowever, I can make a heck of an argument that it actually increases competition. By allowing more firms to directly compete for orders, we are freeing ourselves from the tyranny of the single specialist system. Why should an exchange, a trading crowd or a liquidity provider lose their market share because a specialist doesnít feel that it is worth their while to pay for orders in a particular product. When we open up the system to more players and more competitors, everyone wins.î

The debate over preferenced trading is not unique to the options market. A similar debate has raged in the equities world for years. Countless studies have been carried out on this subject, with each one reaching different conclusions about the efficacy and impact of the practice. As is often the case with controversial subjects, both sides have amassed enough ammunition to continue fighting for years to come.

The Future
After the PHLX let the cat out of the bag in the options market, other exchanges quickly followed suit with their own variations on preferenced trading. While economists continue to debate the effect of preferenced trading on competition, the real question  is whether or not this practice will benefit the options industry over the long term.

Although it is too soon to render judgment on that front, there is one outcome from preferenced trading that has already occurred - it has removed yet another layer of transparency from the already murky options market. While other financial sectors are making great strides toward accountability, the onset of preferenced trading shows that the options industry is content to take a step backward. That is an unfortunate development, no matter where you stand in the great preferenced trading debate.

About Mark S. Longo