By Jessica Titlebaum

After evaluating the impact of the 60/40 rule, Contingent Cross Orders and the more established Penny Pilot Program, some traders believe regulators are driving diversity out of the markets. How? Read on to understand how these initiatives have impacted the market making community and what participants can do to protect liquidity.

The 60/40 Rule

There has been much debate in Washington about the 60/40 rule, which applies to all securities including listed futures, forex, equity options and broad-based stock indices.

One market maker explains how the tax treatment eases operational costs for market makers giving them more capital in which to conduct their business.

“Let’s say you bought and sold a futures contract in the same day, the gain or loss of that would be given tax treatment at the higher short term capital gain rate,” he said. “The long-term rate is lower so the 60/40 treatment is lowering taxes paid on trading activities.”

While the tax treatment is facilitating efficient movement of capital for market making firms, one trader brings up Washington’s efforts to eliminate the rule.

Gavin Rowe is the managing director of the International Trading Institute. He believes the efforts to abolish the 60/40 rule would be bad for market makers.

“The Democrats in D.C. routinely propose eliminating it to raise revenue, which it probably would do; but it would be bad for market makers because that is the only real, final thing that is keeping smaller shops in the business of providing two way quotes,” he said.

Contingent Cross Orders

Another factor impacting market makers is a concept called Contingent Cross Orders, which the Securities and Exchange Commission (SEC) recently ruled in favor of.

Contingent Cross Orders are orders of 1000 options contracts or more that are guaranteed execution but don’t have to be traded in front of resting customer orders. These private orders must be fully hedged with stock and executed at or better than the National Best Bid Offer (NBBO).

The International Securities Exchange introduced the trend and other exchanges soon followed suit, including Nasdaq’s PHLX Options market.

Ruling in favor of said transactions, the SEC believes it will be beneficial to study the relationships between contingent cross orders and equity derivatives when the correlations seem to be out of line with the fair value.

However, not all industry participants find these orders beneficial to the market.

NYSE Euronext released a statement expressing their concern that contingent cross orders hinder market transparency and price discovery as well as diminish incentives to competitively quote orders. They also believe that this is the first step to dark pools in the options market.

Rowe sides with the Big Board.

“The contingent cross rule allows firms who compete for customers to trade preferentially, without exposing the orders to the open market. Even setting aside the crucial theoretical relationships between options, the Commission has created a situation in which price competition is impossible; and discrimination between customers is inevitable,” he said. “Regulators are now choosing which customer orders are more important arbitrarily.”

The Penny Pilot Program

Rowe also believes that regulators are favoring capital-infused firms, which leads to a homogenous market making community. One example he gave was the Penny Pilot Program (PPP).

“Regulators are writing rules that favor capital –infused firms and reducing rewards to other kinds of market markers that will convert liquidity providers into pure, market taking speculators,” he said.

The Commission first approved the program in 2007 stating that they believed it would provide valuable information to the exchanges regarding; the impact of penny quoting on spreads, transaction costs, payment for order flow and quote message traffic.

However, according to comments shared by the SEC in 2009, one of the unintended consequences of the pilot program was a decrease in liquidity in the pilot’s penny classes. Several comments to the SEC expressed concern that decreased liquidity would make it harder for market participants to execute large orders as well as push liquidity-seeking participants to Over-the-Counter (OTC) venues and dark pools.

Extending the pilot program, the Commission stated in a public document that this was an area that required careful analysis.

As trades in penny increments were made in micro-seconds and created massive amounts of data to be sifted through and sorted, the program also forced firms to spend more money on technology,

“Ultimately, to compete in the penny markets, firms are forced to employ large amounts of money into acquiring and maintaining technology,” he said. “Trades happen in micro-seconds now and if you are not right on top of the hyper-speed changes in markets generated by penny increments, you don’t get to play.”

Speed has always been a fundamental part of market making competition, rightfully says Rowe. With the financial barriers to entry so high, he questions the long-term risk to the market against the short-term benefit of tighter bid/ask spreads.

“My greatest concern from these trends put together is the long-term risk to the market stemming from a loss in liquidity provider diversity. If the 2008 financial meltdown stemmed from large, look-alike banks employing a flawed business model, then have the trends in rule changes created similar risk in the options market? By chasing tighter spreads with the stock market model in mind, will the market makers be so homogenous that a market shock leads to the end user suffering as the look-alike firms all pull liquidity at once?”

Education is Key

One of the things Rowe believes will help market makers is educating and informing regulators on alternative solutions.

“Trading penny increments could have been accomplished without penny quotes by structuring electronic auctions on a quote request basis,” he said. “Electronic auctions happen routinely in issues not quotes in pennies.”

While market makers may be frustrated with some of the regulation coming out of Washington, it is important to remember that everyone is on the same side. Market participants work to provide transparency, efficient price discovery and healthy competition in the marketplace.

Have you had similar experiences with the above regulation? Or have you encountered positive impacts? We are anxious to hear your stories and we’d bet regulators would be too.