A Penny for Your (Options) Business

After focusing on how the Boston Options Exchange (BOX) spent its first-year separating itself from other exchanges, today I'll focus on the exchange's innovative, and highly contentious, price improvement period (PIP) process.

This may be the most proactive measure taken by an exchange yet to avoid participating in payment for order flow (PFOF), and it looks poised to become the new way that exchanges do business.

The irony is that most exchanges have complained about PFOF for years, even petitioning the Securities and Exchange Commission to ban the practice, and now they may find that PIP, which they also fought fiercely against, actually might provide a method for weaning themselves from paying for order flow.

The best part is that this remedy not only should save the exchanges and market-makers money, but it also provides customers with a more competitive market.

PIP PIP Hooray

The price improvement period is a process in which BOX market-makers have a three-second window to compete for filling an order by improving on the existing national best bid offer (NBBO) in penny increments. For a more complete explanation of the PIP process, click here.

Critics contend that the three-second period is too short to truly open the market and give the order full exposure, making this a means for brokers to internalize orders.

The counterargument is that today's technology allows for literally hundreds of bids and offers to be processed in a few seconds, a process that Bill Easley, managing director of the BOX, describes as a miniauction. He also notes that there must be at least three competing market-maker bids or offers at the time PIP is initiated.

Also, PIP can be initiated only on prices that improve on the NBBO and must be for the entire quantity of the order. Therefore, the customer order is guaranteed an execution price better than that posted on any other market. The fact is most brokers and nearly all customers don't care which exchange or what firm fills their orders as long as they receive the best price available at that time.

"I would really like to shift the argument away from internalization [toward] why houses are not directing orders to where there is the potential for price improvement," says Easley. An important point here is that for an order to be eligible for price improvement, it must initially be directed or sent to the BOX by the customer or brokerage firm.

Through its first 12 months, the BOX estimates that about 15% of its orders have received price improvement, by an average of 2 cents or $2 per contract. Unlike PFOF enticements (some call them kickbacks) that tend to get stuck in brokerage firm coffers, that $2 from PIP goes directly to the customer. The real battle PIP faces is essentially over it replacing the entrenched PFOF way of doing business.