Options Exchanges Seek To Evaluate And Manage Role Of HFT Traders

With the role of HFT in stocks being actively investigated thanks to Senator Kaufman's ongoing crusade against a two-tiered market, the spotlight has shifted toward High Frequency Trading strategies in options, where now the exchanges themselves are evaluating whether HFT traders are benefiting from their two-tiered role as both a preferential customer and a market maker, however one, having no obligations to create a market, when things turn ugly. A report by Dow Jones titled "Influx Of High-Frequency Traders Prompt New Rules In Options" notes that "options exchanges are drafting new policies to address the ever-expanding role of high-frequency traders in their markets. The policies aim to eliminate some of the advantages that high-frequency traders currently have over professional options market-makers, representing an attempt by the exchanges to level the playing field between these two huge players in the options market and to maintain the orderly functioning of the market." As more transparency is shone on every market dominated by this now-pervasive paradigm, especially with regulators woefully behind the curve, the latest development in the ongoing unmasking of various HFT strategies will only benefit the broader markets.

As Dow Jones points out:

Until now, exchanges treated high-frequency traders like customers, allowing them to get first dibs on those incoming orders. But as high-frequency shops stepped up their participation in options - sometime in 2008 as a result of changes to options prices - the exchanges realized that high-frequency traders behaved a lot like market makers. They traded in bulk and possessed
cutting-edge technology that allowed them to execute orders at lightening-fast speed.

In other words, high-frequency traders enjoyed the best of both worlds. They received the benefits of a customer while possessing the technology of a professional. Seeing this, the exchanges thought it was only a matter of time before market makers would simply transform themselves into high-frequency traders and shirk their current responsibilities. If that happened, the options market would cease to function in the way it has for decades.

Of course, the threat of disrupting profitable revenue streams will immediately generate numerous opposing voices, who proceed with the well-known defense:

High-frequency trading firms dislike the new rules. They say the exchanges are merely trying to protect the market makers from competition, in large part because the market makers pay fees to the exchanges and generate a huge amount of their revenue. They also say the rules will lead to lower levels of liquidity and competition, which are two things that contribute to efficient and well-run markets.

However, exchanges apparently couldn't care less for this front, and are already taking measures, with the ISE at the forefront:

The International Securities Exchange got the ball rolling in October, when it adopted the so-called Professional Customer Rule. That rule says that ISE will distribute incoming orders to both "professional customers" and market makers on a pro-rata basis, divvying up orders according to the number of options that each player has previously indicated they are willing to buy or sell at a certain price.

ISE defines a professional customer as any customer who enters an average of 390 orders or more in a day - one order for every minute of a trading session - and will therefore apply to many high-frequency trading firms.

"This way, customers who behave like professionals receive a pro-rata allocation of order flow...putting them on equal footing with market makers and broker dealers," said Boris Ilyevsky, a managing director at ISE.

The ISE is not alone:

There are three other exchanges that are currently looking at similar policies. The Chicago Board Options Exchange filed a rule proposal with the U.S. Securities and Exchange Commission earlier this year and expects to have its rule in place early next year. The American Stock Exchange and the Philadelphia Stock Exchange, meanwhile - owned by NYSE Euronext (NYX) and NASAQ OMX (NDAQ), respectively - are also mulling the creation of similar policies.

Probably the most critical target all these regulations are set on achieveing:

The effort also marks an attempt by the exchanges to define just what exactly high-frequency traders are, and how they should be treated, at a time when these firms are becoming increasingly influential in both stocks and options.

Indeed, defining the role of HFT in the market is the most critical fixture at this point in the market, where as ever increasing volume from regular exchanges seems to continue disappearing to dark pools, and where the predominant volumes on traditional exchanges and ATS is left in the hands of various HFT strategies. Both retail and institutional investors can only benefit as more HFT market-impact information comes to light.

Comments

[Failure to Comm...]

'Of course, the threat of disrupting profitable revenue streams will immediately generate numerous opposing voices'

Numerous voices yet, strangely enough, all from the same address. Understatement...Got to love it.

[Failure to Comm...]

'The effort also marks an attempt by the exchanges to define just what exactly high-frequency traders are, and how they should be treated, at a time when these firms are becoming increasingly influential in both stocks and options.'

Nice little exchange ya' got here. Be a shame if anything happened to it...

[phaesed]

I'm mixed on this actually.

I like that occassionally when I put a buy order in at $10 or whatever for positions that trade in $5 increments and I get filled @ $8 or $9, so they do provide a lot of benefits to traders like me. In the equity markets? Oh it's bs that they can drill down or provide "support" at will in thin stocks, but options?

Man, those are always "buyer beware"

[Anonymous]

The irony of market makers being good guys and the HFT guys the bad guys is rich.

[SquawkBox]

Hmmm ...

So the options marketmakers have a problem with the HF traders.

Do I have a dog in this fight?

[Anonymous]

We are a high frequency equity options proprietary trading firm--we're scalping for small amounts, making small profits on each trade. In 2010, there will be record volume in options due to the increase of names in the penny pilot. In the second half of the year we may see some consolidation of exchanges as we see a shift from traditional options exchanges to three additional ECN options exchanges ( CBOE ( C2), BATS, and Miami International) opening in 2010. With potentially ten exchanges on top of new options symbology changes from 5 to 25 characters and decimal strikes, there will be an impact on market data messages. We welcome penny options and have built an infrastructure to handle the increased messages but we would like to see less dollar strikes in equities priced above 20 dollars as the dollar strikes and proposed decimal strikes will spread the volume and make it less attractive to trade. It would be nice to maintain penny and nickel spreads but adapt back to two and half dollar strikes.