Directed-Order Revival?

Terry Flanagan

BATS Options’ decision to retract its recently approved but controversial directed-orders program has puzzled some market participants, given the exchange’s formerly gung-ho support, but the Lenexa, KS-based company may return with a revised version sooner rather than later.

BATS filed to retract the program July 25, less than a month after it was approved by the Securities and Exchange Commission staff and 17 days after all the competing options exchanges filed a notice of their intent to petition the commission to review the approval.

Sources at BATS, rival exchanges and broker-dealers declined to comment about the retraction, and why it arrived before the SEC had even decided whether to authorize a review. One noted, however, that the SEC would be hard-pressed to deny a review requested by all the other options exchanges, following comments on the proposal from other market participants that were mostly critical.

An executive at one of the major market makers noted BATS filing May 14 to pursue an IPO may have also played a role. “So during the period leading up to the IPO they won’t have to explain this controversy involving the SEC that’s riling the market,” he said.

That controversy was summarized in a comment letter filed by the Securities Industry and Financial Markets Association (Sifma) Jun 30, more than two months after the comment letter deadline. Sifma noted the options market’s few market makers compared to the equity market. It went on to say the directed order program would undermine many of the other exchanges’ pro-rata approach, which guarantees market makers a portion of a trade according to the size of their quotes, as long as they are at the national best bid or offer (NBBO).

“Accordingly, we believe that the BATS Proposal would discourage market makers on the options exchanges from quoting larger and more aggressive displayed sizes, which would pose a real risk to the provision of liquidity in the options markets and in turn have adverse consequences for investors, both large and small,” Sifma said.

Sifma also reiterated the concern that the directed order program would enable market makers to internalize orders without giving other market participants the ability to compete for those orders. That’s because market makers could capture those orders by matching the best the best bid or offer and then improving it by as little as a penny, without displaying the price improvement to competitors. “It appears that BATS market makers will be able to internalize directed orders without giving other BATS market participants a meaningful opportunity to participate in the execution of the orders,” Sifma says.

Voicing similar concerns, other market participants used more pressing language. “Group One fervently believes the Commission should end the pilot program. Reducing transparency, dampening the price discovery process and metastasizing conflicts of interest all degrade the quality of the market,” writes Ben Londergan, CEO of the Chicago-based proprietary trading firm. “By introducing [the undisplayed price improvement], BATS has removed transparency from the marketplace and is intentionally hiding liquidity.”

Joe Ratterman, BATS’ chairman, president and CEO, acknowledged some of those concerns in a letter sent to clients toward the end of July. While noting the difficulty to determine the actual outcome without implementing the pilot program BATS received approval for, “we certainly agree that outcomes like these are not desirable (nor were they the intent of the program,” Ratterman wrote.

He went on to say that BATS would work closely with customers on design improvements in the “weeks ahead,” suggesting reviving the directed order program may arrive in the foreseeable future. “The end goal remains to provide an alternative mechanism to existing and prevalent [payment for order flow] programs, which would enable market makers to compete by providing better prices directly to retail customers, rather than through payments to the customer’s broker,” Ratterman wrote.

Indeed, a source familiar with BATS’ approach said the exchange company views the IPO timeline as driven by very different forces, including developments in BATS European operations and the overall capital markets environment. The source added that resolving concerns about market makers offering undisplayed price improvement could go a long way to resolving related concerns, such increasing their ability to internalize orders.

Another attempt to institute the directed orders program may still result in controversy and opposition from rival exchanges, but, said the source, BATS potentially could seek commission rather than staff approval in its filing. “So if BATS is challenged again, rather than getting stuck in a QCC-type rat hole, the directed order program could be active while going the challenge process,” he said.

Related articles