As Congress called for greater transparency in markets, the International Securities Exchange (ISE) proposed and the Securities and Exchange Commission (SEC) granted approval for a rule allowing orders to be crossed without first being displayed. The Chicago Board Options Exchange (CBOE) challenged the rule, which is currently under a stay and is being reviewed by the SEC.
At the end of August, the Division of Trading and Markets at the SEC granted approval to ISE for a rule change relating to qualified contingent cross orders. The rule would permit an ISE member to cross the options leg of a qualified contingent trade (QCT) on ISE immediately upon entry if the order is for at least 500 contracts, part of a QCT, and executed at a price at or between the national best bid and offer.
On Sept. 14, CBOE petitioned the SEC asking commissioners to initiate disapproval proceedings for the rule. In its petition to the SEC, CBOE said the rule “will distort competition among exchanges, impair execution of customer orders, and violate longstanding Commission views on order exposure and options exchange markets.”
CBOE also called the rule a major departure from historic and existing practices in the securities markets, under which simple option orders (whether alone or paired with a crossing order) must be exposed to price discovery and under which complex orders (whether alone or paired with a crossing order) must be exposed to price discovery at a net price.
A spokesperson for ISE would not comment for the story, but in a letter to the SEC, ISE said that CBOE’s comments reflected “a fundamental misunderstanding of the purpose of the proposed rule filing.” The letter said that ISE’s proposed qualified contingent cross was better than the current block trade exemption “because it does not allow orders to trade through better prices on other exchanges, while still providing enough flexibility to allow the options component of a stock-option order to be executed.” ISE added that CBOE’s challenge arose from competitive, not legal, concerns.
“We understand [ISE]’s motivation,” says Ed Tilly, executive vice chairman of CBOE. “[ISE CEO] Gary Katz said that these kinds of crosses are already going on in the industry, but we maintain that they are not and that no such order that allows previously established bids and offers by the public customers in any exchange book has ever been ignored — any order type, any time, any where in the options industry. To do so under the guise of an amendment to the new linkage plan is not the way to go about an industry change to a long-standing practice.” He adds that more time for the industry to debate and weigh in on the rule is necessary.
“[What] we’re most troubled by is trading ahead of previously established resting customers with no exposure to our liquidity providers who are charged and obligated to continuously quote. The ability for someone to step in front of them without exposure adds a new challenge and takes away incentive to continuously quote throughout the day,” Tilly says.
In a letter to the SEC, PHLX said “a change to long-held principles designed to protect public customers should be taken only after thorough review, particularly where the proposed rule change would diminish transparency and order interaction.”
Wolverine Trading and Susquehanna International both sent letters to the SEC supporting CBOE’s petition for review.
“Currently, at some level options orders need to be displayed on an exchange,” says George Ruhana, CEO of Options House. “CBOE has historically had more market makers that have no access to flow or crosses, so I am not that surprised they are fighting [the rule]. The risk is that if most of the ‘best’ orders get crossed without market-makers participating, it may cause the market-makers to be less competitive and decrease market quality. There are concerns around whether or not the customer will get the best price possible in this trade, since it is not exposed to the whole market.”
Peter Bottini, vice president of trading at optionsXpress and an ISE board member, says you can basically do the same thing on the CBOE trading floor that ISE is trying to make happen electronically. “There’s a lot of institutional business that’s traded in open outcry, and ISE was trying to offer an electronic alternative. It’s more a competitive issue where CBOE and ISE are fighting over institutional business,” he says.
Mark Longo of TheOptionsInsider.com says, “It is a slippery slope once you allow anyone to cross orders without exchange exposure. The exchange execution requirement is one of the defining characteristics of the options market. If you allow certain orders to be executed upstairs, how long before virtually every order can be executed without first being exposed on an exchange?”
However, he adds, “A significant percentage of options volume is crossed upstairs before it is routed to an exchange for execution. The ISE is looking to garner a larger slice of that crossing pie and the CBOE wants to block that move.”