Prohibition on Market Making Trading Behavior in US Equity Option Market

[ndc24075]

I recently came across a condition in Interactive Brokers' agreement that states clients cannot have market making trading behavior in US equity options. The condition looks very strict. I'm curious about the legality of this condition and whether there have been any challenges or discussions about it. It has been in place for some time, and I would appreciate any insights into the reasoning behind it. The original quote is as follows:

'It is a violation of U.S. option exchange rules and American Stock Exchange ETF rules for a customer effectively to act as a market maker by holding itself out as willing to buy and sell securities on a regular or continuous basis. In determining whether a customer effectively is operating as a market maker, the exchanges will consider, among other things, the simultaneous or near-simultaneous entry of limit orders to buy and sell the same security; the multiple acquisition and liquidation of positions in the security during the same day; and the entry of multiple limit orders at different prices in the same security.' The source for this statement can be found on Interactive Brokers' website in the 'US Options Exchange Rules' section of their registration form (https://ndcdyn.interactivebrokers.c...=registration_1/us_options_exchange_rules.jsp).

 

[newwurldmn]

It’s strict but not criminal.

 

[Robert Morse]

ndc24075-Option Market Makers are regulated and have quoting requirements. Priority customers go in front of Market Makers and Firm orders. You can't be both unregulated and take priority and make two sided markets to open. You can choose to be Professional Customer, lose your priority and make two sided markets. Execution cost are much higher and you are still required to tag your order correctly when a MM does not have to. Once you buy some to open, the sell order should be sell to close. It is not easy.

 

[ndc24075]

ndc24075-Option Market Makers are regulated and have quoting requirements. Priority customers go in front of Market Makers and Firm orders. You can't be both unregulated and take priority and make two sided markets to open. You can choose to be Professional Customer, lose your priority and make two sided markets. Execution cost are much higher and you are still required to tag your order correctly when a MM does not have to. Once you buy some to open, the sell order should be sell to close. It is not easy.

Thank you for the information, Robert. I'm still a bit unclear on the concept of execution cost. Is it just the priority given to orders or are there other factors at play, such as the order tagging you mentioned? I'm also curious about the reason for the difference in regulations between equity and US equity markets. It seems that allowing more participants would lead to greater market efficiency, so I wonder if there are other concerns at play.

 

[Robert Morse]

Your broker might not pass through option exchange fees, but they all have a schedule of what that charge. Some are $0.00, some offer a credit for adding liquidity and some charge for taking liquidity. The rates for priority customer vs pro customer are much better. Too many details to go into here.

Thank you for the information, Robert. I'm still a bit unclear on the concept of execution cost. Is it just the priority given to orders or are there other factors at play, such as the order tagging you mentioned? I'm also curious about the reason for the difference in regulations between equity and US equity markets. It seems that allowing more participants would lead to greater market efficiency, so I wonder if there are other concerns at play.

 

[FSU]

ndc24075-Option Market Makers are regulated and have quoting requirements. Priority customers go in front of Market Makers and Firm orders. You can't be both unregulated and take priority and make two sided markets to open. You can choose to be Professional Customer, lose your priority and make two sided markets. Execution cost are much higher and you are still required to tag your order correctly when a MM does not have to. Once you buy some to open, the sell order should be sell to close. It is not easy.

Bob, I've always been a bit confused about this. My firm suggests that you can be on both sides of the market as a customer if your orders are resting on certain exchanges. I'm guessing these are ones that do not have customer priority. Also, I thought if your orders are on separate exchanges, it was ok as well. I also understood that most brokers will not make this distinction and ban orders on both sides of the market in all cases.

Is this your understanding as well?

 

[Robert Morse]

FSU- I can't confirm that buy to open on one option exchange and sell to open on another is allowed. That might be true. The orders still need to be tagged correctly and your broker's risk and compliance checks need to allow it.

Bob, I've always been a bit confused about this. My firm suggests that you can be on both sides of the market as a customer if your orders are resting on certain exchanges. I'm guessing these are ones that do not have customer priority. Also, I thought if your orders are on separate exchanges, it was ok as well. I also understood that most brokers will not make this distinction and ban orders on both sides of the market in all cases.

Is this your understanding as well?

 

[rb7]

It seems that allowing more participants would lead to greater market efficiency, so I wonder if there are other concerns at play.

This rule exists to prevent participants to act as a MM but without the associated obligations.
In the US Option market, there is no better position than to be a public customer, trading privileges wise.

 

[earth_imperator]

'In determining whether a customer effectively is operating as a market maker, the exchanges will consider, among other things, ... the entry of multiple limit orders at different prices in the same security.'

This is IMO BS, b/c one does this to get an "average price" when the B/A-spread is wide.
IMO a fully legitimate trading strategy.

 

[traider]

This rule exists to prevent participants to act as a MM but without the associated obligations.
In the US Option market, there is no better position than to be a public customer, trading privileges wise.

Can you elaborate on why it's better?