In October, seven options market making firms sent a letter to the SEC outlining their concerns about “the growing trend of exchanges imposing oversized transaction fees on market makers” competing in auction crosses. The firms said they were disadvantaged by the current structure in which internalization is encouraged by the use of a “breakup fee” that keeps market makers from competing with “initiators” of the auction.
The International Securities Exchange (ISE) responded to the debate over price improvement mechanism (“PIM”) auctions by announcing a flat pricing structure for PIM auctions on ISE Gemini, where both PIM initiators and responders will pay $0.05 per contract. Priority customers on the originating side of a PIM order will continue to be free. JLN spoke with Boris Ilyevsky, managing director at the ISE, who explained how the new structure addresses the market makers’ concerns and what’s behind the debate over price improvement and fees.
Q: What is the concern of market makers regarding the price improvement auction and what is the debate about?
A: The big debate, pointed out by a group of market makers in their recent letter to the SEC, is that when order flow aggregating firms – firms like Citadel, Morgan Stanley and Susquehanna, for example — initiate a price improvement auction, they pay very little in fees and, in most cases, earn a net rebate. However, firms that wish to interact with the order being auctioned must pay a very high fee to break up the original cross. In this way, the incentives and fee structure are very lopsided.
Q: Can you explain how the breakup fee works and who is disadvantaged by this?
A: The breakup fee is paid by firms, typically market makers, that wish to respond to the auction and provide price improvement to interact with the order. These can be large market making firms like Goldman Sachs, Morgan Stanley, Optiver, Barclays, as well as small to medium market making firms.
Let me give you an example. Let’s take a retail firm like E-Trade. Suppose they have a customer that wants to buy five contracts. E-Trade sends the customer order to an aggregator like Citadel to execute. They decide to use a price improvement auction like PIM, and they initiate the auction. As the initiating firm, Citadel might pay as little as five cents per contract to interact with that customer order, or in many cases, may actually earn a rebate.
Now suppose there is a market maker, let’s say Goldman Sachs, that also wants to interact with that same customer order. They would do so by responding to the auction. However, their fees to interact with that same order could be upwards of 65 cents. The point these market maker firms make in the letter is that not only is this fundamentally inequitable, but the purpose of these mechanisms is to provide the end customer — the retail customer — with the best price. It is unreasonable to expect they will get the best price when the firms that want to respond to the auction must pay such a high fee to do so.
Q: Can you describe the implementation of the new ISE Gemini structure and how that remedies this problem?
A: After talking to the market makers about their letter, we thought why not voluntarily and unilaterally introduce a fee structure that is more equitable with lower fees to see if we can produce a fairer environment with more direct price improvement. With the new ISE Gemini structure, the initiating firm that brings the cross pays five cents but so does everyone else; except of course that the retail customer never pays any fees on either model. We believe that the difference now, which can be as much as 50 or 60 cents, will on average end up in the customer’s pocket.
Q: ISE Gemini implemented this structure on January 2. It’s very early in the game, but what has been happening so far?
A: We are seeing some participants, but not a whole lot of activity yet. However, soon we will be able to take a much closer look at the results to see how we’re doing. There are a couple of different ways to look at the results. One way will be to look at the actual price improvement versus the prevailing best market price, and ask, “Are responding participants improving on the firm that initiates the auction?”
Another way to look at it is the participation rate. Are firms actually responding, and how much are they getting of the original order? We would hope that with the lower fees, the participation rate for auction responders would be higher and for auction initiators would be lower.
The question we got from participants and that we asked ourselves is, how do you encourage firms to initiate these auctions on ISE Gemini when the fee structure at ISE, BOX and elsewhere is more advantageous to them because of the rebate and the higher likelihood that they can internalize these orders. We hope, however, that because of all the discussions about market structure and the growing focus on execution quality metrics by the retail firms, we’ll be able to compel at least some portion of that business to come to ISE Gemini because the new fee structure will create a level of price improvement that makes these statistics look favorable to the firms initiating these orders.
In general, those initiating firms are aggregators of retail order flow. They commit to their customers, the retail firms like E-Trade, to an average execution quality in any given month and they track it in real time. There may be some orders they do not want to trade at an improved price, but if they don’t, the month’s EQ statistics will be impacted. In that case, it may be more attractive to initiate a PIM at ISE Gemini so that the order receives price improvement from a third party responder. With the new fee structure, the chance of another firm coming in and improving the price is higher. As far as the retail firms are concerned, their partner has provided the committed level of price improvement, and it doesn’t matter if that results from an auction process or otherwise. We also hope as the retail firms become more aware of what we are trying to do, they will encourage their partners to send some of these orders to ISE Gemini.
Q: If ISE is successful in drawing participants with this new structure, is it likely the other options exchanges will copy it?
A: Other firms could copy it, yes. A “PIM-style” auction is offered at most of the options exchanges although everyone has a different name for it. If the new fee structure is recognized as a successful model, it would ultimately benefit the end customer and that would be good for all of the exchanges.
Q: Have you received any negative reactions or objections to the new structure?
A: There have been some lukewarm reactions only because some people thought we would fail to attract any interest. We hope we earn a respectable piece of the retail order flow being sent into these auctions by the aggregators and that this eventually becomes another flavor of pricing and is taken into the mix by the aggregators along with maker-taker and payment for order flow.
Q: How does the new system provide more transparency?
A: There are two ways it provides transparency. One is that unlike some other exchanges, the PIM on both ISE and ISE Gemini is visible to all participants. Any ISE or ISE Gemini member can respond to a PIM.
Another is that transparency is just another word for fairness, and not having tiers is a very transparent way of conducting that business. You don’t have to worry that another firm is getting a lower fee because they hit some special tier.
The market makers look at the trends in payment for order flow, and they look at the business from the perspective of where they came from; up until 10 years ago, they were proprietary trading firms, so they see themselves both on the inside and the outside. They look at things from a long term lens and want to make sure the industry is healthy in the long term.
Q: What about the recent market structure reform proposals from ICE and BATS…etc?? Would those proposals have any impact on the options market?
A: Those proposals are really focused on the equities markets and remain separate from options. On the equities side, there is a debate about access fees and maker-taker pricing, stemming from the fact that more than 40 percent of equities volume trades in dark pools. We watch that debate carefully because there are parallels, but it doesn’t directly affect our business. The only similarity is that these auctions can be tools for internalization. The far greater difference is that they are auctions, they are transparent, and they are available to all types of participants.
The letter to the SEC from market makers can be found here: http://www.sec.gov/comments/sr-nysemkt-2014-52/nysemkt201452-1.pdf
The related ISE press release can be found here: http://www.ise.com/press-room/press-releases/2014/ise-gemini-introduces-flat-pricing-for-price-improvement-auctions/