A pricing change by Nasdaq Options Market (NOM) slated to go into effect on Thursday highlights a trend underway at the options exchanges that has market makers seeing their costs go down, while brokers handling customer orders are seeing theirs go up.
In the midst of a heated battle for market share, exchanges are rolling out the red carpet for dealers, hoping they will quote aggressively and draw flow to their platforms. To win their liquidity, maker-taker exchanges are increasing their rebates. Meanwhile, traditional exchanges are introducing rebates for the first time.
To fund the rebates, the exchanges are increasing the fees they charge for customer orders, or introducing fees, where before there were none.
Because market makers provide most of the liquidity on options exchanges and customers do most of the taking, the moves put more money in dealers’ pockets and leaves less in brokers’.
For the traditional exchanges this is a fundamental shift. At exchanges such as Nasdaq OMX PHLX and the International Securities Exchange, market makers have historically paid transaction fees, while customers traded for free. Dealers say the changes are necessary.
"In the past, market makers were making enough money that they could afford to bear the costs," said Slade Winchester, a director in Citigroup’s U.S. equity derivatives division. "But markets have tightened up to a level where market makers can’t continue to bear the cost and make tight markets. So the costs are shifting." Citi is one of the largest market makers in the options industry.
The trend began earlier in the year when Nasdaq OMX PHLX, sister exchange to NOM, adopted maker-taker pricing for some of its more actively traded options. The Philly replaced fees with rebates for market makers providing liquidity and began charging customers for the first time.
The result was a sharp spike in the Phlx’s market share; a windfall for dealers; and increased costs for brokers.
The Phlx now rebates market makers 23 cents per contract for providing liquidity. It charges "regular" customers 25 cents to take liquidity and professional, or very active, customers 40 cents to take liquidity. The program now applies to about 80 of the Phlx’s most heavily traded options, accounting for at least half of Philly’s volume.
The ISE quickly followed the Philly with a maker-taker pricing program of its own. The ISE program is less aggressive than the Phlx program: it pays market makers less and does not charge small-lot customers.
ISE pays its most aggressive market makers a 10-cent rebate. It charges professional customers 25 cents to take liquidity. It charges customers trading large lots–100 contracts or more–20 cents to take liquidity. It does not charge customers trading fewer than 100 lots.
The ISE, which has seen its market share in non-index options drop by one-third in the past year, now includes about 50 options classes in its maker-taker program, accounting for about half of its traded volume.
In April, NYSE Arca, which saw its market share drop as the Philly’s rose, took steps of its own to compete. It increased its rebates for market makers in 15 of the most actively traded classes. It also increased rebates for trades in all other penny names for its biggest market makers by tiering its fee schedule. (Options in the penny pilot now account for nearly 90 percent of all traded volume.)
For market makers supplying liquidity in the QQQQs and 14 other names, Arca now pays 35 cents per contract. That’s 5 cents more than its standard pricing. In the remaining options, for market makers posting quotes in at least one million contracts per month, Arca will also pay more than the standard rate.
NOM is the latest exchange to react. Effective July 1, it will increase both rebates and take fees for trades in penny pilot names. The exchange will pay member market makers 30 cents per contract to quote, up from 25 cents. It will charge customers 40 cents to take liquidity, up from 35 cents.
For NOM, the pricing move is a reversal of tactics from last year when it eliminated all take fees for customers trading the penny names. NOM’s customer take fee is now headed back up to where it was when NOM launched in 2008. Rebates for liquidity providers will reach that level on Thursday.
With the Phlx and the ISE now applying maker-taker pricing to half their flow, the pricing scheme is becoming mainstream. (Executives at NYSE Amex have said they may take the plunge as well.)
The impact can be seen in the statistics for options based on the SPDR S&P 500 exchange-traded fund, or SPY. For the month of May, two-thirds of all volume in the SPY contract was done on a maker-taker basis. Excluding the ISE’s volume, for which small-lot customers pay no fee, that figure was still half of all volume.
That’s huge. It means market makers are catching a big break and customers–or their brokers anyway–are spending more to trade. With customer take charges ranging from 25 to 45 cents on maker-taker platforms, industry officials expect retail customers or their brokers to start feeling more pain.
That doesn’t sit well with retail brokers. "Our job is to show the customer a quote, an NBBO quote," Pete Bottini, executive vice president of customer service at optionsXpress, said at this year’s Options Industry Conference. "They access that quote. They have a great experience. They get charged the fee they knew when they placed the order. We don’t pass through maker-taker fees. We don’t want to introduce new fees to our clients."
