A shift in the competitive environment for options market making could lead to a drop in liquidity for lesser traded instruments, as technology continues to influence trading in the asset class, research has shown.
The findings are part of a new report from consultancy TABB Group, which stated that 59% of total trading volume in US options now comprises high-frequency trading (HFT) strategies. In terms of market making flow, HFT accounted for 94% of total volume traded.
Despite the increasing prevalence of HFT strategies in the equity options market, the majority of those questioned by TABB said they believed high-speed trading firms contribute to market quality.
However, the study added that options HFT activity that is not subject to exchanges’ market making obligations do cause concern.
“What is open to debate is whether these accounts have unfair advantages in terms of market access and participation without having the responsibilities of market-making firms with extensive quote obligations,” read the report.
The report also noted a trend of brokers trying to maximise their access and control of order flow by matching two sides of a trade internally or using auction mechanisms. Exchanges, meanwhile, are attempting to attract more order flow through a variety of order types and fee structures, some of which restrict access to liquidity or favour certain market makers.
Around 64% viewed the need for sophisticated technology as the biggest challenge facing the options market making business, particularly smaller firms, a number of which have exited the business or established hedge funds, proprietary trading operations or advisory services.
Given the need for better quality technology, market making firms have focused their activities in the most heavily-traded names. Last year, 72.5% of volume was concentrated in the most liquid options contracts, according to TABB.
The study, titled ‘US options market making: Scale, scope and survival’, questioned 26 options market makers operating on one or more of the existing 11 US options exchanges, accounting for around 45% of total industry volume.