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.

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)

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.

A Penny Earned

The price improvement period was the BOX's way of giving its market-makers a way to win business based on merit and providing a better market, not making payments. Like any business, the market-makers and specialists try to make up those costs that may be subsidized by the exchanges but basically come from their pockets in some way; this is often accomplished by posting wider bid/ask spreads. This hurts the customer, often giving back much of the savings that managed to get passed along.

The PIP process basically streamlines the PFOF, making the customer the direct beneficiary. The net effect to the market-maker should be minimal, and the benefit to the customer is measurable. The only loser seems to be the largest of the online brokers, which will lose PFOF receipts and likely have a hard time raising commission fees to replace that revenue.

The exchanges have complained about and have been trying to do away with payment for flow for years, and the PIP process is the only alternative currently being put into practice. It offers a reasonable remedy for finally kicking what had become a bad and costly habit.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

steve.smith@thestreet.com.