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Options Exchanges and Order Flow

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In the TabbFORUM, a web platform for discussion of the capital markets by informed participants therein, I see a new piece by Andy Nybo about the segmenting of the order flow in the U.S. listed options markets.

Nybo is head of derivatives research for the TABB Group, where he has worked for 10 years. So he knows all its mysteries, such as presumably why the capitalization convention for the TABB Group is reversed for the name of the TabbFORUM.

His article begins with the observation that there are lots of US options markets, and that they try to compete with one another with various innovations. Isn't that a good thing? Well ... it depends on the innovation. He complains that one new trend is raising havoc, "price improvement auctions."

He defines a price improvement auction as "a trading protocol that allows market makers to improve prices for a segmented swatch of order flow," and claims it has a "number of detrimental consequences."

In essence the market maker (an exchange member) submits a two-sided offer -- that is, both a buy and a sell price -- into the market looking for takers. If there ARE takers, then this is by definition and for them an improvement on the quoted market price. Otherwise they would have bought (or sold) at the quoted market price.

This bifurcates the market and, in Nybo's view, it has contributed "to a steady decline in the long-term health of US listed options markets."  The so-called "lit" market is stripped of its "most valuable retail flow."

Nybo doesn't suggest a solution, though. In fact he ends with a warning that "solutions often have unintended consequences themselves."

That's an odd way to end the piece but, hey, who am I to question Nybo's literary talents?

The discussion confirms my general sense that huge changes in the business of financing business lie just ahead. The next five years or so will see an explosion of new technologies in the field, along with the playing-out of old institutions that are of as much continuing use and vitality as a physical trading floor in the 21st century.

Huge. I said it.
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