Early Options Rebate Plans Get Few Takers

As Susquehanna, a well-respected East Coast options firm, aggressively calls on its biggest customers to find out if they'd like a monthly "rebate" in exchange for guaranteeing to trade with the firm, it's getting a less enthusiastic reception than it anticipated.

Susquehanna is finding it much harder to actually cut the payment for order-flow deals because customers sending trades to the firm's traders feel they may be sacrificing the best price. As exchanges battle for volume in a market that lists popular options on as many as four exchanges, firms will go to greater lengths to secure orders. The so-called payment for order-flow deals is one of the strongest signs of such practices.

"We have been approached by [Susquehanna], though theirs is one of a half-dozen proposals we've received and are still evaluating," says Greg Novak, senior vice president with Mesirow, a large Chicago-based options dealer. "But we're not anxious to jump at it, especially absent a national market system" linking the country's four options exchanges. "Best execution for our customers still takes priority," he says.

Firms such as Mesirow, Datek and ABN Amro have apparently received offers from Susquehanna for "monthly payments based on total options volume." Theoretically, Susquehanna would "rebate" those firms, say, 50 cents per option contract. For a firm doing roughly 60,000 option contracts per month, that would work out to $8,000 back to the firms.

"We don't have options available yet, and in Nasdaq equity trading, we don't accept any order-flow payments. In a small number of listed securities, we do accept payment for order flow, and sometimes the best trade for customers involves payment," says Michael Dunn, a Datek spokesman. "But it's too early for us to say." Datek hopes to offer options by the first quarter of 2000.

With the deals Susquehanna is pursuing, the firm is pioneering breaking wide open a new frontier in options. While payment for order flow has been standard practice in stocks, payment for order flow had until now never been blatantly offered to big option customers.

Payment for order flow in some camps ultimately hurts the customers, critics say, because the market makers have less of an incentive to work for the best price for their customers. "It's a bribe, plain and simple," says Chris Delzio, a seat owner and member of the American Stock Exchange who leases to option traders.

Regulators have howled over payment for order flow in equities. Now they may have to deal with its inevitable creep into options, which amid skyrocketing valuations in the bull market, are emerging as a lower cost way for retail investors to roll the dice.

Securities and Exchange Commission Chairman Arthur Levitt has decried payment for order flow, but even that regulatory agency has conceded there is nothing illegal about the practice as long as it doesn't conflict with getting the best execution.

The rebates are just one part of the new world of trading. Exchanges and the major firms that occupy their floors are spending more time than ever wooing clients who send them orders. Microsoft (MSFT) options, for instance, traded only the Pacific Exchange until a few months ago, when they were listed on the American Stock Exchange and Chicago Board Options Exchange.

The P-Coast has managed to win back the bulk of the order flow in Microsoft from the CBOE after at least one large customer decided to switch back to the San Francisco crowd after trading with the primary Microsoft market maker in the Windy City.

For the week of Oct. 19-25, the Pacific logged roughly 65% of the Microsoft trades, and the CBOE about 25%. And, the Pacific Exchange's Retail Advisory Committee this weekend was plying the floor's biggest customers with everything from wine-tasting tours in the rolling hills of Sonoma to yachting events to keep it that way.

"Hey, I like the exchange people in San Francisco," said one option customer from Mesirow based in Chicago. "What can I say? They sat down and said, 'What can we do to make sure you stay?' That counts for a lot."

Whether that translates into sustainable order flow once the four exchanges are linked and rebates proliferate remains to be seen. The four exchange presidents and other honchos met in Chicago Monday to hash out how to implement regulators' demands for linkage.

And Susquehanna, at this point, has not yet signed any payment-for-order-flow deals. A spokesman for the firm, located outside Philadelphia in Bala Cynwyd, Pa., wasn't immediately available to comment. Last week, however, asked about the practice, he replied, "it's definitely coming."

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