Article on Rule Change

Discussion in 'Options' started by Trajan, May 14, 2005.

  1. Trajan


    This looks like some bad news in this Barron's article. Normally I don't get to excited about these things, but my first impression is that this bad for small traders:
    Under Pressure
    Is the heyday of specialists over?


    ARE THE DAYS NUMBERED for the option-market specialist?

    It hasn't been a good week for specialists in general. Over at the New York Stock Exchange, 15 former specialists were charged with mishandling trades and essentially cheating customers, which revived debate about the role specialists play in executing customer orders. LaBranche (ticker LAB) said earlier this month that earnings won't be up to snuff, which highlighted the profit squeeze specialists face. (See Follow Up for more on LaBranche.) And in the options market, proposals making their way up Capitol Hill could change the way investors' option orders are filled, and, in turn, hurt the specialist firms executing these trades.

    At least three option exchanges are pushing rules that would allow brokerage firms to route customer orders to a designated market maker at an exchange, thereby selecting not just the destination market but the specific firm. Details of such "preferencing" or "directed orders" proposals vary, as do the politics and competitive reasons motivating each exchange. But the proposals sparked a boisterous round of lobbying, since they will influence how market-makers compete, and give firms more reason to kiss up to those brokerages that can steer business their way.

    "In the world contemplated by these proposals, competition among market-makers will change from a focus on providing tight quotes with large sizes, which benefits investors, to establishing cozy relationships with order-flow providers," writes the global hedge fund Citadel Investment Group, whose derivatives unit is also a major option market-maker, in an April 6 letter to the Securities and Exchange Commission.

    So far, the Chicago Board Options Exchange, Philadelphia Stock Exchange and the International Securities Exchange (ISE) have submitted such proposals. Other rival exchanges, some of which have criticized this turn of events, say they nonetheless may submit their own plans to stay competitive if regulators approve directed orders. An SEC spokesman declined comment, but people who have spoken with regulators say they believe the proposals have made their way past the SEC staff and are now before the commissioners.

    Should they greenlight it, directed orders will erode the already-waning clout of specialists. "Directed orders diminish the incentive for a specialist, but not their obligations," says Thomas Peterffy, chairman of Interactive Brokers, whose Timber Hill unit is one of the largest U.S. options specialists.

    Specialists match buyers and sellers, committing their own money when necessary to keep trading orderly. Because option volume is splintered over so many different strike prices and expiration months -- at any time, there are only so many people looking to buy or sell, say, Citigroup's August 55 calls -- option specialists play a more crucial role in ensuring a smooth flow of liquidity than their stock-market counterparts. For shouldering that obligation to post continuous quotes and make markets, specialists are assured of filling a guaranteed portion of customer orders.

    But the function of the specialist, as a go-to market-maker-in-chief presiding over a crowded trading pit, has come under pressure in this electronic age, when market makers can post quotes and trade electronically from remote and disparate locations.

    "Indeed, [preferencing] does change the single specialist model into a competing specialist/market-maker model," says Meyer 'Sandy" Frucher, chairman of the Philadelphia Stock Exchange. "Sure, it breaks up the 'old boy's club', but it narrows quotes and enhances competition."

    But not everyone believes preferencing will boost competition and be good for customers. A sure way for a specialist or a market-maker to snag a big share of a customer order now is to quote prices aggressively and to stand ready to fill even large orders. Preferencing, on the other hand, could prod market-makers to rely on other means to divert customer orders to themselves without a corresponding obligation to improve the market.

    And while safeguards exist, and orders must be filled at the market's best price, firms may have less incentive to quote aggressively.

    "Market-making firms will shift their focus from competitive pricing for customer orders to competitive pricing for a broker's business," says Pacific Exchange chairman Philip DeFeo in a recent letter to the SEC.

    Proponents argue that preferencing lets brokerages route orders to firms that can best execute their orders, and promote competition among a wider pool of market-makers. But what they don't say is how this will allows certain brokers to reward firms with whom they have the chummiest ties. Many brokerages now accept payment in return for sending customer orders to certain markets -- a system of kickbacks that the SEC has allowed despite the flagrant conflicts of interest. With directed orders, these brokerages can potentially see many more trading firms fighting to pay them for their orders. That potential revenue stream will be sorely needed, at a time when many brokerages have slashed commissions to attract customers and are desperate to monetize this valuable asset they control -- their customers' orders.

    Preferencing also will allow some brokerages to send orders to their own affiliates or units, thereby allowing a brokerage to "internalize" or take the opposite side of its own customers' trades. This also presents a conflict of interest, since the brokerage will act as both agent and principal in its quest to find a best price for the customer. But it has also been allowed by the SEC and by all accounts is on the rise in the options market, as more brokerages see the value of trading against their own customers.

    In fact, some of the exchanges pushing preferencing say that they do so most reluctantly, in a bid to compete with rival markets whose platforms or thin trading crowd allow brokerages to more easily internalize customer orders. And if Washington has decreed it okay for brokerages to trade against their own customers, and see no harm to market competition, then these exchanges' preference is for that action to occur on their turf and where they can charge transaction fees.</blockquote>
  2. If specialists and MM's become even less aggressive in maintaining a tight bid/ask, won't that open up an opportunity for traders to take up the slack and improve your chances of getting filled on a limit order?
  3. Trajan


    That's only if our order gets gets some sort of priority, but what if it just sits in the book while Ameritrade orders get routed to some other specialist and, while they have to match the best bid or ask, we don't get filled. I can see your point though, I may just be overreacting.
  4. nitro


    You are not allowed to make a two sided option market unless you have "MM status."

    Also, with cancel fees, it is impossible to do so profitably even if you just were on one side.

  5. nitro


    Thanks for posting the article.

  6. cvds16


    it was possible to make some money trading options and hedging the stock before cancel fees since then it has been impossible for me.
  7. trajan;

    Good info; made a note to write against it to SEC.

    Thought ''curent tight quotes'' compared
    with new proposal may result in ''cozy relationships with order flow providers''-Quotes -Citidel/major market maker of options.

    Some of the high volume stuff is reasonably tight;
    new proposal is not likely to help that, and i wish they shoot that new proposal down:cool: