The dramatic growth in institutional investors’ demand for options trading presents a big opportunity for brokers, argues Chris Kelley of Fidessa. But the market is changing so fast that if they want to compete, brokers face daunting technological challenges. The equity markets offer a partial roadmap.
If you’ve been watching the cash equities market structure in recent years, you might be experiencing a sense of déjà vu. The listed options market now appears to be following a remarkably similar path, giving brokers new revenue opportunities.
Much of the increase in options volumes can be attributed to institutional investors, looking for both improved alpha and risk management strategies.
But it is not just the investors that seem familiar. Market fragmentation, penny pricing, the introduction of intermarket sweep orders (ISOs) and the prospect of much tighter regulation are all areas where the market for options appears to be echoing the cash market’s recent past.
The economics of options trading are in flux. The transition to penny pricing has resulted in much narrower bid/offer spreads, smaller national best bid or offer (NBBO) quote sizes, and the dispersion of liquidity across more trading venues.
There is virtually no payment for order flow in penny-priced options. To keep this business profitable, brokers must find ways to increase execution volumes without raising costs.
Automate to survive
The fallout from the decimalisation of the cash equities markets offers some useful survival tips. Early adopters of automated solutions managed to remain profitable, despite earning less per trade.
Sophisticated order management workflow solutions, seamlessly integrated market access applications and electronic interfaces to investors all allowed firms to operate more efficiently on a larger scale.
The growing number of options exchanges mirrors the proliferation of share trading venues some years ago. As options liquidity becomes more diffuse, smart order routing solutions that can quickly root out liquidity wherever it resides become increasingly essential.
In the equities world, this once-rarefied technology is now commonplace and it seems assured that the options markets will follow a parallel track.
Another factor pushing smart routers on to options brokers’ must-have lists is the recent introduction of the ISO order type. Without ISOs, smart routers are bound by the options market’s trade-through rule, which effectively prohibits simultaneous access to multiple markets at multiple price levels. With this restriction now removed, smart routers are even more valuable.
Lastly, the emergence of an Order Audit Trail System-style audit requirement for options seems likely. Even while this remains uncertain, brokers’ increasingly influential audit and compliance staff are requiring similar information to be captured and stored for internal purposes.
The economic factors discussed earlier are driving the options markets toward fully automated trading solutions; an OATS-like rule for options would accelerate this evolution dramatically.
These parallels with the cash equity markets offer valuable insights to options brokers. However, the options markets also offer some entirely unprecedented challenges.
The most obvious is the proliferation of complex orders. Brokers are expected to execute each leg of these orders in perfect proportion, even when one leg is an order for the underlying equity. Brokers must also be able to accept and record these orders – with the legs appropriately linked – both verbally and via FIX, and then pass them intact to floor brokers and electronic venues.
Even this level of sophistication around complex orders may soon begin to look old-fashioned. Increasingly, options brokers are investing in their own legging technology, which allows the broker himself to work each leg of an order individually on whichever markets are optimal for that particular leg, while still ensuring that the legs execute in proportion.
Options clearing workflows also pose unique challenges. Options trades clear the next day (T+1), while cash markets are T+3.
At the same time, clearing member trade agreements, whereby ‘multi-prime’ investors (those with more than one prime broker) clear all or part of a trade with a broker other than the executing broker, are commonplace.
What’s more, these multi-prime customers often divide a single trade among several CMTA brokers, and all involved parties (executing brokers, clearing brokers, trading venues) must have the same understanding of the trade mechanics to avoid a break on T+1. When such arrangements are used for complex orders, the clearing challenges are multiplied.
Yet the traditional tolerance for breaks resulting from these intricacies is rapidly eroding in the face of shrinking per-trade margins and investors’ mounting service demands, further driving the need for front-to-back automation.
The options markets are evolving rapidly on many fronts at once, and brokers could be forgiven for being daunted by the pace of change and its technological imperatives.
However, the time is ripe for ambitious brokers to establish a firm foothold in a market that continues to grow in value. An awareness of the history of the cash markets, an appreciation of the singularities of the options markets and an appetite for meeting the growing demands of clients across both of these asset classes are the prerequisites for success.