The Shadowy World of Trade Crossing - Part One.
For over a quarter of a century, the options industry has relied upon its proven transaction system to meet the demands of the financial marketplace. At the heart of this system are the brokers, market makers and exchanges that execute option trades. However, in recent years, a new transaction system has emerged that threatens to reshape the entire industry. This system is known as trade crossing.
WHAT IS IT?
Trade crossing (a.k.a. internalization) occurs in two distinct forms. The first form occurs when a brokerage house becomes the counter party to their customer’s order. Alternatively, brokerage houses can also arrange for their customers to become order counter parties. In either scenario, these transactions are arranged prior to reaching the exchange and involve little or no market maker participation.
Trade crossing has sparked a fierce debate within the options industry. Opponents of the practice, primarily market makers and floor traders, believe that it is a direct usurpation of their role as liquidity providers. Supporters of the practice, primarily brokerage houses and the exchanges, believe that trade crossing expands the industry’s revenue stream, increases trading volume and improves customer satisfaction. Which viewpoint is correct? As with most debates, the answer lies somewhere in the middle.
WHY THEY DO IT
Trade crossing came about in an effort to improve customer satisfaction and increase brokerage fill rates. On any given trading day, a large number of option orders remain unfilled. This is due to a variety of factors including price, size, market movement and the complexity of the order. Each unfilled order represents lost revenue for the brokerage houses, exchanges, market makers and clearing houses. It also represents an unsatisfied customer.
To reduce this problem, brokerage houses began to cross their partially filled orders. Since this service entailed additional labor and risk for the brokerage house, it was usually reserved for the accounts of loyal customers. However, the benefits of this service were believed to outweigh the costs. Trade crossing improved customer satisfaction, increased brokerage fill rates and generated additional commission revenue. Many industry analysts believed that trade crossing was a good idea whose time had come. Unfortunately, as often happens with good ideas, it soon took on a life of its own.
Trade crossing soon began to drastically affect other established practices within the options industry. The first change came in the way that orders were handled inside the brokerage houses. Under normal circumstances, the specifics of options orders remained confidential until brokers announced them in the trading pits. Any market makers or traders who violated this confidentiality faced steep fines and even criminal charges. Confidentiality was strictly enforced to prevent advanced knowledge from moving the markets and adversely affecting the customer’s order.
Nevertheless, order confidentiality gradually slipped away as trade crossing became more prevalent throughout the industry. In order to cross their trades, brokerage houses needed to find counter parties for their customer’s orders. This could only be done by showing their orders to other customers, a practice known as shopping.
Since order shopping is a time intensive process, it was initially done on a very limited basis. But, as competition intensified within the brokerage industry, many firms began to look for alternative sources of revenue. The double commissions generated by trade crossing, as well as the customer goodwill engendered by the service, made it an irresistible lure. Order shopping quickly became widespread as brokers competed to cross their order flow.
Today, virtually all significant options orders are repeatedly shopped before they ever reach the trading floor. The expansion of order shopping has helped to fuel the raging debate over trade crossing. In the eyes of most market makers and floor traders, early access to critical information is a primary benefit of exchange membership. Exchange members are usually the first to learn about significant orders and the first to see trends develop in the marketplace. However, these benefits vanished when brokerage houses began revealing their orders to other customers.
Order shopping gave nonmembers access to order information before it was revealed to market makers and other exchange members. Over time, this disparity of information flow had a significant impact on the dynamics of the marketplace. The tracking of customer and brokerage positions, a necessary function for market makers, was obscured by the large volume of shopping and crossing activity. It became virtually impossible to determine which side of the trade represented the customer, whether the customer was opening or closing their positions and who took the other side of their trade. As a result, it became difficult to identify trends or inefficiencies in the marketplace. Additionally, market makers had to fend off front-running attempts by proprietary traders attempting to exploit their early access to order flow.
Many market makers turned to the exchanges to address their concerns over trade crossing. The options exchanges had always tolerated trade crossing as way to facilitate customer transactions. However, in order to protect their members, they had also taken steps to regulate the practice. Trades could not be crossed on the bid or offer prices disseminated by the market makers. A brokerage house had to provide a better price for their customer if they wanted to cross a trade. In addition, they also had to provide the market makers with a chance to participate in the trade. These regulations worked well until the advent of multiple listing for equity and index options in the late 1990s.
The options exchanges soon found themselves locked in a heated battle for trading volume. All trades, including crossed trades, were fought over bitterly. The exchanges even began to pay their member firms to route orders to their trading floors. They even adopted a specialist system similar to their equity counterparts as a way to further their competitive efforts.
RISE OF THE SPECIALIST
These specialists, also known as Designated Primary Market Markers (DPMs) decentralized many of the functions of the exchanges. DPMs became responsible for the lion’s share of the marketing, trading and enforcement activities in their particular option products. The old restrictions on trade crossing were gradually relaxed as individual specialists struggled to attract more business. Crossing trades on the disseminated bid or offer prices was allowed as long as the market makers received a chance to participate.
This stipulation sounded good in theory, but it fell apart in practice. Most brokerage houses shopped their orders before they routed them to a particular exchange. As a result, many of their orders arrived at the trading pits with counter parties already attached. These orders were essentially filled before they ever reached the trading floor. This left little room for the market makers, floor traders or specialists to participate on the trade.
If the exchange members protested or tried to block the trade, the order was routed to a more lenient exchange with a specialist that needed the volume. Market makers and floor traders, armed with precious little leverage, found themselves in an increasingly untenable situation. They could either remain silent and allow the transactions to take place without participating or block the trades and risk losing a significant percentage of their trading volume.
To be continued...
View Mark S. Longo's post archive >