The International Securities Exchange, in a preemptive move to protect its market share, will eliminate its customer fees for options on exchange-traded funds and indexes, starting tomorrow. The exchange is doing this to compete more aggressively for flow in an increasingly cutthroat trading environment.
“We don’t want to give customers a reason to look elsewhere,” said Boris Ilyevsky, head of the ISE’s options market. “We wanted to make sure we’re competitive.” Although the 18-cents-per-contract fee for these products is being scrapped, the ISE will continue to charge customers for trades in its own proprietary indexes.
Nasdaq OMX PHLX and NYSE Amex Options do not charge customers for the vast majority of ETF options. However, the ISE and Chicago Board Options Exchange, for several years, have charged customers fees for most premium ETF and index products (except the QQQQ). All of these exchanges earn the bulk of their transaction fees from broker-dealers, firms and market makers.
For the ISE, the decision to retire its customer fees for premium products was perhaps inevitable, given increasing customer interest in ETF options compared with single-stock options, against the backdrop of a fiercely competitive marketplace. “This was not an easy decision to make because ETFs are a large percentage of the pie of options volume,” Ilyevsky said. “It’s not a revenue-friendly move cutting our fees this way, but it was the right time. We’re hoping to benefit in market share and increased trading activity.”
He stressed that the decision was proactive. “It’s important to never be forced into reacting and making a hasty decision,” he said. “We wanted to do this from a position of strength.” The announcement came just prior to the Options Industry Council’s 27th annual conference, currently underway near Ft. Lauderdale.
The industry’s largest market is the CBOE, whose volume includes high-turnover contracts such as the SPX and OEX, based on the Standard & Poor’s 500 and S&P 100 indexes, which are proprietary. The ISE is the second-largest exchange in overall volume, and has the largest market share in multiply listed equity options.
Last month, the ISE’s market share in equity options volume was 29.6 percent, down from 32.1 percent a year earlier. The CBOE had 27.2 percent, compared to 28.4 percent in March 2008. These figures include a half-percentage-point dip so far this year for the CBOE, and a gain of more than one percentage point by the ISE.
“The ISE’s market share hasn’t slipped in recent months, but people might have been thinking about moving away from them to seek lower fees,” said Randy Frederick, director of trading and derivatives at retail broker Charles Schwab. “If a firm can trade on seven exchanges and smart order routers can route specifically away from the ISE to cut fees [when the ISE is tied at the best price with at least one other market], that could hurt.”
Penny quoting and the rise of smart routing to access liquidity across markets have forced all the exchanges to battle one another on price and speed. More electronic trading from a range of participants, particularly in penny-quoted options, has fueled this contest.
Andy Nybo, a principal and head of derivatives research at TABB Group, a financial markets research firm, sees even more competition on the horizon. “The greater adoption of technology, the entrance of new types of market participants, and the evolving regulatory environment are just beginning to impact the options market,” he said. “Exchanges will continue to test new market structures, fee schedules and trading protocols in an attempt to gain–and maintain–market share.” He said these efforts are only likely to intensify.
Kevin Fischer, head of block trading at Interactive Brokers, notes that competition for flow by the exchanges, whether it involves changes to their market models or fees, benefits the industry. “When fees go down, that’s good for the business,” he said. “It induces more trading and tighter markets, and it makes transactions more efficient.”
Nasdaq’s Philly exchange, the third-largest venue, did not add fees for customers trading ETF options several years ago when the bigger markets added their charges. “Nasdaq OMX PHLX has never charged fees for premium products and has the lowest transaction rate in the industry for its electronic complex order system,” said Tom Wittman, president of the Philly exchange. “This has resulted in an increase of business [sent] to the exchange.”
Phillly added customer fees for four ETF options last year but will retire those fees tomorrow. The exchange’s March market share was 17.4 percent, up from 15.0 percent in the year-earlier period. Its April volume is on track to mark the first time the exchange has surpassed 17 percent for three consecutive months since options were multiply listed.
The ISE, CBOE, Philly and Amex all have similar market models. They’re pro rata exchanges in which customers execute before other participants and are not charged fees for executions in options on single stocks. They all rely on liquidity from market makers who are interested in interacting with that flow.
The three other options markets–the Boston Options Exchange, NYSE Arca Options and Nasdaq Options Market, which together account for 21 percent of the market–are price-time priority exchanges that do not differentiate between types of participants. They have maker-taker pricing for the products that account for the bulk of their volume, charging participants for taking liquidity and paying those providing liquidity to their markets.
According to the ISE, dropping its fees for premium products reflects a shifting environment. “The way ETFs and index options trade now is not that different from single stocks, so they should have similar fees,” Ilyevsky said. “We continue to believe in our market structure and fee structure, while others push for maker-taker pricing and other business models.”
The fee change is intended to keep the ISE’s pricing competitive and to benefit other market participants playing on its turf. “We’re on a pro rata customer-priority model, which gives market makers the best chance of interacting with retail customer flow,” Ilyevsky said. Many large firms that aggregate and route retail options order flow are also affiliated with market-making firms. “So what we do for one side [of the business] could also help the other,” he said.
He noted that UBS, Goldman Sachs, Citadel, Interactive Brokers and other firms operate market-making units and also route customer orders to the market. “What we’re doing incentivizes more of that [customer] business to come to the ISE,” Ilyevsky said. “It also encourages market makers to quote more aggressively, knowing more order flow is coming their way.”
The ISE’s fee elimination could now put pressure on the CBOE to do the same for its non-proprietary products. “It will be interesting to see if the CBOE decides to follow suit,” Schwab’s Frederick said. The CBOE was not able to immediately comment on the ISE’s pricing change or its own pricing plans.
Nybo noted that the exchanges are watching one another’s moves. “Rule filings and fee changes are often quickly mimicked by competitors, especially when the new rules and methodologies are successful in attracting order flow,” he said. “I expect CBOE will closely monitor the market share data and react accordingly.”
