Citadel Investment Group LLC, Chicago, the $22 billion hedge fund manager, is urging regulators to cap a new pricing system for options trading that could translate into higher costs for institutional investors needing to hedge their portfolios.
At issue is the “maker-taker” model, created by electronic communications networks fighting over market share in equity trading. The system hands out rebates to participants posting orders on a given venue — those who “make” the market — but charges a hefty fee to investors trading against those orders — or those who “take” liquidity away.
NYSE Arca Options, a division of NYSE Euronext, New York, introduced the maker-taker pricing system last year and just raised both rebates and fees.
Institutional investors are almost always liquidity takers, as they trade against buy or sell orders posted on exchanges. As takers, they may end up being charged higher commissions by their brokers to reflect the higher exchange fees the brokers must pay.
“If I am a fundamental investor in S&P 500 stocks and I want to buy a lot of puts to hedge my positions, I would generally buy those puts by taking liquidity, not quoting passively. As a result, my orders would be hit with higher fees and would be unlikely to earn rebates,” John Nagel, managing director and deputy general counsel for Citadel, said in an interview.
Executives at Citadel, the parent of leading options market-maker Citadel Derivatives Group LLC, take the issue so seriously that on July 15, they formally petitioned the Securities and Exchange Commission “to limit the fees that options exchanges may charge to non-members to obtain access to quotations to $0.20 per contract.”
The next day, Arca, the fourth-largest of seven U.S. options exchanges, raised its taker fees to 55 cents per contract, up from 45 cents, to support higher rebates of 35 cents to 40 cents, up from 25 cents. These fees apply to highly liquid options quoted in pennies, which attract a lot of trading activity.
Regulators quickly reacted to Citadel's petition. On July 17, Erik Sirri, the SEC's director of the division of trading and markets, asked the Securities Industry and Financial Markets Association's options committee to consider the cap proposal.
“What we are really after is to make it a fair and transparent market for the client, with a fee structure that is not excessive to the marketplace or creates confusion for the investor,” said Christopher Nagy, managing director at TD Ameritrade Holding Corp., Omaha, Neb., and a member and past president of the SIFMA options committee.
Two other exchanges have emulated Arca's maker-taker model: the Boston Options Exchange, which has a 5.8% market share; and the Nasdaq Options Market, launched on March 31.
Not passed on yet
So far, options brokers trading on these exchanges have not passed on the exchanges' taker fees to their clients, but they likely will have to do so, because absorbing the new fees is hurting their bottom line.
There would be no way to avoid passing on the fees if any of the top three options exchanges — the Chicago Board Options Exchange, the International Securities Exchange, New York, and the Philadelphia Stock Exchange, just acquired by Nasdaq OMX Group Inc., New York — were to endorse the same maker-taker model, even for only part of their trading.
Technology-savvy liquidity providers arbitrage electronically among various exchanges all day long, constantly posting buy and sell orders for stocks and options contracts to pocket tiny profits. Every time they post orders and make markets, they qualify for liquidity rebates and pad their bottom line at the end of the month.
The bigger the rebates offered by an exchange, the more desirable a venue it is to post orders — and the more likely it is to provide institutional orders with their match at the best price.
“We are not a provider of liquidity, we draw down liquidity. Because of the size of the assets we have under management, it is a concern to us to have a combination of tight markets and attractive commission levels,” said Ronald Egalka, chief executive officer of Rampart Investment Management Inc., Boston, with $13 billion in assets under management, mostly invested in options strategies.
“We have not felt the (pricing) pressure yet as liquidity taker. But it would be a huge problem for us to be forced to add the cost of doing business because the smaller exchanges are adding fees when we have sufficient liquidity at the other exchanges,” Mr. Egalka said.
A simple solution would be to program trading software to ignore markets with taker fees, but this is not possible because of the best-price rule, which requires brokers to execute orders at the best quote posted on any of the seven options markets. Fees cannot be taken into consideration as part of best execution, but for asset managers like Mr. Egalka, they matter as part of the overall transaction costs.
“Under some circumstances, regulatory obligations require broker-dealers to route orders to the exchange quoting the best price, regardless of the size of any taker fee,” Mr. Nagel of Citadel said. He complained in a July 23 letter to the SEC commenting on the NYSE's latest fee filing that some exchanges charge “excessive fees to obtain access to their quotations and are thereby causing distortions in the options market.”
Seeking to avoid unintended consequences
To solve the rebate-best price quandary, the SEC imposed a fee cap in the equity market as part of the Regulation NMS reform implemented last year — a solution that Citadel advocates for options.
The maker-taker problem could be solved as part of a broader reform for the options market where regulators are considering a series of rule changes, similar to some provisions of Regulation NMS.
One problem that surfaced with the maker-taker model in equities is the “locked markets,” when participants post bids and offers at the same price. This creates a clear distortion of markets' pricing mechanism since there is no point in buying and selling the same stocks or options at the same price.
In its petition, Citadel cited “a dramatic increase in locked and crossed markets,” due to aggressive quoting to pocket rebates.
Each of the options exchanges already submitted proposals to deal with the “locked markets” problem.
Other Reg NMS-type reforms considered would be to replace the SEC-mandated linkage network that ties options markets together with individual access systems. Another would allow intermarket sweep orders, or ISOs, which would make it easier to execute large orders.
One positive impact of the maker-taker pricing system with a cap is that it could reduce the system of payment for order flow, whereby a broker pays to get orders from another broker to execute on his behalf. This practice has raised best-execution issues. If the broker paying for order flow must also pay a taker fee, he has little incentive to buy customer orders.
William McGowan, managing director at Greenwich, Conn.-based Interactive Brokers Inc., a major options broker, believes the time for reform in the options world has come.
“What we've got here once again is an unleveled playing field. Because the pricing models are dramatically different among exchanges, there is room for gaming, which in the end does not benefit the marketplace and certainly not institutional clients,” said Mr. McGowan, who is based in Chicago.
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