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Bats Options Program, Criticized by Rivals, Gets SEC OK

Regulators approved a program proposed by Bats Global Markets over the objections of CBOE Holdings Inc. and other exchanges that allows market-makers on its options venue to give certain brokers better prices.

The U.S. Securities and Exchange Commission said it will allow Bats Exchange Options Market to introduce a so-called directed-order program. The plan was criticized by the Chicago Board Options Exchange, Nasdaq OMX Group Inc., NYSE Euronext, International Securities Exchange and BOX Options Exchange. The SEC’s approval order was published today.

Bats first proposed a directed-order program in December. The Lenexa, Kansas-based company withdrew it after exchanges objected and suggested a different version in March. The program will operate on a six-month pilot basis that ends on Jan. 30, 2012, the SEC said.

Bats will provide “plenty of data for public consumption so people can determine the efficacy of the directed-order program,” said Randy Williams, a Bats spokesman. The exchange will also submit monthly reports about the program to the SEC.

The Bats exchange had 4.1 percent of options volume last month, according to data compiled by Chicago-based OCC, which clears all equity derivatives contracts in the U.S. The largest individual market is the CBOE, with 25.4 percent.

Options Volume

CBOE Holdings, NYSE Euronext and Nasdaq OMX each had between 24 percent and 27 percent of total options volume last month, OCC data showed. CBOE Holdings, whose total volume was the industry’s highest, and Nasdaq and NYSE, both of which are in New York, each run two options markets. ISE accounted for 16.3 percent and Boston-based BOX had 2.4 percent. NYSE Euronext plans to merge with Frankfurt-based Deutsche Boerse AG, which owns ISE in New York.

Nasdaq OMX called the proposal “discriminatory” in a June 24 letter to the SEC. The plan “will make trading standardized options incrementally darker and less transparent by enabling market makers to trade exclusively against orders directed to them without exposing the orders to other market participants,” it told the SEC.

The Bats program allows market makers to send the exchange two prices on options contracts. One would be displayed publicly while the other, assuming the first is quoting at the national best bid or offer, would improve that price and be hidden.

Hidden Orders

The second, better price would be available only to brokers directing orders to that market maker who are on a list of approved firms. Others couldn’t access it.

Traders on most stock and options exchanges can use hidden or non-displayed bids and offers to trade without showing their intentions. While no broker can see those orders, evidence such as trades being executed on the exchange at prices better than the national best bid or offer could tip them that hidden orders exist. Those orders have always been available to anyone entering a market and not just certain firms.

CBOE urged the SEC in a June 29 letter not to approve the Bats proposal. Customer orders on Bats wouldn’t be subject to “any semblance of transparency and competition,” it said.

“The SEC has appropriately insisted that an exchange provide order exposure and interaction on the exchange,” CBOE said. By allowing market makers to provide better-priced quotes only to a subset of chosen firms, the Bats plan “deviates from these concepts dramatically.”

Public Quotes

NYSE Euronext told the SEC in a June 17 letter that the Bats program allows market makers on that venue to offer their best prices only to “pre-selected firms,” in contrast to market makers on other exchanges quoting at the national best bid or offer. Approval of the program would allow the firms on Bats to “discriminate on whatever basis they deem appropriate, to the ultimate detriment of the market,” NYSE wrote.

The Bats market maker’s hidden order can trade against a directed order up to the number of contracts the market maker is quoting publicly, Bats told the SEC. That gives market makers an incentive to quote publicly, it said. If other hidden orders are submitted at prices equal to or better than the market-maker’s non-displayed price, those bids or offers would trade first.

The SEC said in approving the proposal that while “order exposure” usually benefits the options market, giving retail traders prices superior to the NBBO is also important.

Order Flow

“The proposal allows market makers to differentiate between orders from traders that are relatively more informed about the short-term direction of prices and orders from less informed traders,” the SEC said. “It may enable Bats Options market makers to provide better prices to less informed order flow that they otherwise would not be willing or able to provide if they had to make those prices available to all incoming order flow.”

The SEC added that the Bats program provides an alternative to so-called payment for order flow arrangements that push market makers to compete for orders by offering cash or other inducements to brokers sending them orders. The SEC has tried to shrink those programs for more than a decade in stocks and options.

The program gives a “drastic and unfair advantage” to the Bats market maker receiving directed orders, Citadel LLC, which makes markets in options, said in an April 25 letter to the SEC.

Multiple NBBOs

It would also create multiple NBBOs “because each market maker would have a private NBBO for certain approved directed order senders,” Citadel said. Bats market makers in the program “would cherry-pick the most desirable order flow from the market with private hidden quotes,” prompting other firms to quote less aggressively, widening the bid-offer spread, it said.

TD Ameritrade Holding Corp., based in Omaha, Nebraska, said in a letter to the SEC dated June 30 that the Bats proposal will benefit retail investors by giving them better options prices. While the program “could be disruptive to many of the current large options market makers,” new firms may enter the industry to compete for orders, according to the letter, which hasn’t yet been published on the SEC website.

Clients of the Omaha, Nebraska-based retail broker have about $420 billion in assets, TD Ameritrade said.

Bats, which operates equity and options exchanges in the U.S. and a stock market in Europe, plans to have an initial public offering. The company, formed in 2005, is owned by firms including Tradebot Systems Inc. in Kansas City, Missouri; Bank of America Corp. in Charlotte, North Carolina; Citigroup Inc. in New York; and Zurich-based Credit Suisse Group AG.

Directed Orders

CBOE told the SEC the Bats program allows market makers to trade with 100 percent of a directed order at a hidden price, a “guarantee” unavailable elsewhere through existing programs.

“It’s another step in the direction of internalization,” or the ability of brokers to trade with customers without exposing the orders publicly, said Peter Bottini, executive vice president for trading and customer service at Chicago-based optionsXpress Holdings Inc. That’s not a “positive step” for the industry, he said.

Some options exchanges currently have programs that allow brokers to send orders to specific market makers, who can then receive up to 40 percent of the contracts as long as they’re quoting at the industry’s best price. The rest of the contracts are distributed to other firms quoting at that price.

NYSE Euronext told the SEC in its June 17 commentary that a Bats letter to the SEC dated June 2 contained “multiple inaccuracies” and misstatements about how current “preferencing and directed-order mechanisms” function. It said the Bats program “will have a significant and damaging impact on the options industry as a whole, and create a less competitive atmosphere for the investing public.”

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