US options: Rage inside the machine

US options: Rage inside the machine

According to the famous poem ‘If’ by Rudyard Kipling, a sign of true maturity is the ability to keep your head while all around you are losing theirs, and blaming it on you.

The US equity options market should consider adopting this as a maxim.

While the credit crisis has unleashed a frenzy of recrimination aimed at derivatives, the exchange-traded equity options market has not only kept its head – it has thrived.

Trading of US equity and index options reached 2.58bn contracts in the first eight months of the year, according to the Options Clearing Corp, a rise of 7% on the same period last year. That puts the market on track for another annual record, beating 2009’s total of 3.63bn contracts, itself 1% up on 2008’s haul, despite the crisis.

Such slight growth was very unusual – over the past decade, options volumes have increased more than fivefold.

At the heart of the boom is the belief that options are a toxic-free way of expressing long or short views, mitigating risk and accessing leverage. Amid soaring popularity, the CBOE Volatility Index of options volatility has entered mainstream financial argot, attaining unrivalled status as Wall Street’s fear gauge.

Competition turns fierce

But in the nature of capitalism, an efficient market – such as US options seems to be – is rarely the result of harmony. In fact, once you are inside the options market, many of the players seem more like Kipling’s bad examples – blaming and mistrusting each other in an all-out scramble to gain advantage.

The introduction of penny pricing, and attendant tightening of bid-offer spreads, have fuelled growth and spurred intense competition among exchanges, which sit at the centre of a rapidly evolving regulatory environment. In response, they have launched a welter of initiatives designed to grab market share and attract new money.

The key battlefield in the war for market share is pricing models, and exchanges have this year bombarded customers with pricing structure tweaks, fee rebates and commission increments, all designed to boost transaction flow.

Meanwhile, exchange executives have fought an unseemly war of words, each claiming to offer the best and cheapest customer experience, while maligning competitors’ offerings.

In recent weeks the backbiting has come to a head, with angry letters fired off to the US Securities and Exchange Commission, contesting the legality of practices at rival exchanges.

“We have eight exchanges operating in a hyper-competitive environment, all trying to attract order flow, and using pricing models as incentives,” says Andy Nybo, principal and head of derivatives at Tabb Group, the Massachusetts-based research and strategic advisory firm. “With a ninth exchange set to start trading in October, the situation is only going to continue to get more complex, and we may come to a point where the regulator steps in to dictate fee revenues for exchanges.”

Smaller exchanges catch up

As exchanges have experimented with new pricing models and protocols, market share has swung back and forth almost monthly.

However, putting aside squabbles over how contract share is measured, the established exchanges have lost ground over the past year.

In August, the Chicago Board Options Exchange had 27.2% of the options business, according to the Options Clearing Corp, compared with 32.5% in the same month last year. International Securities Exchange, owned by Deutsche Börse, had 18.3%, down from 27.4% a year ago.

The gainers are the exchanges owned by Nasdaq OMX and NYSE Euronext. Nasdaq OMX PHLX now has a 23.4% market share, up from 15.5% in August 2009, while the smaller Nasdaq Options Market has grown from 3.3% to 4.6%.

NYSE Amex Options, which only took 6.1% of trading last August, is now getting 11.8%, a shade more than NYSE Arca’s 11.7%, up from 10.9% last year.

Among the smaller players Boston Options Exchange (Box) has suffered a market share drop from 4.4% to 2.7%, while Bats Options Exchange, which only began trading in February, has captured a 0.4% slice of the action.

Us and them

On pricing, the eight exchanges can broadly be divided into two camps. The traditional or classic pricing camp (comprising CBOE, ISE, PHLX, Amex and Box) uses a system called payment for order flow, designed to keep costs for ‘customers’ to a minimum. Customers are defined as end users who bring orders to the exchange through brokers.

The exchange’s costs are borne by market makers, defined as professional participants that quote prices continually for large swathes of options, and are willing to take orders at those prices.

The exchange assigns a certain portion of incoming orders to market makers, which compete to offer the best price. The better their prices, the more of the incoming order flow they get. They pay fees for completed trades, part of which are used to reward brokers for bringing customer orders to the exchange.

The alternative camp (Arca, Bats and Nasdaq Options Market) uses a price-time priority pricing system alongside a so-called maker taker model of pricing.

This system is more similar to what prevails in the cash equity market. Maker taker pricing appears to have gained a slight advantage in the public debate in the past year, though its gains on the ground, in terms of actual market share, have been limited.

Under this system, orders are executed at the best available price in the order in which they were received. The fee is charged to the broker (and hence the customer), and the party that receives a rebate is the market maker.

“The maker taker model is a lower cost model for the market maker because of the fee charged to customers,” says Ed Ditmire, an analyst at Macquarie Group in New York. “That enables the market maker to offer tighter quotes and is why the system has taken a good chunk of the market and is growing faster.”

