Ask an incumbent cash equities exchange operator in Europe about payment for order flow and he’ll probably grumble about the maker-taker pricing models that incentivise brokers to direct flow to multilateral trading facilities. Raise the same subject with an executive from one of the more established equity options exchanges in the US, and he would be likely to damn maker-taker for putting the last nail in the coffin of a market structure that supported payment for order flow for many years. This is less a contradiction than a comment on the relationship between the traditions and structures of the cash and equity options markets.
Payment for order follow first became an issue in the US equities markets just over a decade ago. After years of relatively peaceful coexistence in which no exchange listed leading options contracts already listed on a different exchange, the Chicago Board Options Exchange announced that it would start trading options in Dell Computers in 1999. This move led to an explosion of competition that resulted in exchanges and specialists paying brokers to route orders in their direction. Market makers would pay a certain amount per share to a broker in return for order flow being routed in their direction. Such incentives could cause significant upswings in market share for exchanges, which sought to boost their market makers’ efforts by developing means of collecting transaction fees from specialists that could be made available to pay for order flow sent to the exchange.
The US Securities and Exchange Commission (SEC) soon acknowledged the potential for such arrangements to give rise to a conflict of interest between the brokers’ desire to optimise payment for order flow and their fiduciary responsibility to achieve the best price for client orders. In 2000, the SEC also noted that payment for order flow typically did not reward aggressive quote competition, warning that regulated firms were expected “to seek the best possible execution for their customers’ orders, irrespective of payment for order flow or other order routing inducements”. To this end, the SEC attempted to bring transparency to the market by introducing disclosure rules as well as establishing linkages between exchanges to ensure orders could not be executed at an inferior price to the best price available in the market.
But the US regulator was not done yet. 2007 saw the introduction of a pilot scheme to establish whether penny pricing, which would reduce margins and therefore squeeze the available funds to pay for order flow, could be made to work in the US equity options market. Although the pilot had mixed success, in that some options experienced lower volumes, it coincided with increased institutional participation in what had previously been a retail-dominated market and the launch of new trading platforms. A number of these not only featured an order-driven, price-time priority model of trade matching execution, as opposed to the options market’s traditional quote-driven, pro-rata model, but also maker-taking pricing strategies that offered rebates for passive order flow.
Much of that past 3-4 years in the US equity options market can be seen as a battle between exchange models, with traditionalists arguing that ‘alien’ concepts imported from the equities markets are causing irreparable damage to the execution quality experienced by certain market participants. The traffic appears to flow one-way at present. In February, BATS went live with its maker-taker based options exchange, while last month, the International Securities Exchange and Nasdaq OMX’s PHLX platform both announced plans to expand their use of maker-taker pricing to boost market share.
But maker-taker is also under scrutiny. Like the system it appears to be superseding in the options market, it risks the broker putting rebates ahead of client services. And a study published in March this year by three US academics, including two ex-chief economists at the Securities and Exchange Commission, has suggested that maker-taker’s benefits are illusory because narrower quoted spreads are generally offset by access fees. Incentives to attract order flow, it seems, will always risk distorting prices.
To vote in this month’s poll on trading venues, click here.