The multiple-listings wave that has begun washing across the U.S. options markets may bring lower costs for investors, but it may also spark the emergence of payment for order flow in the listed derivatives world.
Payment for order flow, a practice in which market makers essentially pay brokerage firms to send trading volume their way, is an accepted evil in the equity markets. But it hasn't prevailed in the options world because many options were traded on just one exchange, so customers -- brokerages or individuals -- didn't have the opportunity to cut deals on price.
Now that even these single-listed options can trade on more than one exchange, market makers are realizing they have to cut commissions to lure orders. And options order flow, more than the security itself, has become the battle prize to win.
The listings war officially started Monday, when a crowd of more than 100
Chicago Board Options Exchange
traders muscled their way into a new pit to begin trading
, previously a
single-listed option on the
Philadelphia Stock Exchange
. Now that Dell trades on three exchanges, brokerage firms suddenly have the power to send their Dell order flow to different places, creating competition for the volume and with it payments to get that volume.
A flurry of listings and counter-listings by the Philadelphia Stock Exchange and the
American Stock Exchange
also are in the works. (The
so far has declared neutrality and refrained from listing other exchanges' so-called grandfathered options, says spokesman Dale Carlson. By doing so, it apparently believes it can protect its single-listed options.)
The concern, however, is that payment for order flow agreements get put ahead of best executions for clients. Customers may not benefit if order flow is sold to a particular market maker and not shopped for the best possible price.
Still, payment for order flow is on the way. Some Chicago pros point to the headline deal between Tony Saliba's
as building a "soft" model for payment for options order flow. In July, Saliba set up a partnership to trade 20 options for Schwab, getting a simultaneous "look" at all of Schwab's options orders as they hit the CBOE's trading network.
Working as a kind of "upstairs" market maker at the CBOE, Saliba's firm tries to give Schwab a better price than someone in the trading crowd. Schwab and other firms are hunting for three prizes: "Lower costs, accountability and more value of out their order flow," Saliba says.
"We have Schwab as our partner, and we have incentive to build up its order flow. There's nothing corollary in what we're doing to payment for order flow," he says, adding the firm wants to do between 20% and 30% of every Schwab order.
A veteran options trader from
, a rival Chicago firm pursuing similar deals, says the issue is blurry: "Saliba is not paying them outright for order flow. What he is doing is sharing profits with them as part of a partnership; that's his way of paying for order flow." Saliba concedes his rival's point.
The rest of the options trading community is thinking along the same lines, plotting how best to survive in a multiply listed, payment-for-order-flow free-for-all.
Back when it was going public -- and before
agreed to pay $500 million for it -- even market maker
said in an
filing it was "exploring opportunities to obtain new avenues for order flow for both equity derivatives and securities, which could include payments for order flow."
Hull said payment for order flow was one of the ways it planned to boost orders from online brokers, large retail broker dealers, money center banks and hedge funds.
Stafford says it's willing to cut prices down to "commission-less" -- that means "free" -- on electronic trades, simply to channel orders its way.
Meantime, the options industry's technology is lagging behind the customer demands in the pit. Monday's trading in Dell often left Chicago and Philadelphia traders unable to see one another's bid-ask spread. Until the four U.S. options exchanges link electronically, that's going to keep happening.
"Theoretically, we get a look at what's going on with bids and offers on other exchanges, but sometimes you just don't see what's trading and where it happens," says another Pacific Exchange market maker. "If there was a better way of transmitting those quotes, it would definitely be better for the customer."