Imagine a car with no brakes. If it is traveling along a long, straight highway with no other traffic, the ride could continue indefinitely without any issues. What would happen if the highway ends? The inevitable crash is akin to the “flash crash” that affected the market on May 6, 2010. To call it a “flash crash” is somewhat of a misnomer. Yes, the market dropped precipitously and rose again in rapid succession. In that sense, the events did happen in a flash. The factors that contributed to the market shock, however, have been in the making for over a decade. Many of us knew that the car was running without brakes. We just did not yet know when the highway would end until that day.
Although there are many factors that contributed to the flash crash, one of the most important is the sheer volume of equities trades that take place at a venue other than an exchange on a daily basis. This practice, known as internalization, happens when a broker trades with an order, most likely to be a retail order, at a price equal or better to the national best bid or offer and then prints the trade to the tape via a trade reporting facility (TRF). That order is never exposed to the marketplace to benefit from the competitive process that occurs when other market participants have the opportunity to step up to trade with the order. On any given day, approximately 30 percent of all equity volume executed in the U.S. is reported through a TRF rather than executed on an exchange. For comparison’s sake, consider that the NYSE and NASDAQ execute approximately 26 percent and 18 percent, respectively, of all equities volume in any given day, and the relative magnitude of off-exchange trading quickly becomes clear.
As long as investors are receiving executions that are priced as good as, if not better than, displayed prices on the exchanges, then what is the harm of internalization? On the vast majority of trading days, there is no harm. Retail investors receive prompt fills at the prevailing price. Brokers are able to interact with “good” order flow, which can translate into price improvement for the customer. The brakeless car hums along smoothly so long as there are no bumps in the road.
Problems surface, however, when the “end of highway” signs indicated that it was time to brake. On May 6, the car riding smoothly along needed to brake or in market terminology, the markets operating smoothly until then, suddenly needed liquidity, but none could be found - the car truly had no brakes. The reality of today’s markets is that many traditional liquidity providers have fled from the exchanges. To attribute this occurrence solely to internalization would be to oversimplify the very complex factors that impact the business models of today’s market makers; however, it is accurate to point to internalization as a significant contributing factor. Because internalization allows the good order flow to be traded with before it ever reaches an exchange, to continue the car analogy, the only flow that makes it to an exchange is simply exhaust. A traditional market maker who stands ready to make a two-sided market for any order presented has very little interest in interacting with exhaust. The risk-return balance is stacked against him such that he is taking on more risk by trading with professional or high-frequency flow, and his returns are likely diminished. Not only does internalization preempt any competition to trade with a given order, it harms the overall competitive dynamic of the marketplace by discouraging traditional market makers from providing narrow, continuous quotes on the exchanges.
In an environment such as May 6, where prices were unreliable and alarm bells were going off, typical internalizers did not want to interact with the flow routed to them and, in turn, sent those orders to the exchanges for execution instead. In many cases, the liquidity providers formerly resident at the exchanges were no longer there to absorb the influx of volume. As we all know, we reached the end of the highway and the car crashed. Although markets have recovered, lingering damage remains to investor confidence.
Since last year, the SEC and the exchanges have worked diligently on a number of new safeguards to mitigate rapid price fluctuations, but they have failed to adequately address the root problem of making the equities exchanges an attractive and level playing field for market makers. Internalization removes the ability for market makers to compete for good order flow, thereby diminishing the ability of an exchange to function smoothly in all market conditions and to support true price discovery in any environment.
With this background in mind, let’s consider the options markets. Unlike in equities, all options trades must be executed on an exchange. There is no TRF and no off-exchange internalization is permitted. The strength of this model was borne out on May 6 when the options markets were able to absorb the spikes in volatility and trading volume because market makers stood ready to interact in any and all market conditions. The result was that trades were executed at prices that stood.
Over the past several years, there has been a push by some market participants to remake the options markets to look more like the equities markets, with penny ticks and maker/taker pricing. Some participants have also advocated for introducing internalization vehicles into the options markets. In the absence of an options TRF, certain pricing mechanisms and order types have been proposed to enable firms to trade against their retail order flow through an exchange, thereby disenfranchising market makers from the opportunity to interact with this flow and disadvantaging retail investors by removing the opportunity for price improvement.
Although internalization vehicles in the options market may masquerade as new order types or pricing schemes, it is important that regulators recognize these proverbial wolves in sheep’s clothing for what they truly are: ways to remove competition for order flow. Two specific examples from recent months are BATS Options’ proposal to introduce a new order type known as a Directed Order and the Boston Options Exchange’s (BOX) proposed pricing for its Price Improvement Period (PIP). The Directed Order proposal would allow a market maker to post a hidden price at which he would be willing to trade with an order sent from another market participant pre-selected to receive improved pricing. This proposal contravenes the SEC’s established precedents that require exposure for all retail options orders sent to exchanges so that market participants can compete to trade with the order through an auction process which may result in price improvement for the customer. It also violates SEC rules for participation guarantees, currently set at no more than 40 percent, by ensuring that the recipient of the Directed Order would be guaranteed 100 percent of the trade.
PIP is an example of a crossing order type where the firm entering the order is willing to trade against the entire size of the order. As mentioned, SEC rules require that the order must be exposed via an auction to other market participants for possible price improvement. In practice, however, BOX sought to nullify this requirement by establishing fees that made it prohibitively high for any other market participant to respond to the auction. Because orders could be entered into PIP at prices inferior to the NBBO, and then “improved” by the entering firm to match the NBBO, investors were denied the benefits of price improvement, with the full benefit going to the firm internalizing the order at the prevailing market price.
In both instances, comments from industry participants, including ISE, had a positive impact. BATS withdrew its proposal for Directed Orders after all eight of the other options exchanges joined together in an unprecedented move to petition the SEC to review its staff’s approval of the rule. Likewise, the SEC has instituted proceedings that could result in the disapproval of BOX’s fees for PIP following submission of a number of concerned comment letters from the industry.
Given the intensely competitive environment that we operate in, some options exchanges will continue to seek an edge by creating on-exchange internalization mechanisms. It is imperative that the other options exchanges persist in commenting publicly against such proposals and advocating for a market structure that encourages market makers to act as liquidity providers. Finally, the role of a strong and balanced regulator is critical. The SEC must vigilantly continue to enforce the established rules of the road to ensure that inequities do not occur, to prevent erosion of the structural foundations that act as safeguards for the options markets, and to protect the investor confidence that is our engine for future growth.
Gary Katz is President and Chief Executive Officer of the International Securities Exchange (ISE) and is a co-founder of the Exchange. Mr. Katz is a Director of ISE and serves on the Executive Board of Eurex. He is also on the Board of Directors of The Options Clearing Corporation and Direct Edge Holdings, LLC. Mr. Katz has an MS in Statistics with Distinction from New York University and a BA from Queens College.