Equities and Options Trading: Background
Equities Trading Systems
Trading of equities occurs in the United States on seven exchanges as well as in the over-the-counter ("OTC") market. There are seven U.S. stock exchanges.1 For all of the equities exchanges except one, each stock that is traded on the exchange is traded at a centralized location on the exchange floor called a "crowd."2 The crowd consists of exchange members trading on behalf of their customers as brokers and a market maker, called a "specialist." A specialist is an exchange member that "specializes" in the trading of one or more securities and has market making responsibilities in these securities. On most exchanges, each stock has one specialist.3 Specialists are required to make fair and orderly markets in the stocks assigned to them, maintain the limit order book in those stocks, and maintain the exchange quotation in those stocks. In maintaining the limit order book, specialists must comply with the Display Rule.
The OTC equities market in the U.S. is a geographically dispersed group of traders who are linked together via computer systems and telephone connections. The largest OTC market in the U. S. is a subsidiary of the National Association of Securities Dealers ("NASD") called the Nasdaq system ("Nasdaq"). Nasdaq is an electronic quotation system in which market makers in equities enter their bid and ask price quotations. The quotation system compiles all of the quotations and disseminates to the members the best bids and offers for each market maker in each security.4 In the OTC equities market, including the Nasdaq market, for each stock there is more than one market maker. The market makers compete with each other in the OTC market, which differs from the exchange markets, where specialists compete with the limit order book and the public orders of brokers in the crowd, among other sources. As discussed previously, OTC market makers are also required to comply with the Display Rule for Nasdaq traded securities.
All exchanges and many OTC market makers receive the bulk of their order volume through automated order routing systems.5 All exchanges and some OTC market makers use proprietary routing, display and execution systems. Other OTC market makers use third party vendors to construct and operate their order routing, display, and execution systems. Orders delivered through automated routing systems typically originate from broker-dealers, their institutional customers such as pension funds and money managers, and their retail customers. After receipt of the orders, the exchanges' order routing systems route the orders directly to the specialist responsible for trading the individual security. Similarly, OTC market makers' order routing systems direct a customer order to the trader responsible for making a market in the individual security.
Some exchanges and many OTC market makers have automated order execution systems for smaller-sized customer orders. These "auto-ex" systems provide for the automatic execution of customer market and marketable limit orders6 in various sizes, depending on the liquidity of securities. In addition, all equities exchanges and most of the larger-volume OTC market makers have automated display systems, which are designed to automatically display in the quote the best bids and offers in their limit order book.
Exchange specialists, and OTC market makers in varying degrees, route certain orders off their respective trading floors to other market centers for display and/or execution. For instance, exchange specialists use the Intermarket Trading System ("ITS")7 to route orders to other markets.8 OTC market makers also typically route orders in securities in which they are not market makers to other market makers and/or ECNs. The Display Rule provides that specialists and market makers may comply with their display requirements by re-routing orders in this way, provided that the orders are routed in accordance with its requirements.9
Options Trading Systems
The four options exchanges reviewed operate under two primary market structures: the specialist system, used by two exchanges, and the modified market maker system, used by the other two exchanges. The specialist system used by the options exchanges is similar to the specialist system used by the equities exchanges described above. Under the options specialist system, specialists are required to make fair and orderly markets in the options classes assigned to them, maintain the limit order book in those classes, and maintain the exchange quotation in those classes. The options exchanges that use a specialist system have crowds at each specialist's post. The crowds include Registered Options Traders ("ROTS"), who function like market makers. A ROT is a member of the exchange who has received permission to trade in options for his own account. In return for trading privileges, ROTS have some affirmative market making duties, such as making a market upon request for the classes of options in which they are registered. ROTS interact with the specialist to provide liquidity and depth.
Under the modified market maker system, all options on the same underlying stock trade in a centralized place on the exchange floor, which is also called a crowd. Trading in each crowd occurs before either an Order Book Official ("OBO"), a Designated Primary Market Maker ("DPM") or a Lead Market Maker ("LMM"). An OBO is an exchange official who administers the limit order book.10 The DPMs and LMMs are generally allocated by individual exchange rules a percentage of the executions in certain options classes traded by the crowd in exchange for performing duties similar to those of a specialist, including administering the limit order book. DPMs and LMMs are generally obligated to ensure that market quotations are accurate, honor guaranteed markets, and determine the formula for generating automatically updated market quotations. In addition, one exchange also requires its floor brokers to exercise "due diligence" to display orders when in receipt of eligible customer limit orders. The crowds also contain market makers from different firms who trade for their own accounts. In return for being allowed to trade for their own accounts, market makers, like ROTs, have certain affirmative duties, such as making a market upon request for the classes of options in which they are registered. One exchange permits market makers to improve the quoted market by directly inputting their better quotes into the automated display system. On other exchanges, market makers must verbally communicate their better quotes across the floor so that they can be input into the system
The specialists, DPMs, LMMs (collectively the "dealers") and the market makers and ROTS are subject to "firm quote" rules, which provide generally that they must execute customer orders of up to a certain maximum number of contracts at their displayed quotation at the time the customer order is received at the trading post. These rules are also referred to as "20-up" or "50-up" rules, depending on the maximum number of contracts specified by an SRO's rules.
