Options Market Structure: Is it Getting Too Complex?

Options exchanges have been developing innovative products, such as mini-options that debuted this week, launching new trading venues and tweaking their fee schedules to attract new entrants with low latency trading strategies. But at the same time, exchange operators are creating a more complex market structure, and one that requires scale to compete.

With two additional U.S. options exchanges launching by year-end bringing the total to 12, brokers are grappling with complexity in the market structure. The newest entrant is the Miami Options Exchange, while earlier this month, the International Securities Exchange (ISE) announced plans to launch a second U.S. derivatives exchange, called Topaz.

“We’re seeing more fragmentation,” said Slade Winchester, head of U.S. Derivatives Electronic Execution Sales and Strategy for Citi at a media briefing at the firm’s offices in lower Manhattan. As the complexity increases, Citi’s router has to be more sophisticated. “You have to have a good understanding of these [models] to run a router efficiently,” said Slade who runs an electronic trading group and educates Citi’s clients on the market structure of the listed equity derivatives market.

Although brokers like Citi have expressed concerns about the growing complexity driven by the proliferation of options venues, exchanges are continuing to create new execution protocols with specific fee schedules that can be embedded into smart order routers. Institutional clients rely on their brokers like Citi to decipher the various fee schedules and integrate them into their smart order routers.

However, the trend is not stopping,according to sources, who expect more U.S. equity derivatives venues to open. "Beyond opening the eighth exchange, there’s not a lot of benefits,” according to one source who declined to be named.

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In a webcast yesterday, Andy Nybo, principal and head of derivatives research for Tabb Group, said that smaller market makers are struggling to survive in an environment with smaller margins and lower volumes that requires connectivity to 11 options exchanges and fees for market data feeds.

Nybo based his talk on his recent report, “US Options Market Making 2013: Scale, Scope and Survival,” which is based on interviews with 26 listed equity options market making firms active on one or more of the 11 US option exchanges.

While the proliferation of exchanges has added to the opportunities, it has also exacerbated the complexity facing market makers. In the webcast, Nybo noted that in 2000 there were 4 exchanges and today there are 11 each with the potential to offer trading opportunities to a market maker. Laying out all the different market making models, Nybo said creating and maintaining all the routing connections is an expensive proposition.

Market makers are dealing with 12 exchanges, 12 different sets of fee schedules and 12 different sets of protocols. “Managing all that complexity becomes a technological nightmare for market makers,” said Nybo in the webcast.

Market makers are also operating in an environment with more aggressive regulations, which is consuming considerable staff time and compliance time and could result in fines for non-compliance. For example, a regulator could request specific details on a contract that was executed six months ago based on data stored in a ticker plant. Maintaining that data is expensive for smaller market makers.

All of this complexity, rising costs for data and need for technology are happening in an environment where volume is low, said Nybo. Options volumes grew from 3. 5 million contracts in 2001 to a total of 18 million contracts traded in 2011. “Volume has increased more than five-fold since 2002,” Nybo wrote in his report. After a decade of spectacular growth, 2012 volumes fell by 12.5 percent from the record 4.6 billion contracts traded in 2011, according to Tabb Group.

Given the structural shift in the options markets, and the fragmentation, technology has become critical. “It’s become a business of scale. Technology is absolutely necessary for building the business that supports low latency trading, tick data, colocation plant facilities,” said Nybo in the webcast.

While the larger firms have an infrastructure to connect to an exchange with teams of connectivity experts, smaller firms may have to outsource this type of services. “Again, connectivity to the fragmented landscape is significantly more expensive, particularly if you are ramping up to four or five exchanges,” said Nybo.

Another trend in options is that volume (72 percent) is concentrated in the top 100 names. “The markets are much faster, pricing changes are much more rapid, he said. The end result is that options trading is faster, and so market makers need black box technology to manage quotes and “get in and out” of markets. In fact, “screen-based trading is a dying art,” typically reserved for smaller firms with much more focused strategies, perhaps operating on one or two exchanges with a directional model, he said.

As a result, 94 percent of today’s market makers use black boxes to support their market-making activity. In options, 60 percent of the volume executed through low latency strategies, estimated Nybo, who added that he expects that figure to increase as buy side firms become more sophisticated in use of technology and strategies such as volatility.

Despite the complexity, market makers are counting on rising volumes and new types of products such as weekly and daily options and VIX products. “Future growth will come down to rising volumes and product innovation,” said Nybo. “The more they quote, with more names, strike prices, and symbols, the more opportunity they have for profits, he suggested.

While the future is bright for equity derivatives, the growing complexity and fragmentation is something to watch.