The Shadowy World of Trade Crossing - Conclusion.
...continued from Part One.
CHERRY PICKING ORDER FLOW
Despite these difficulties, most market makers do not mindsurrendering a portion of their volume to facilitate legitimatecustomers. Market makers and floor traders know that customerfacilitation helps generate the repeat orders that are the lifeblood oftheir business. However, a recurring complaint among trade crossingopponents is that the practice blurs the line between legitimatecustomers and competing traders looking to cherry pick order flow.
Thetraditional definition of a customer is anyone from a retail investorto a mutual fund manager who legitimately wants to open or closepositions in a particular option product. These customers are still afforded order priority on most major options exchanges. However, in theirurgency to generate crossing revenue, many brokerage houses began toshop their orders to their own proprietary trading desks and to othertrading entities. Exchange market makers were then expected to stepaside while these “customers” took the other sides of their trades.
Manymarket makers grumbled that they were providing regular liquidity and pricediscovery only to have nonmembers attach themselves to thebest orders in their product. In some cases, off-the-floor andproprietary traders had better access to order flow than exchangemembers. This unequal access to order flow deepened the industry’sdivide over trade crossing.
The trade crossing debate put the exchangesin an unenviable position. On one hand, they had a responsibility toprotect their membership from predatory trading practices. On the otherhand, they also had to ensure their own survival during a period ofunprecedented change in the options industry. Crossed trades have becomea significant part of the options landscape, accounting for one-thirdor one-half of the average daily volume in some products. The exchangessimply cannot afford to ignore that business without jeopardizingtheir own economic viability. As a result, they begrudgingly acceptedthe fact that a significant portion of their volume was taking placewithout market maker participation.
The increasing amount of trade crossing in the marketplace has given rise to a practice known as preferenced trading. Preferenced trading, or directed trading, takes the concepts ofinternalization & payment for order flow to the next level. This practice allows liquidityproviders to purchase orders directly from order flow providers. These ordersare then earmarked specifically for their own accounts without ever having todeal with that pesky middleman known as the free market.
If the notion ofbuying orders and routing them directly into your own account appears unseemly toyou, then you’re not alone. Preferenced trading has caused atremendous uproar throughout the industry. Proponents claim that it improves the overall efficiency of the marketplace by allowing order flow providers to interact directly with liquidity providers. Opponents claim that it willdecrease competition and increase the number of back room order flow deals thathave become a PR and regulatory nightmare for the options markets. No matter what your opinion, the speed at which preferenced trading has spread throughout the industry suggests that this practice is here to stay.
BLESSING OR CURSE?
In the final analysis,trade crossing has been both a boon and a bane to the options industry.The benefits of the practice are undeniable. Options orders that neverwould have been filled a decade ago are now finding counter parties.In addition, customers are receiving better prices on many of their transactions, adefinite plus for the industry.
Crossed trades have also provided asteady source of revenue for the brokerage houses and exchanges duringan otherwise tumultuous period. However, all of these benefits havecome at a steep price. Trade crossing has greatly diminished therevenues of floor traders and market makers. Ten years ago, exchangemarket makers could participate in virtually any transaction in theirchosen products. Today, the percentage of trades available to them ismuch smaller.
This change is indicative of a fundamental shiftin the options industry. Market makers are no longer the sole providersof liquidity in the marketplace. By crossing a significant portion oftheir order flow, brokerage houses have become major liquidityproviders in their own right.
The outcome of this shift is still impossible to predict.Some industry analysts believe that the growth of trade crossing willlead to tighter bid/offer spreads and, therefore, to greater liquidityin the marketplace. Other analysts believe that the resulting loss ofexperienced trading firms and professional market makers will lead towider markets and an overall loss of liquidity. Only time will tellwhich outlook is correct. While the future direction of the industry isuncertain, the debate over trade crossing can only be settled if both sidesare willing to make changes.
THE FIX IS IN
The first step is to implement several key fixes within the options industry. These fixes include:
- The industry needs to abolish customer priority and embrace the shift toward flat and open order books.
- Crossed trades must be clearly delineated in the daily volume reports of all exchanges. Exchange members and the investing public have a right to expect accurate accounting of options trading activity.
- Limits must be established and enforced on the percentage of every order that a member firm can cross. These limits must be industry-wide to prevent individual exchanges from setting their own limits and creating competitive imbalances.
In addition to these fixes, both sides of the trade crossing debatemust make concessions. Liquidity providers must accept thefact that trade crossing is here to stay. It is far too popular and fartoo profitable for it to be abolished. Those who oppose the practicemust develop alternative day trading and position management techniquesin order to compensate for their reduced trading volume. This is adifficult task, but the continued success of many market making firmsproves that it can be done.
Onthe other side of the coin, the member firms and the exchanges need torealize that the explosive growth of trade crossing may have unexpectedconsequences for the entire industry. The reduced access to tradingvolume has driven many trained market makers out of the business. Whilethe brokerage houses may be able to compensate for the liquidity lostby their absence, they cannot replicate the accurate price discoveryservices provided by experienced liquidity providers.
The exchangeshave also felt the impact of the flight of the market makers. It can beseen in the continual weakness of seat leases and the shrinkingmembership base. A deep and liquid options market is in everyone’s bestinterest. Gains in efficiency and productivity should not come at theexpense of the marketplace’s integrity. After all, options are not azero sum game. The marketplace should not be either.
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