Are Third-Party Smart Order Routers the Best Option for Options Investors?
With liquidity fragmented across seven U.S. options exchanges, online brokers typically leverage smart order routers to execute their retail customer orders at the best price and meet their best execution requirements. But while the retail brokers, including optionsXpress, largely rely on routers supplied by third parties (which often have market-making operations), the Chicago-based online broker has raised concerns that payments for order flow create conflicts of interest.
Even though smart order routers, known as SORs, objectively route orders to the exchange displaying the best price — defined as at or better than the national best bid or offer (NBBO) available on other exchanges — they can be programmed to favor a particular market maker as long as the specialist is offering the same best price that is available on another exchange. Meanwhile many discount brokers have agreements in place with market makers that provide the brokers with payments for their order flow.
"A lot of the online brokers have made deals with various market makers to route the order flow through those market makers in exchange for payment for order flow," says Andy Nybo, a New York-based senior research analyst with TABB Group. "You have the Ameritrades, optionsXpresses, Fidelity Brokerage Services — all of those have agreements in place," he contends.
Peter Bottini, EVP of trading and customer service at optionsXpress, says, "While payment for order flow has been a somewhat controversial practice, it's a transparent process — though the SEC is not happy that it exists." He explains that the exchanges that still sponsor payment for order flow — the Chicago Board Options Exchange, International Securities Exchange and Philadelphia Exchange — charge their market makers a fee up front and then allocate that money back to specialists based on liquidity contributions. The specialists then can redistribute the funds to their broker customers. The payments, Bottini concedes, help the brokers maximize their revenues.
Though trade-through rules ensure that retail customers still receive the best price, some sources suggest that the retail brokerages are giving the market makers a first look at their order flow. Bottini maintains that routers tied to market makers "have a conflict of interest in that they are serving two masters." The customer experience, he asserts, sometimes takes a backseat to the market maker's profitability. "Basically, the market maker is going to interact with as much of the order flow as possible," Bottini says.
A Proprietary Solution
In part because of these concerns, optionsXpress spent two and a half years developing its own proprietary SOR, XpressRouter, which went live in May 2008. "I had a concern that there were conflicts of interest with the market-making firms — we'd get quick fills on the open at wide markets, and we found out that the market maker was on the other side of those trades, and it didn't feel good to us," relates Bottini, who declines to single out any firms. Today, he says, optionsXpress routes less than 50 percent of its option flow through third-party routers, though the broker still accepts payment for order flow.
Bottini acknowledges that optionsXpress accepts payment for order flow, but he says the firm accepts payments directly from the exchanges. The difference, he explains, is that in the past the payments were an incentive to use someone else's router.
"Generally, if we use a router to route to the specialist, they'll pay us more. When you get that extra incentive, you have to scratch your head and think about it," says Bottini. By using its own router, optionsXpress receives a lower payment for its order flow. "We decided we would take a lower rate and route direct because it wasn't in our customers' best interest [to use third-party routers]," he says.
According to a written statement from Thomas Peterffy, chairman of Interactive Brokers, which operates market maker Timber Hill, optionsXpress used to be an IB customer. "Timber Hill got a benefit from the order flow to the extent that Interactive Brokers was able to route their orders to those exchanges where Timber Hill was a specialist in the relevant options class, at a time when more than one exchange represented the equally best price for executing the order," wrote Peterffy. "As a specialist, Timber Hill received a preferential allocation of the order versus other marker makers who were bidding or offering the same price. Interactive Brokers did not need to peek at the orders to do this — all it needed to know was which class of options was Timber Hill a specialist in at which exchange and build its routing tables accordingly."
Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio
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