By Heetesh Rawal, Vice President at Devexperts

In April of this year, the SEC held a roundtable on options market structure reform. Preceding the event, comments were submitted by the public to gather concerns and to help inform the conversations that were to be had. These included letters from individual market participants, institutions, and academics.  

An interesting one from Lauren Rauch, co-CEO of the Chigago Trading Company, concluded by saying she anticipated that defenders of the status quo would use the roundtable as an opportunity to say that retail investors have “never had it better.” The general tone was indeed celebratory, and subsequent coverage of the roundtable did use those words to describe the overall sentiment among participants. 

SEC Chair, Paul Atkins, remarked that the event was “neither a prelude to, nor a harbinger of, any options rulemakings in the immediate term.” In other words, the issues raised throughout should be seen as firmly in the fact-finding stage.  

While this statement might lead us to keeping our expectations in check, the issues below, which led to the strongest disagreement, are at least a sign that certain practices are coming under increased scrutiny. 

Directed market makers and the five-lot rule 

The debate around whether directed market makers (DMMs) should be given guaranteed access to orders of five lots or fewer, was contentious. Currently, exchanges designate specific market makers as specialists in given auctions classes. These appointments are not democratic, or performance based, and are often for life. This means that these firms end up filling the lion’s share of retail positions irrespective of what other market makers might be quoting. 

The practice comes with quoting obligations and originates from a time when these institutions were crucial to providing liquidity in thin markets. The argument against them goes that they’re not required in highly liquid names, and their monopoly over these orders is anti-competitive.  

Those urging for reform of this practice are proposing that DMMs should be limited to the least liquid options, that appointments be subject to annual review, that they should expire and be renewed within a given period, and that DMMs be prohibited from “unbundling” larger orders so that they gain preferential access to them under the five-lot rule.  

Price improvement auctions 

The issue of price improvement auctions was also top of mind for many participants. These auctions are ostensibly about achieving the best possible execution for traders. However, their various mechanisms, such as auto-matching, and the fact that affiliated market makers receive preferential allocation, have come under scrutiny.  

When a firm’s price is uncompetitive, it can tactically initiate an auction rather than altering its quote. It then automatically matches competing prices under the auction’s rules while still gaining up to 50% of the allocation. The practice is criticized for prioritizing the capture of order flow over the provision of competitive prices. 

One of the suggestions coming out of this debate is the removal of this auto-matching practice as it disincentivizes auction initiators from putting up their best price at the outset. Another would see the review of allocation advantages for the initiator’s market marker.  

Payment for order flow (PFOF)  

Finally, payment for order flow. The explosion of zero-commission retail trading is synonymous with this practice. Rather than forwarding to an exchange, retail brokers route orders to wholesalers, like Citadel and Susquehanna, that pay a fee to the broker for that flow.  

In this way, the bulk of retail trades are internalized by wholesalers, but through on-exchange mechanisms such as the ones discussed above (as opposed to off-exchange internalization that takes place in equities trading). Defenders of the practice point to the explosion in retail participation and volumes. Its detractors claim that retail is actually receiving a worse deal.  

The results of a study authored by Xing Huang and Christopher Schwarz, which reflect trades placed with six brokers in 2024, were provided to the SEC in advance of the roundtable. It suggests that PFOF is negatively correlated with price improvements (-0.91), with the frequency of using auctions (-0.83), with price improvements when using auctions (-0.93), and with price improvements when using auto-execution (-0.91). 

Interestingly, PFOF, which is the most understood by retail traders, is probably the least likely to change in the coming years. This is because it has been such a boon to the options trading industry.  

An outright ban of the practice seems extremely unlikely, and the most critics can hope for is a conciliatory effort to at least increase transparency so that traders at least know the quality of execution they’re receiving. 

Final thought 

So, to answer the title’s question: yes, change is on the horizon, but there’s no telling how long that horizon can continue to recede as we get closer to it.