A Penny for Your (Options) Business

Pay to Play?

Even as they continue to practice it, all of the option exchanges would love to see payment for order flow disappear. Several exchanges at various times have put a halt to PFOF, but like an airline that hikes rates and none of its competitors follow suit, they have been forced to reinstate payments to protect market share.

Most brokers see nothing inherently wrong with PFOF provisions but they, of course, are the main beneficiaries. Vincent Phillips, the CEO of Charles Schwab's (SCH Quote) CyberTrader, says, "Pass-through agreements are very straightforward. If I'm a net liquidity provider, I get paid a certain amount. Unlike soft dollars, you know exactly what you are paying for and there is no conflict of interest. The customer is always due NBBO; I don't really care which exchange it comes from." Phillips says much of the payment gets passed along to customers but does acknowledge that PFOF is a revenue source for his firm. Still, he claims he would not lament the end of payment for order flow.

In fact, many brokerage firms that receive only minimal revenue wouldn't mind the elimination of PFOF because its removal would simplify the pricing structure and make it more transparent.

"It makes it more difficult to compare total costs of transactions and determine which is truly the best market," says Bill McGowen, a managing director at Interactive Brokers, a firm that co-founded the BOX. He notes that most active firms have fairly sophisticated software to help them "smart route" orders to the exchange in which the best bid/offer combined with the current PFOF agreement presents the best place to complete the transaction.

The SEC, despite the exchanges' claims and petitions, has basically ruled that PFOF is a legitimate business practice. Indeed, even its critics, such as the BOX's Easley, admit that it does provide competition, which can translate into lower transaction costs to customers, mainly in the form of reduced commissions. But others see PFOF rife with conflict and a legacy of the old boy network in which the SEC does not want to take away a risk-free revenue source from the biggest liquidity providers.

The PIP process was somewhat validated last month when the International Securities Exchange (ISE) implemented its own price improvement mechanism, or PIM, which basically follows the same process as PIP. This is probably the first time in the ISE's short history it has had to respond and adopt a competitor's strategy to protect its market share.

The Chicago Board Options Exchange (CBOE) says it too will be launching its own penny price improvement process sometime in the near future. History shows that when competitors adopt a business practice, however reluctantly, it is usually an improvement and a benefit to the customers.