Fairness debated

Proponents of the two models are equally adamant that theirs is the right method. Payment for order flow (PFOF) supporters say it enables customers to get the best price and terms of execution.

Maker taker fans insist their way is more transparent, because all ‘makers’ of liquidity (the market makers) are rewarded fairly, while all ‘takers’ of liquidity (those sending in orders) are charged fairly. In PFOF, they claim, exchanges and brokers can allocate payments in obscure ways to suit their commercial ends.

Surrounding these two basic methodologies, however, is a tangle of price offerings from all the exchanges, often combining the two systems. The terms and special offers can vary from month to month and often from customer to customer.

Among such variations, different access fees may be charged for individual option classes or market participants, as well as according to the size of orders. There are varying fees, with minimum trading increments, different order types and auctions, individual option series and even time periods.

That is aside from numerous “blue light specials” like discounted access for professional customers. So prolific are the changes that in the first quarter of this year listed option exchanges submitted some 22 fee-related filings in 24 days.

Customers rebel

Not surprisingly, this constantly changing array of prices has raised the hackles of some investors, who question the benefits of a menu that is at best excruciatingly complex. At worst, they complain, it could hinder broker-dealers from living up to their best execution responsibilities.

“While competition fosters innovation, listed option exchanges have increasingly competed through ever more complex fee structures that do not bring the value normally associated with innovation,” said Anthony Saliba, CEO of trading system provider LiquidPoint, in a letter to the SEC in July. “This level of activity does not serve the interests of any market participant – except the exchanges. Market participants cannot reconcile the amount of fees they are charged and it places an enormous burden on development of trade routing and execution technology.”  

Still, the exchanges are unperturbed. In the view of some market participants, they would rather throw brickbats at each other than simplify fee structures.

Transaction fees remain the most incendiary point of combat. ISE this August wrote to the SEC complaining of what it termed “anticompetitive and discriminatory” fees charged by three of its rivals, which it said had the effect of locking out rivals.

“Box introduced a fee schedule which made it cheap to trade for the initiating broker but extremely expensive for anybody else, which makes the probability of price improvement almost impossible,” says Boris Ilyevsky (pictured right), managing director of ISE in New York. “The differential was so outrageous we had to comment.”

The CBOE and PHLX had imposed separate financial barriers with the same effect, Ilyevsky said.  

Executives at rival exchanges have reacted furiously to ISE’s claims, saying that ISE itself routinely exceeds SEC caps on fee differentials, and branding the accusations “unfounded” and “slanderous”.

“We tend to operate a little bit differently,” says Edward Tilly (pictured below), CBOE’s executive vice-chairman. “Rather than firing shots at what they have developed we take the lead – we would rather innovate than take the opposite approach.”  

Fees ‘too high’

Concern over access fees was first raised by Kenneth Griffin’s Citadel, the Chicago-based options market maker and hedge fund manager. In July 2008 Citadel asked the SEC to limit the ‘take’ fees options exchanges can charge non-members for access to quotations to $0.20 a contract.

Requirements that brokers buy and sell securities for clients at the best available quote in the marketplace may encourage venues to charge “excessive” fees to access their systems, masking the true cost of trading, Citadel said.

Chris Nagy, managing director of order routing strategy at TD Ameritrade in Omaha, says fees continue to exact a punitive tax on retail investors. “The fees issue is not resolving itself on its own and the cost of trading is far too high. There should be a cap or a system like in Europe where the fee is tied to notional trade value.”

A punitive tax may seem a strong description for necessary fees that have not prevented huge growth in the market. But there is no doubt many agree with Nagy, and the debate has now broadened to include all fees.

The SEC has yet to lay down the law on fees, but is moving toward doing so. In April it published proposed amendments to Rule 610 under the Securities Exchange Act, in which it proposed setting a fee limit at $0.30 a trade, mirroring the cap in equity markets.

“In the Commission’s preliminary view, limiting access fees to $0.30 per contract would promote intermarket access, standardization of quotations, and the Commission’s goals for an effective and efficient linkage between and among the options exchanges,” the SEC said in its draft. “The proposed fee limitation would place all options exchanges on a level playing field in terms of the fees they can charge for the execution of incoming options orders against their best bid and offer.”

Some exchanges (presumably those favouring a PFOF pricing model) might choose to charge lower fees, so as to be more attractive to order routers, the SEC said, while others (operating maker taker pricing with rebates) might charge the full $0.30 fee and rebate a substantial portion to liquidity providers.

Competition between the exchanges would ultimately decide which pricing model was most successful, the SEC opined.

The proposed rule changes have been cheered by brokers, some of which have called for the cap to be set at an even lower level, but booed by the exchanges, which plead that transaction fees are their most important source of revenue.

“Capping fees is a mistake and they shouldn’t do it,” says Ed Boyle, executive vice-president of NYSE Euronext in New York. “Any time regulators get into the business of capping fees it’s anti-competitive. If we had a monopoly it might be a reason for a fee cap, but options is competitive so regulators have no business coming in dictating fees.”

