Penny Pricing In Options Raising Possibility of Options ECNs
But some institutional investors believe the increased transparency and narrower spreads resulting from penny pricing would make up for the fragmentation. "I think the ECN model is going to win out," says Stephen Davenport, VP and head of equity risk management at Wilmington Trust Investment Management Group in Atlanta, which has about $45 billion under management. "I think people want to trade electronically, and they want to have a little bit more privacy than is inherent in the market-maker model."
Davenport says he has increased the proportion of order flow he sends to the New York Stock Exchange's Arca electronic platform to reflect his view. NYSE Arca operates an options platform based on the technology it acquired with its purchase of the Archipelago Exchange. Although it uses a "lead market maker" system, in which dedicated participants post quotes to attract orders, NYSE Arca's model closely resembles equities ECNs, on which orders are executed based on arrival time at the current best price, regardless of size.
The Arca platform has the unique capability to display five price levels on each option, according to Jon Werts, vice president, derivatives products, NYSE Arca.
The Nasdaq Options Market, set to launch in the fourth quarter of 2007, pushes the model even further, running a straight price-time priority market. "The things that influenced us [to start a] seventh [options] exchange are volume growth and new participants -- more hedge funds, institutional players and black-box strategies," says Adam Nunes, head of the Nasdaq Options Market. "Our market structure is built for pennies and price-time priority."
The Exchanges' 2 Cents
As both reduce the incentive to chase large trades and cut into market makers' ability to fund incentive programs, price-time priority and penny quotation upend the way market makers are compensated for providing liquidity, threatening the pro rata model under which options trading has operated since its inception. This may have the potential to decentralize the marketplace. Not surprisingly, some exchange leaders are not confident that penny quotation is the answer. They cite the amount of quote traffic as a challenge and assert that institutional investors actually may be disadvantaged by the smaller order sizes that result from narrower spreads.
The preliminary findings of the pilot were a "mixed bag," according to Mike Bickford, head of options at AMEX. While average daily volume increased 29 percent across the exchanges, volume declined on seven of the 13 names. Spreads decreased about 50 percent overall, while order size decreased 80 percent on penny classes and 65 percent in "nickel-dime" classes.
"We are not advocating full speed ahead with the penny pilot," Bickford says. "If on seven of 13 stocks we saw business go down [with the initiation of the pilot], you have to ask yourself if people are expressing a preference for transacting at greater size."
The ISE published its own analysis of the pilot in late May, recommending that the SEC "be very cautious" in expanding penny quoting. "To process quotes in pennies at all price levels will require that ISE quoting capacity be tripled," the report warns. "We further believe that the cost to the industry to process quoting in pennies at all levels is not justified."
At the CBOE, executives are confident that quote traffic can be managed, but they express reservations about the market impact of pennies on the next generation of participants. "A retail investor with 14 to 18 shares in pennies probably did have a good experience -- but more of our order flow is now institutional," says CBOE Executive Vice Chairman Ed Tilly. "Institutional traders can now see reliable, accessible firm quotes at the top of the market -- that has fueled the growth in institutional trading in a big way. Pennies has actually taken that down."
A Penny for Your Thoughts
Wilmington Trust's Davenport says he believes narrower spreads and penny quotations would decrease the cost of doing business. "I am not sure how to read the penny pilot results that show liquidity declines," Davenport says. "There are people who would like to see it fail. Sometimes you need to undertake things that may not give results in a particular subgroup that could do some good for the overall market. I think it has been a ridiculously cushy market for brokers. If I have a nickel spread on an option on GE, one of the most liquid stocks in the world, that is 20 percent of my profit going to commission."
But the established exchange leaders don't believe transitioning to the equities-style model is inevitable or even desirable. "Equities and options markets are inherently different -- you cannot just take the equities market model and apply it to options and have it succeed," says AMEX's Bickford. "There are many things that have gone on in the equities market that have had unintended consequences," he says, referring to fragmentation.
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