Bloomberg News

Bats Withdraws Options Market-Maker Plan Rivals Criticized

July 19, 2011

(Adds Londergan comment, information about exchanges’ petition and context starting in fifth paragraph.)

July 19 (Bloomberg) -- Bats Global Markets, the exchange operator planning to go public, withdrew a program that would have let market makers on its U.S. options venue give certain brokers better prices than those publicly available.

“The rule has many elements that are broadly seen as positive, but when taken as a whole, there may be a few concerns that could be better addressed,” Joe Ratterman, the chief executive officer of Lenexa, Kansas-based Bats, wrote in a newsletter distributed today. “We will retract the currently approved rule until we are confident that the final result will, in fact, make markets better.”

The so-called directed-order program was approved by the U.S. Securities and Exchange Commission three weeks ago over the objections of CBOE Holdings Inc., Nasdaq OMX Group Inc., NYSE Euronext, International Securities Exchange and BOX Options Exchange. Bats proposed the program to win business by offering market makers incentives to quote on its platform.

The Bats program would have let market makers 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. The second price would be available only to brokers on a list of firms approved to direct orders to that market maker. Others couldn’t access it.

Payment for Order Flow

Bats’ original proposal was a way of addressing a practice in options and equity markets known as payment for order flow, in which market makers compensate brokerages for steering them requests to transact securities. The arrangements have been used with the sanction of regulators who tried to limit their impact in options by setting ceilings on how much of any given order can be executed by a favored trader. Payment for order flow in equities has diminished over the last decade.

Options market makers quoting at the best price can usually get up to 40 percent of an incoming order directed to them, with the rest split among others quoting at that price. The rules dictating the allocation of orders are determined by exchanges.

The Bats program would have let market makers execute orders from specified brokers at prices better than the national best bid or offer, while the price available to those firms remained hidden and unavailable to others in the industry. Those market makers could also trade with the entire order instead of limiting their portion to 40 percent.

‘Information Deficit’

“These mechanisms reduce competition and ultimately hide order flow and price information,” Ben Londergan, chief executive officer of Group One Trading LP, a Chicago-based market-making firm, told the U.S. SEC in a letter on July 13. “Lacking certainty about market prices leaves customers at an information deficit.”

Londergan said the Bats program, which gives the best prices to only a subset of customers, reduces the incentive for market makers to supply electronic quotes to exchanges. The ability to trade with an entire customer order would shrink competition among market makers, he said.

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 Chicago Board Options Exchange at 25 percent.

The eight other U.S. options exchanges asked the SEC to review its approval of the Bats plan in a July 15 letter.

Harm Investors

Clearing the Bats program would “harm retail investors and burden competition in violation of the Securities Exchange Act of 1934,” the exchanges said. It “permits Bats options market makers to discriminate among order flow providers -- granting access to the best prices to certain members and investors while denying it to others.”

Keeping orders from individual investors hidden would reduce transparency, the exchanges said in their letter. Doing so would run counter to comments from Chairman Mary Schapiro, who has expressed concern about the level of stock trading on dark pools and away from exchanges, the eight companies said. Unlike in equities, brokers in options can’t trade away from regulated exchanges.

The SEC’s approval “expands the type and degree of discrimination the Exchange Act permits,” the letter said. It asked the SEC to review the approval of the Bats program.

Full Commission

“Setting standards for significant policies belongs in the exclusive province of the full commission, not in a staff- approved pilot that other exchanges will be forced to copy,” the letter said. The exchanges also said the SEC’s approval includes “material misstatements of fact regarding the operation of the Bats directed order program, payment for order flow, and trading in penny pilot options,” or products that can be quoted in smaller price increments than are allowed for other contracts, it said.

Christopher Nagy, managing director for order strategy at TD Ameritrade Holding Corp., told the SEC in a letter dated June 30 that the Bats program would benefit individual investors by giving them better prices. While the program “could be disruptive to many of the current large options market makers,” firms may enter the industry to compete for orders, he wrote.

Ratterman said in the newsletter that Bats will work with customers in the next few weeks on “possible design improvements” to the directed-order program.

Payment for order flow programs “prevail today because they have not had a legitimate challenger,” Ratterman said. “We will continue to challenge the status quo, because we don’t believe it reflects the best market structure available for trading options.”

Bats may delay its initial public offering to the first quarter of next year because of a U.K. regulatory review of the company’s purchase of Chi-X Europe Ltd., a person with direct knowledge of the matter said today. Stacie Fleming, a spokeswoman for Bats, declined to comment on the possible IPO postponement and the withdrawal of the directed-order program.

--Editors: Chris Nagi, Nick Baker

To contact the reporter on this story: Nina Mehta in New York at

To contact the editor responsible for this story: Nick Baker at

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