The CBOE is also up in arms, describing the proposals in a letter to the SEC as an “extraordinary step”, and saying that access fees accounted for 73.8% of its revenue in 2009.

Flash without the crash

A further complication for the traditional exchanges is the potential knock-on effects of any fee cap, for example on the use of ‘step-up’ or ‘flash’ orders. These are offered by four exchanges and are also the subject of proposed SEC regulation.

Flash orders emanated from the SEC’s creation of a national market system for securities and options. All the US options exchanges are interlinked, and by law, each exchange must route away to another exchange any incoming order which could be executed at a better price on that exchange.

Under this system, exchanges were allowed to give participants on their own exchange an opportunity, for a short period, to “step up” to the National Best Bid or Offer (NBBO) price quoted on a different exchange. This “flash” functionality gives exchange participants a tiny window of opportunity to match or beat the best price available on another exchange, before the order is sent away.

In 2009, there was a burst of public anxiety that sophisticated high frequency trading (HFT) firms and banks were taking advantage of slower-footed investors. HFT players, which use algorithms to dip in and out of markets hundreds of times a second, are thought to generate as much as 60%-65% of total trading volume at options exchanges, according to an estimate by Tabb Group.

The practice has been branded unfair by US politicians and is subject to a review by the SEC. Opposition crystallised around flash orders, which critics say give the HFT firms an advantage because they are the only ones that can react in time to fill the orders.

The SEC launched a consultation about banning flash orders in both the equity and options markets.

The great divide

In the options world, whether you support or oppose a ban on flash trading tends to come down to whether you favour PFOF or maker taker pricing.

Maker taker exchanges stand to benefit from a ban on flash orders, because some of the time, their market makers, emboldened by the prospect of fee rebates, quote more aggressively than those on PFOF exchanges. If flashes were banned, more orders would probably be routed automatically from the PFOF exchanges to the maker taker ones.

The other camp hate this idea, saying that routing orders to the NBBO does not necessarily give customers the best price, because they may then be landed with an access fee at the maker taker exchange.

Therefore the CBOE and ISE oppose a ban on flash orders, pointing to the system’s role in lowering trading costs, while Nasdaq OMX and NYSE Euronext – both of which operate one maker taker market and one using PFOF – support prohibition.

“Open access to the best displayed prices fosters order interaction, price discovery and market efficiency, while restricted access creates order isolation, price opacity and inefficiency,” says Tom Wittman, president of Nasdaq OMX PHLX. “Flash mechanisms create disincentives for market makers to provide their best market, and we support the elimination of flash orders.”

There are weaknesses in both sides of the argument. Although flash orders can cause aggressively quoting market makers to be disappointed, it is hard to see how it disincentivises them.

However, one of the key arguments in favour of flash orders is that, besides protecting customers from paying to trade, they counterbalance excessive option fees. The problem for supporters of flash orders is that if fees are capped, one of the strongest arguments in their favour is eliminated.

Getco, a market maker and high frequency trader, might be expected to oppose flash trading in its role as a liquidity provider, while as a leader in HFT, it might prefer to maintain the system.

In fact, as a strong proponent of maker taker pricing (and part owner of the Bats exchange) it has come down against flash orders, opposing what it calls a “two tier market”, and seemingly swimming with the tide on an issue that the SEC is likely to resolve sooner rather than later.

Competition forever

As the SEC considers its options, the battle for market share rages on. CBOE celebrated in July the success of a four year legal action to prevent ISE from offering options on the S&P 500 Index and the Dow Jones Industrial Average – a market that CBOE now enjoys exclusively.

Meanwhile, Nasdaq has tweaked its maker taker offering and Box has opened talks with four retail brokerages about selling an equity stake.

Meanwhile, yet another exchange is set to launch in October, when CBOE opens a second platform called C2. It will be an all-electronic alternative to CBOE, aimed at reclaiming some of the market share lost to maker taker exchanges, with what the exchange calls a “modified price/time matching model”.

The move will bring CBOE in line with Nasdaq and NYSE, which already have separate exchanges offering both pricing models, and ISE, which offers, for a select group of liquid contracts, a choice of formulas on its one exchange.

With so many offerings on the table, and hybrid pricing mechanisms proliferating, executives say there is little chance of the options market mimicking its cash cousin, where one price-time pricing model is now standard.

Part of the reason is that exchange-traded options are not subject to the internalisation processes that have changed the equity markets, where banks and brokers absorb order flow, filling trades from their own books rather than passing them on to market makers. In effect, they act as mini-exchanges.

In options, business has so far stayed on exchanges, fuelling competition in pricing. “We might see some maximum level where one system holds more market share than the other, but the competition we see is part and parcel of the special dynamics of the options market,” says Jeromee Johnson, head of Bats Options. “It is here to stay.”

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