Actually, the situation will be a little worse than what you describe. The order book queuing algorithms work because they are creating an instantaneous option with their position in the order queue. What instantaneous option am I referring to? Why, its your order of course! This cannot happen in the options market, because there is a known theoretical fair value for the option. If the algorithm simply placed orders ahead of you in the queue, it would eventually exceed fair value and get executed with a negative expectancy. The impact of penny quoting in the option markets will be a lack of liquidity. When every 2-cent change in the underlyer results in a 1-cent change in the derivative (or worse), market-makers will simply widen their spread and deepen their quote to avoid quoting every 1/2 second. -segv
The most significant issue I see is the cancellation fee. Since I deal primarily in CME products, I am not exposed to it - but I see the results. I have always thought the cancellation fees were BS and anti-competitive at a minimum. If an institution wants to jump ahead of my order, they risk getting filled. If they join me, then I am first in line with them which is even better. If I remember correctly, IB seemed to have a ratio of cancellation fees vs. credits worked out so that those who are legitimately seeking fills would see very little in the way of actual charges. As much as I would like to think that most policies instituted at the exchange level are done so to deter questionable trading practices, I still understand that those same organizations are all trying to make a buck any way they can.
Again, this is not going to happen in the options markets. The algorithms that quote options may often join you on the bid or offer, but they will seldom exceed your quote. And, if they penny your bid above fair-value, sell it to them! -segv
Check the example of a market-maker 3.00 bid, 4.00 offer market. If you go 3.01 bid, and the THVL is 3.50 (midpoint of bid and ask), why wouldn't the market-maker's algorithm automatically go 3.02 bid? Equities already behave this way. And when they go 3.02 bid, you will not sell to them.
Remember the original justification for the options cancel fee. It was to relieve congestion in the order entry and exit process. Now the exchanges and firms propose to quote options in pennies - a nightmarish expansion in disseminated data. But they say they can handle this expansion with ease. And the cancel fee remains in place.