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Hide Not Slide‏ @HideNotSlide Oct 13

The SEC mandates that every options order be executed on exchange before going to the OCC for clearing. Wholesalers legally can't circumvent the exchange despite paying for all the order flow. This creates a peculiar competitive dynamic.

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Hide Not Slide‏ @HideNotSlide Oct 13

There are five exchange groups that compete for options order flow. Nasdaq & CBOE control a similar share of the market with NYSE in third and MIAX quickly catching up. Competing for order flow means making top wholesalers happy.pic.twitter.com/UjxWCI8Z8S

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Hide Not Slide‏ @HideNotSlide Oct 13

How do exchanges make wholesalers happy? They create their own form of PFOF. On-exchange MMs are charged "marketing fees" which are then pooled & rebated to the wholesalers in exchange for flow. On-exchange firms subsidize wholesaler order flow.

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Hide Not Slide‏ @HideNotSlide Oct 13

There are other ways wholesalers exert power over the exchanges. Let's revisit your Robinhood order routed through CitSec. Imagine CitSec chooses CBOE to execute its order. CitSec enters the market and says "I've got an order that needs filling, who can give me the best price?"

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Hide Not Slide‏ @HideNotSlide Oct 13

What happens next is called a "price improvement auction". MMs will compete to win the auction by offering a price at or better than the NBBO. CitSec has a separate entity that will compete w/ other MMs for the order. Order by order competition? That's great! Well… not quite.

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Hide Not Slide‏ @HideNotSlide Oct 13

Because CitSec is the wholesaler their on-exchange affiliate has an advantage over other MMs. Exchanges charge them 1/10th the fees as a reward for bringing the order to their exchange. With 10x the fee hurdle, many MMs can't compete.

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Hide Not Slide‏ @HideNotSlide Oct 13

There's also the specialist angle to consider. Exchanges choose MMs to act as a specialist for each traded stock. Specialists have higher quoting obligations & in return get even more order flow exclusivity. Who are the top specialists? You guessed it - the top wholesalers.

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Hide Not Slide‏ @HideNotSlide Oct 13

So to review, wholesalers pay brokers for order flow & to manage their routing obligations. Exchanges pay wholesalers & give them special trading privileges for their order flow. Double the PFOF, double the fun! What happens if it's banned?

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Hide Not Slide‏ @HideNotSlide Oct 13

In my opinion, not much would change at first. Brokers would still route to wholesalers because they don't want to deal with exchange connectivity & routing. They just wouldn't be getting paid PFOF anymore. Wholesalers would CLEAN UP in this scenario.

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Hide Not Slide‏ @HideNotSlide Oct 13

Complex exchange connections & rules have given wholesalers a way to insert themselves in the flow of options volume & control immense amounts of power, more so than equities. Banning PFOF won't immediately take that power away. We can't look solely at equities to make policy.

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Hide Not Slide‏ @HideNotSlide Oct 13

Thanks for reading - hopefully you learned something from this thread. I'll be doing a deeper dive into options market structure in an upcoming post - sign up below if interested:https://frontmonth.substack.com/

10:09 AM - 13 Oct 2021

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11 replies 5 retweets 144 likes

1. Chris Stewart‏ @Chris_Stewart_5 Oct 13
  Replying to @HideNotSlide
  
  I remember Griffin mentioning that all options trades are required to be executed on an exchange during his gamestop testimony, I meant to look into this further but looks like you've consolidated all relevant information. Thanks!
  
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1. Caffeinated‏ @nol_mcc Oct 13
  Replying to @HideNotSlide
  
  This is good stuff
  
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1. HF Trader‏ @HF_Trader Oct 13
  Replying to @HideNotSlide
  
  Good stuff sir.
  
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1. Dog Lover‏ @dg_lv Oct 13
  Replying to @HideNotSlide
  
  Great thread
  
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