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Does The World Really Need Another Options Exchange?

28

June, 2012

They may not be able to process the order flow in the biggest IPO in years, but Nasdaq is very good at creating new exchanges and altering their pricing models.  On Monday, July 2nd Nasdaq will launch their third options exchange called BX Options. This will be the 10th options exchange in the US with plans for two more exchanges  to open by the end of the year.  Isn’t that wonderful, ten options exchanges.  That must be healthy for ALL investors since it adds competition, right?  Well, not exactly.  This new options exchange is just copying rules from the existing Nasdaq Options Market :

The purpose of the proposed rule change is to operate a new options market, identical to (but separate from) the NASDAQ Options Market (“NOM”)… Initially, BX Options will have the same market structure and rules as NOM, focusing on a price/time priority market. Over time, as the BX Options market secures more participants, it will introduce additional, innovative technology.”

Actually, there is one innovation with this new options market – the pricing model.  According to Securities Technology , “customers receive a rebate for removing liquidity: $0.12 per contract rebate in SPY, IWM, QQQ, and $0.32 per contract rebate in all other Penny Pilot options listed on BX Options.”

Of course, the old rebate model.  That really is the only “competition” that all of these new exchanges offer.  The constant game of microsecond arbitrage only works well when you have multiple destination points with different pricing models.

One of the biggest structural problems in the markets are these payment for order flow/rebate schemes that exchanges and internalizers employ.  Yesterday, the NY Times featured an article where they highlighted the murky process of internalization.  They compared the internalization process to Bernie Madoff’s payment for order flow system:

“The practice of diverting retail shares away from public markets and into financial firms is called “internalization.” Bernard L. Madoff is credited with inventing the practice in the early 1990s through his legitimate trading firm, which was on a different floor from his Ponzi investment scheme…

Today, four firms — Knight Capital Group, UBS, Citigroup and Citadel — have made a business out of paying for retail trades and trading against them. These firms generally pay retail brokers 15 cents for every 100 shares they are sent to trade against, industry experts say.”

Exchange rebates and internalizer payment for order flow are not innovative ideas any more.  They do not promote price discovery.  Just the contrary, by creating artificial arbitrage opportunities, they actually are distorting the price discovery process.

Next up on the payment for order flow agenda is having issuers pay market makers to “add liquidity” in their stocks.  But that’s a story for another day.

 

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