Liquidity to disperse further as new options venues launch

The prospect of greater choice between US equity options exchanges is being treated with caution by market observers who claim that fragmentation is already making execution more difficult, especially for deals in institutional size.

The prospect of greater choice between US equity options exchanges is being treated with caution by market observers who claim that fragmentation is already making execution more difficult, especially for deals in institutional size.

Hot on the heels of the launch of Nasdaq OMX’s third options exchange on 29 June, the Deutsche Börse-owned International Securities Exchange (ISE) announced on Monday a filing with the Securities and Exchange Commission (SEC) for a second exchange licence that would offer “market structure and pricing flexibility”.  

Speaking just before the ISE’s announcement, Andy Nybo, head of derivatives of financial markets at consultancy TABB Group, said fragmentation of liquidity was already a concern for the trading desks of asset management firms.

“There is no doubt that, with 10 options exchanges, fragmentation is a considerable challenge for the buy-side, especially when trading blocks of options,” he said. Nybo added that the difficulties of trading in size were often “exacerbated” by penny pricing. “In the more liquid names, with liquidity resting at penny increments for say 10 contracts, it’s hard to get 10,000 contracts done.”

In a blog entry entitled, ‘Does the world really need another options exchange?’, Themis Trading co-founders Sal Arnuk and Joseph Saluzzi argue that Nasdaq OMX’s new BX Options platform will only benefit high-frequency market makers deploying ‘microsecond arbitrage’ strategies across multiple venues with different pricing models. “One of the biggest structural problems in the markets are these payment-for-order-flow / rebate schemes that exchanges and internalizers employ,” the agency brokers wrote.

The ISE’s new options exchange, expected to launch before the end of the year, will use an existing technology platform, Optimise, and member connections. But no details on products, pricing or market structure have yet been provided. “Having a second exchange licence will enhance ISE’s flexibility to meet the evolving needs of our members in a highly competitive environment,” said CEO Gary Katz. One of the earliest all-electronic US options exchanges, the ISE already offers options trading in more than 2,000 underlying instruments across equities, exchange-traded funds, indices and FX.

Expanding options

Announcing BX Options in March, Nasdaq OMX said the new platform would provide additional liquidity for retail customers “initially with a price/time trading system”. In addition to the functionality available to market participants via the venue operator’s existing options exchanges – Nasdaq Options Market (NOM) and Nasdaq OMX PHLX (PHLX) – such as low latency and bulk quoting, BX Options would offer “a hybrid allocation model, directed order flow, and a new multi-faceted price improvement auction”. Emphasising the complementary nature of the new service to the existing hybrid PHLX and NOM’s fully-electronic, price/time allocation model, US executive vice president for transaction services Eric Noll said Nasdaq OMX would compete “… not only with cutting-edge trading tools that service the full cycle of a trade, but also with inventive market structure that provides true discovery for an under-served segment of investors.”

In its SEC filing, Nasdaq OMX acknowledges that BX Options will at first have the same market structure and rules as NOM, introducing “additional, innovative technology” as momentum, volumes and participants build. And in an FAQ, Nasdaq said that, following a subsequent SEC filing, some products “will be subject to a pro rata execution allocation with customer priority”.

From 2 July, BX Options offers a US$0.12 per contract rebate for removing liquidity in SPY, IWM and QQQQ options series, rising to US$0.32 for all other options listed on the platform. BX launched on 29 June with five options series, with a further 50 penny pilot options slated to go live on 10 July and remaining options trade from 17 July.

“Exchange rebates and internaliser payment for order flow are not innovative ideas any more. They do not promote price discovery,” said the Themis partners. “Just the contrary, by creating artificial arbitrage opportunities, they actually are distorting the price discovery process.”

Buy-side sophistication

In its latest report on the market, ‘US options trading 2012: Standing out in the crowd’, TABB Group notes a growing sophistication and automation in the buy-side’s approach to options trading. As both traditional asset managers and hedge funds search for more efficient ways of managing exposures, for example making greater use of multi-legged options trades, greater technology investment is required both in the back and the front office, the report asserts. “We will seem more penetration by algorithms in the more liquid options,” said Nybo, noting however that the buy-side continues to depend on brokers for capital when trading less liquid names, as well as other research, execution and advisory services.

According to the TABB report, options volumes have not fallen as significantly as in the equity markets. While US options volume is just 5.7% lower in the 12 months to May 2012, equity volumes fell 10.4% in the same period. TABB attributes the discrepancy to greater adoption of options strategies by the buy-side and the growing popularity of replication strategies that use short-term options as a proxy for the underlying. Although TABB expects a 10% fall in overall 2012 US options volumes, it predicts a recovery in 2013.

TABB also notes that in a low-trading environment commission levels rates have increased to date in 2012. High-touch commission rates for options priced under / over US$1.00 reached US$1.08 / US$2.56 per contract, while low-touch rates were US$0.78 per contract.

“If volumes are down, buy-side firms don’t have the pricing power they once had. They are looking to stay relevant to their brokers: if they’re spending less in equities or fixed income, one way to increased spend is through options. Buy-side firms want to be top of mind with their brokers, who increasingly take a holistic view of clients across asset classes,” said Nybo.