How ISO trades done in financial firm

Regulation NMS, the National Market System, has been around since 1975. Congress directed the SEC to facilitate the establishment of a national market system (NMS) to link together the individual markets that trade securities. Developing a national market system is in the public interest to protect investors and maintain fair and orderly markets to assure fair competition among exchange markets.

Options exchanges set up a plan in 2000 to comply with Reg NMS. Before 2000, most options were listed only on a single exchange, hence why we did not come up with our own NMS for twenty-five years. In this plan, exchanges agree that the dissemination of locked or crossed markets should be avoided and if members lock or cross a market, they should take action to unlock or uncross these markets. A locked market means a quoted market in which a bid is equal to the offer or vice versa. A crossed market means a quoted market where the bid is higher then the quoted offer or an offer is lower than a quoted bid.

Under the current plan, the OCC, along with all option exchanges, created a “Linkage Hub” that is run by the OCC, Options Clearing Corporation. The Linkage Hub is a centralized data communications network that electronically links the option exchanges to one another and helps participants to route orders to limit trade-throughs.

Come Monday, Aug. 31, 2009, options markets will transition from the linkage hub to direct order routing. That is where the ISO comes in. Let me introduce the ISO. ISO stands for intermarket sweep order which will allow exchanges to route orders to other markets directly instead of having to send them through a central hub. Equity markets have already transitioned to a Reg NMS compliant system that uses ISO orders.

The Intermarket sweep order is an IOC (Immediate or Cancel) order. IOC orders are limit orders that are executed in whole or part as soon as the order is received and any portion not executed will be immediately canceled.

To prevent trade throughs, ISO orders will be routed to exchanges where the “protected bid” is superior to the sell order limit or the “protected offer” is superior to the limit price of a buy order. “Protected bid or offer” means a bid or offer that is displayed by an exchange, disseminated pursuant to the Options Price Reporting Authority (OPRA) and is the Best Bid or Best Offer (BBO) of the exchange.

Clients can send ISO orders to several exchanges simultaneously to fulfill their obligation to prevent trade throughs, or as an alternative, clients can send a non ISO order to one exchange and have the exchange send out ISO orders to clear the away BBOs.

Here’s some technical jargon just in case you are impressed by this sort of thing:

The ISO order type will be indicated in FIX tag 18 with the value “f”.
The ISO order type will be reported to OPRA with a special ISO trade qualifier (Type code “S”).

• And here is how the ISO will work:
o An inbound ISO order type received on NYSE Arca or NYSE Amex
— Will ignore the NBBO.
— Will never route to another exchange
— Will trade vs. the existing depth of book
* Any remaining volume of the ISO order will cancel back to the sending firm.

• Clients can of course still send non ISO orders. If there are better markets away when a non ISO order is received, the ISO order type will also be used by NYSE Arca and NYSE Amex when routing orders to away exchanges.
o Outbound ISO orders will always have a TIF of IOC
o Outbound ISO orders will be sent for the lesser of the ISO order volume or the size of the displayed volume at the away BBO
o Outbound ISO orders will be sent contemporaneously to trade all available top of book size on away exchanges (up to size of the incoming order) regardless of NBBO
o Once the ISO orders have been sent to clear the away BBOs at the time of the order’s receipt, the order will access depth of book, up to the order’s limit price.

Most important to you, NYSE Arca Options and NYSE Amex Options are ready for our Trading Permit Holders who wish to test ISO orders in the CERT environment to do so immediately. Contact our Connectivity Hotline at (888) 689-7739 or email to connectivity@nyx.com. By testing in our CERT environment, you get peace of mind and you can be assured that when the change happens, your firm is ready.

For those readers that would like to see a full copy of the plan, please visit the SEC website here to read all about it: http://www.sec.gov/rules/sro/nms/2009/34-60405.pdf

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