Research and strategic advisory firm Tabb Group has released a new paper predicting considerable challenges ahead for options market makers.
The report, titled ‘Trying to Make Change: Market Makers and the Evolving Options Market’, says that without sophisticated technological capabilities, market makers are at a critical disadvantage.
Andy Nybo, senior research analyst at Tabb Group, explains in a statement that regulatory initiatives such as penny increments and dollar strikes require changes to business models and technology infrastructure. “Penny-price increments result in an increasingly competitive business environment, forcing them into making tighter markets, sharply reducing their profit potential,” he said. “Dollar strikes have another downside, namely increased quoting requirements.”
The evolving options market structure has attracted the attention of a powerful new class of trading institution, the report argues. Rising liquidity, greater adoption of technology and structural changes have combined to create a fertile ground for these institutions, which use quantitative trading strategies perfected in the equity markets to tap the evolving options marketplace. These new players, Nybo adds, “are leveraging the capabilities of technology to implement quantitative modelling with automated systems that mimic trading techniques long used by market makers.”
Nybo also believes that market makers need to have the same powerful technologies at their fingertips to manage the evolving complexity of the buy-side’s trading strategies and furthermore, invest in systems that are even faster than their customers’.
The report says the introduction of new pricing models by exchanges is creating a ripe environment for new trading strategies involving quantitative models that exploit fleeting arbitrage opportunities and market miss-valuations.
Tabb Group believes all the ingredients are present for the successful implementation of automated strategies in the options market. Technology has become more powerful and affordable, trading volumes are rising and regulations are creating an environment that is favourable to the execution of these automated strategies. “As exchanges fight for market share through new pricing schedules and trading protocols, market makers will need to adapt and choose when and where to operate,” says Nybo.
In Europe, however, disparate exchanges and limited interconnectivity are resulting in significant complexities for market makers with cross-border operations. “Managing a multitude of connections in different countries, all with different regulatory regimes, quickly becomes a full employment act for compliance departments,” writes Nybo. “With the need to support a wide variety of proprietary protocols for each individual exchange and dramatically increasing bandwidth requirements, it’s clear that operating in multiple jurisdictions requires significant investments in both staff and technology.”
Internationally, Tabb Group believes Asia, Europe and South America, as well as derivatives markets in other locations, offer promise for firms that can invest in the connections and systems that open up the market to existing clients seeking alpha.