All of the options exchanges have automated execution systems for small retail customer market or marketable limit orders. These "auto-ex" systems generally provide retail customers with a guaranteed fill at the current displayed quote. The customer orders in the auto-ex systems are usually executed against the specialist or the market makers in the crowd on a continuing rotation, generally referred to as "the wheel."
Orders that are entered into the automated order routing systems but that are not eligible for the auto-ex systems (which accept only smaller-sized customer orders that are market or marketable limit orders), are routed to one of several places. Limit orders at prices that are away from the market are generally entered into the electronic limit order book. Limit orders that are not qualified for the book or the auto-ex system11 may be routed to a member firm's booth on the trading floor, to a floor broker's handheld computer or a stationary computer in a trading crowd, or, on some options exchanges, to the specialist for manual handling.
Customer limit orders on the options exchanges can reach the trading crowds in one of several ways. As stated above, on some exchanges, orders may be routed to the crowds electronically through the exchange's automated order routing system.12 These electronically-routed orders may also be routed, on two of the options exchanges, to a floor broker in the trading crowd who is positioned at a computer terminal or is using a handheld computer that is equipped to receive orders from the order routing system. Orders can also be transmitted via telephone to the member firm's booth on the trading floor, and then delivered to the crowd by a runner. On two of the options exchanges, all system-eligible orders that are transmitted via telephone to the member firm's booth on the trading floor can be entered into the exchange's automated order routing system via a booth entry system.
The seven equities exchanges are the American Stock Exchange LLC ("Amex"), which is a subsidiary of the National Association of Securities Dealers, Inc. ("NASD"), the Boston Stock Exchange, Inc. ("BSE"), the Chicago Stock Exchange, Inc. ("CHX"), the Cincinnati Stock Exchange, Inc. ("CSE"), the New York Stock Exchange, Inc. ("NYSE"), the Pacific Exchange, Inc. ("PCX"), and the Philadelphia Stock Exchange, Inc. ("Phlx").
Beginning in 1976, the CSE phased out its physical trading floor and replaced it with an electronic system that connects CSE members located in geographically dispersed locations.
Both the CSE and the BSE have competing specialist systems. This system allows more than one specialist in an issue to compete against other specialists in that issue for order executions.
In addition, a growing portion of OTC order flow is being captured by electronic communication networks ("ECNs"), which are electronic systems that widely disseminate specialist and market maker orders to third parties and permit such orders to be executed in whole or in part through the system. Some ECNs also accept and disseminate limit orders received directly from customers.
Some of the exchanges receive the bulk of their share, as opposed to order, volume through manually handled order flow brought to the specialists by floor brokers. Floor broker orders tend to be larger in size than systems-routed orders.
A marketable customer limit order is an order that upon its receipt is executable. For instance, if the market is 20 bid and offered at 20 ¼, a customer limit order to buy at 20 ¼ represents an executable customer limit order.
ITS is an electronic system that links the exchanges and, through a separate linkage to the NASD's Computer Assisted Execution System (CAES), certain NASD market makers.
In addition, some exchange specialists also use other markets' automated routing systems, such as the Designated Order Turnaround ("DOT") system (NYSE) and the Post Execution Routing System ("PERS") (AMEX), to route orders directly to a specialist post.
A specialist or market maker may fulfill the requirements of the Display Rule by re-routing a customer limit order: "[i]f the specialist or OTC market maker immediately sends [an] order to a system or to another specialist or OTC market maker that complies with the rule, the specialist or OTC market maker that routed the order would have satisfied its obligation to display the order." See Adopting Release at 48,296; see also Exchange Act Rule 11Ac1-4(c)(5), 17 C.F.R. § 240.11Ac1-4(c)(5)(2000).
OBOs are also exchange employees.
Limit orders that are not qualified for the book or the auto-ex system may include non-customer orders and orders that have contingencies attached to them other than price.
Similar to the equities exchanges, the options exchanges' automated routing systems deliver the majority of customer orders received by the exchanges.