CBOE Delays New Options Market as SEC Mulls Ban on Flash Orders

(Bloomberg) -- The Chicago Board Options Exchange, the largest U.S. equity derivatives market, will wait until the second half of the year to start a new platform catering to high-speed traders while the Securities and Exchange Commission reviews industry practices.

The possibility that transactions known as flash orders may be barred in the stock and options markets has made it impossible for the Chicago-based company to complete trading rules for the C2 Options Exchange, Ed Tilly, vice chairman of the CBOE, said yesterday in New York.

Criticism from U.S. Senators Charles Schumer and Ted Kaufman as well as NYSE Euronext, operator of the New York Stock Exchange, helped prompt an SEC review last year of trading techniques used on some venues in the world’s largest equity market. Flash orders, often called step-up orders in the options industry, enable brokers operating on one trading venue to match better prices available on other exchanges.

Without market makers maintaining the ability to “step up” to a better price available elsewhere, C2 might have to alter its algorithms that match buy and sell orders and change “incentives to get our market makers on top of the market,” Tilly said yesterday.

CBOE and Eurex’s New York-based International Securities Exchange, which together account for two-thirds of market volume in U.S. equity options, have told Congress and SEC commissioners that flash orders are necessary to compete for some business with newer exchanges such as NYSE Arca Options.



Resolution Soon



While the SEC proposed banning flash orders in September, a final decision hasn’t been announced. The opportunity for the public to comment on its proposal ended on Nov. 23. Bill Brodsky, chairman and chief executive officer of the CBOE, said yesterday that he expects the flash order issue to be “dealt with in the relatively near future.”

The CBOE provides bids and offers that are the best available prices in the market 95 percent of the time, Brodsky said. The exchange uses step-up orders when it isn’t already quoting the industry’s best price.

Schumer, a New York Democrat, and Kaufman, a Democrat from Delaware, are among critics who argue that trading practices such as flash orders give unfair advantages to some investors. CBOE and ISE say flash orders help brokers whose customers are individual investors avoid certain costs on other exchanges while getting executions at the best prices, CBOE and ISE say.

CBOE is creating C2 to appeal to so-called high-frequency traders who sometimes send thousands of orders a second to exchanges to take advantage of fleeting price changes. The all- electronic exchange was approved by the SEC on Dec. 10.



Secaucus, Not Chicago



C2 will enable CBOE to compete more effectively with newer exchanges with different market models, the Chicago-based firm says. As part of this effort, C2’s matching engine will be based in Secaucus, New Jersey, instead of Chicago, reducing the time to trade and update quotations for C2’s participants based in the New York metropolitan area.

The conflict over flash orders in options highlights a conflict between different market structures. Options exchanges use one of two market models. CBOE, ISE and other traditional markets are pro-rata exchanges that allocate up to a certain amount of an incoming order to market makers quoting the best price. Orders from individual and institutional investors, as well as trades originating from hedge funds and other firms that are not brokers, pay no fees to execute on these exchanges.



First Come, First Served



The other market model is based on price-time priority. At exchanges including NYSE Arca Options and Nasdaq Options Market, orders are filled on a first come, first served basis. Price- time markets pay market participants to provide liquidity and charge those taking liquidity, or executing against orders posted on the exchange’s system.

C2 will match marketable orders it receives based either on price-time priority or a pro-rata system depending on which type of option is being traded. The exchange may also provide other rules to give advantages to non-brokers or firms that improve the best price in an option.

These rules for matching orders are intended to distinguish C2 from NYSE Arca Options and Nasdaq Options Market, which execute most trades based on price-time priority, by providing incentives to market participants quoting on C2.

Whether C2 would use its previously planned matching algorithms is now undecided, Tilly said. It’s difficult to define them without a “total picture from the SEC” about what types of trading practices will be allowed, he added.