Competition in the options world just got a little dicier. Order flow used to go to the exchange that had the greatest liquidity, because that's where the bid/offer spread was tightest and the best execution possible. As of last month, however, the options complex took on a new mantra: Follow the money. On July 6, the Chicago Board Options Exchange, the world's largest options mart, jolted the industry by announcing a program to facilitate payment for order flow.

How this situation came about is no secret. After exchanges became more aggressive about multiply listing options last fall, Susquehanna Partners, a major Chicago-based market-making firm, began paying some customers for order flow, according to published reports. Other specialist firms apparently did the same. The exchanges took note, and the result was that some trading firms were sporadically enticed or paid for flow in an effort to attract liquidity to those markets.

The CBOE, seeing its volume threatened, issued its July decision to stanch the seepage of flow from its floor to those of other options exchanges already offering payment. "We introduced [this] program because we saw some member firms focusing in on payment for order flow as a significant factor in setting [order-flow] switches,” notes Edward Joyce, CBOE president and COO.

"If we end up paying more money to be in this business, we're going to charge more by simply widening our bid/offer spread or executing less aggressively.” —Trent Cutler Cutler Group

The exchange argues that it had its back against a wall, since payment for order flow has become yet another competitive front in the battle for business. "While we have always been very successful in competing on all of the other fronts—the execution price of the order, the speed at which we turned it around and the effectiveness of our systems—we felt that we would just have to compete on this last, most recent component of competition, which is payment for order flow,” says Joyce.

According to the CBOE plan, which went into effect July 1, market-makers and designated primary market-makers are charged a $0.40 "marketing fee” per option contract (excluding index options). The money, held in segregated accounts, is available to the DPMs to pay clients at their discretion for actions "reasonably likely to be effective in attracting order flow to the Exchange in the option classes traded at a DPM's assigned station,” according to the exchange's statement. The CBOE announced this plan even as it expressed concern over payment for order flow. And in a letter to the Securities and Exchange Commission in April, the exchange was especially clear on the matter, writing that "payment for order flow and similar practices can be troublesome and are not in the best interests in the securities industry.”

The Philadelphia Stock Exchange, after upbraiding the CBOE for its recent action, said on July 14 that it would officially join the payment game—and then some, upping the ante 150 percent by offering $1 per contract. The American Stock Exchange had said it would launch a program of payment for order flow on July 5, just before the CBOE came out with its announcement. The Pacific Exchange in late July put forth its own program, noting that it would levy fees "at rates comparable to those announced by the other options exchanges.” The International Stock Exchange, an all-electronic market scheduled to trade options on 600 stocks by year-end, says it is still looking at the "strategy” of payment for order flow. Nonetheless, say industry sources, the likely scenario is that all of the exchanges will wind up competing on payment for order flow—because they won't have a choice if they want to maintain their franchise.

The SEC's dilemma

The issue, of course, is that payment for order flow seems to fly in the face of the SEC's vaunted goals of greater intermarket access and price competition among the exchanges. If options exchanges are holding up dripping slabs of Grade A sirloin to the leonine brokerages and discounters, those firms may lick their chops at the expense of getting the best fills for their customers.

Payment for order flow taints those who would take advantage of it, argues a Chicago-based market-maker. "My biggest objective is to give the best-quality market to customers, and I would think that wouldn't mean I had to pay for that order flow,” he says. He would pay if that were the only way for him to maintain order flow, he says, but he makes clear that the conflict of interest isn't his. "The conflict is with brokerage firms justifying to their customers that they're selling their order flow—and making sure the customers are getting the best fills they can get, since that's their fiduciary responsibility,” he notes. He also thinks the SEC should stand shamefully in the corner for allowing this practice—with its potential for abuse—to gain a foothold in the options market.

So is this how payment for order flow will work?

Not quite, according to the SEC. At the same time that the Commission is allowing payment for options order flow to take place (it already exists for stocks), it's insisting that exchanges guarantee customers the best execution available at the time and and that broker-dealers disclose trade-throughs to customers. Trade-throughs are executions of orders at prices inferior to the best quote.

Some in the industry suggest that the SEC may also be using the issue of payment for order flow as a carrot to get all the options exchanges signed on to its linkage plan for the options markets. If a broker-dealer sends an order to an exchange that's a member of the intermarket linkage plan the Commission recently approved (which is currently in a comment period that ends early next month), it will be exempt from having to disclose trade-throughs, presumably because the plan will reduce the likelihood of trade-throughs, which the Commission estimates is currently at 5 percent. The effect of this is that each exchange will have to join the linkage plan in order to stay competitive.

What this also means, points out a New York-based market-maker, is that payment for order flow in the options markets will merely be a part of the industry's evolution. It would be worrying—but only were it not for the fact that the SEC is requiring exchanges to have systems that will provide a paper trail, if necessary, to show that a customer got the best price at the time of execution. "Without that,” he says, "payment for order flow would be a big problem.” The SEC has also proposed a rule that will improve execution—namely, the firm-quote rule, which will require market-makers to honor quotes for orders routed from market-makers at other exchanges. "Payment for order flow will ultimately become a non-event because it could all end up being the same price,” says the New York market-maker. "They'll all pay and it just won't be a major factor as we go forward.”

But not everyone thinks this will happen—or makes sense. "What the SEC is putting in place to reduce trade-throughs doesn't moderate the conflict of interest that's inherent in payment for order flow,” says Trent Cutler, founder and general partner of Cutler Group, a market-making firm in Chicago and San Francisco, and on Eurex. Payment for order flow, he argues, is essentially a non-transparent tax on customers—exactly what the SEC is committed to working against. Market-makers will match what others pay in order to get their fair share of the order flow, he says, but "If we end up paying more money to be in this business, we're going to charge more by simply widening our bid/offer spread or executing less aggressively—just by some infinitesimal amount, because the payment for order flow is not huge. But that charge is simply passed on to the customer in the end—and it's totally non-transparent because the customer doesn't see this cost.”

Another problem with the SEC's plan is that the prices on the screen are not always the best prices. "Simply promising the best execution of what's on the screen doesn't ensure that the customer gets the best price possible, because there are markets where there's more liquidity than what's quoted on the screen,” points out Cutler. "That happens all, all, all the time.”

His solution: a central limit order book. If the options exchanges are connected electronically, orders could theoretically go through one single place to get filled. That would ensure the best price.

Of course, getting all the exchanges to agree to this is another matter entirely. Don't hold your breath.