US SEC's penny quoting pilot program

SEC released the results of Penny quoting Pilot program 2 weeks back. In this program, exchanges quote option prices in pennies instead of nickels and dimes. The findings were not starking different from stocks where penny quoting was introduced in 2001

Penny pricing was allowed in 13 options. The major conclusions drawn by the exchanges are –

• Average quote spread has tightened for the 13 options
• Quote message traffic has increased
• Quotation size has reduced i.e. liquidity has reduced

All the above mentioned conclusions can be explained using market micro structure theory.

Time precedence is advantageous only if the minimum price increment is not small. When a trader quotes a best bid/offer price then he holds a time precedence advantage till any other trader quotes a new best bid/offer price. If the minimum price increment is small then new best price will be discovered very often and time precedence will lose its meaning. The market finding is consistent with the theory because the quote message traffic increased i.e. time precedence’ relevance was reduced.

Spreads have reduced owing to following reasons-

• Smaller tick size may lead to higher trading activity and, consequently, narrow spreads
• Smaller tick size reduces the probability that the minimum price variation is a binding constraint on spread widths

Quotation size has reduced owing to following reasons-

• Decimalization leads to reduced time precedence
• Reduced time precedence leads to higher front running (please note that the front runners extract profit at the expense of passive traders)
• Risk of losing to front runners increases and prompts the traders to quote smaller size hence reduced liquidity in the market

Going by the early results, we can see that the institutional investors may be put to disadvantage if penny pricing is implemented -

• Institutional investors generally place big orders
• Penny pricing leads to high risk of front running and hence lower quotation size which is not sufficient for institutions to fill their orders
• Owing to less liquidity in the market and more transparency, institutions may not trade on the exchange traded options which will further reduce the liquidity

CBOE was not buoyed by the early results and has submitted its report urging SEC to analyze and understand all the implications of penny pricing on all the market participants before taking any decision.