The launch of the Nasdaq OMX BX options exchange, at the end of June, marked not only the debut of the industry’s 10th exchange, but an expansion of the use of taker-maker pricing.
In contrast to the conventional maker-taker pricing model whereby exchanges pay liquidity providers and charge liquidity takers, BX Options will pay liquidity takers and charge liquidity suppliers. While the scheme is relatively common in the cash equities business, its usage has been limited in options.
Nasdaq has said it expects BX Options to appeal to broker-dealers who are big takers of liquidity and may not be receiving payment for their order flow from intermediaries; or they may be unsure if they are being adequately compensated by their intermediaries. BX Options will not otherwise facilitate payment for order flow.
Professional traders who trade directly on the exchanges rather than go through an intermediary are expected to benefit. So too are some retail brokerages that deliver mostly market, or liquidity-taking, orders to intermediaries.
“Competitively speaking, this is a positive,” said Gary Sjostedt, director of order routing and sales at TD Ameritrade. “It keeps the exchanges on their toes price-wise.”
The BOX Options Exchange actually pioneered the taker-maker pricing strategy in the options market in 2009, but was the only exchange using it until this year. Then, in early June, the International Securities Exchange switched 25 options classes to taker-maker pricing.
BX Options instituted taker-maker pricing on July 2, becoming the third exchange to do so. There are differences among the three offerings. In contrast to the ISE, BX Options will offer taker-maker pricing in all options traded in penny increments. In contrast to BOX, Nasdaq will limit the rebate strategy to customers only.
For most of the BX names, Nasdaq will pay 32 cents per contract on customer orders that take liquidity. That compares with 22 cents for BOX’s “regular” market and 30 cents for trades in its auction. ISE also pays 32 cents per contract.
BOX chief executive Tony McCormick has dubbed the new Nasdaq exchange “NOX,” as he considers it a knock-off of BOX. BX Options has priced its take rebate 2 cents more than BOX’s auction rebate, and McCormick said he may have to react. “They priced it at 2 cents over our inducement fee, so we might bump them. Everybody plays that game,” he said. Roughly half of BOX’s volume is done in its price improvement auction.
BOX went taker-maker in 2009 to attract retail brokers or their intermediaries to send it flow. Previously, due to philosophical objections, the exchange did not offer a standard-issue payment-for-order-flow mechanism. That worked to its detriment as all the other exchanges did.
Still, rather than institute a similar scheme whereby it administered market-maker payments to order-senders for their flow, it chose to pay for market orders directly.
Taker-maker pricing and payment-for-order-flow schemes are close cousins. The latter has historically greased the wheels of an options industry heavily reliant on retail market orders. Most retail brokers contract with intermediaries known as consolidators or smart routers. The retail firms deliver their orders to the consolidators and the consolidators deliver them to the exchanges.
The middlemen pay the retail brokers some amount every month based on the number of contracts and the quality of flow they collect. UBS, Citadel, Citi/ATD, Susquehanna, and Merrill Lynch are all big consolidators. They also all run large market-making operations on the exchanges which they “preference” with the incoming flow.
BOX’s switch to taker-maker was not its salvation from a declining market share. Because it figured out a way to tie the pricing scheme to it price improvement auction, it gradually won over order senders. Consolidators with market-making units send flow to BOX’s auction so as to trade against the flow. Their customers get better prices than they otherwise would.
The downside of taker-maker is that the burden of keeping the lights on at the exchange is shifted to the market makers. Although the incoming flow may be desirable they would still prefer to get paid to supply liquidity. This is why taker-maker is largely a niche business. BOX’s market share has never risen above 5 percent.
Still, a market exists for the service. “By using different fee structures, you can segment the market to cater to a specific clientele,” says Boris Ilyevsky, an ISE managing director. To a large extent, ISE is targeting the disenfranchised. These are brokers who have never been paid for their flow “because the profile of the flow is not considered to be as valuable,” Ilyevsky explained. “We give these traders and their brokers an incentive to come to us directly.”
For the consolidators the story is different. On Jan. 3, the options world was turned on its head when the Chicago Board Options Exchange instituted its Volume Incentive Program, under which it doled out extra payments to high-volume traders. The move was aimed at the large consolidators and has proved beneficial to CBOE’s market share. By contrast, it has sent its competitors scrambling for a counter-offensive. None however have tried to match the CBOE’s largesse.
Ilyevsky says the ISE’s new pricing model should also appeal to consolidators. The program is competitive with other exchange offerings and even if it isn’t, “that doesn’t mean we don’t want to be the second destination,” he noted. “It might be a large order that has to sweep more than one market for size, or that first market may not be on the NBBO.”
Consolidators and their customers differ on the taker-maker programs. One exec with a consolidator, speaking of the Nasdaq program, noted that most customers of consolidators are already receiving generous monthly payments. They don’t care where their orders trade.
Another exec at a large consolidator found Nasdaq’s program lacking and said he would avoid it unless they added improvements such as an auction mechanism similar to BOX’s. Nasdaq, which plans to add functionality in the near future, would not comment for this article.
