Options markets suffer when exchanges battle: report

NEW YORK & LONDON, December 7, 2010 – The emergence of a new market structure has forced exchanges to become proactive in their battle to attract order flow by altering market models, pricing schema and trading protocols, all to gain the attention of options traders.

This battle has gotten out of hand, says TABB Group in a new research report, “Survival of the Fittest: The Ongoing Battle for US Options Order Flow,” as the industry is increasing its call for a measure of sanity in the way exchanges introduce and implement new rules.

According to Andy Nybo, a TABB principal, the advisory and research firm’s head of derivatives and author of the report, the options industry wants greater clarity and standardization in the rules and protocols governing trading activity on US options exchanges. “The complex pricing environment created by US options exchanges will only get worse. With nine exchanges competing for a finite amount of volume, they have little choice but to chase after disparate order flow that may be swayed by changing a pricing structure or a trading protocol.”

“The constantly evolving market structure is creating significant business challenges for market makers who are being forced to adapt their operations in order to remain competitive in the rapidly changing marketplace,” he adds. “Market-making has evolved into a technologically intensive endeavor that rewards firms that can both afford and leverage the capabilities of technology.”

Although options trading will increase by 5.6% to 3.8 billion contracts in 2010, trading volume has been negatively impacted by constantly changing pricing rules and trading protocols, explains Nybo. “Through October 2010, the nine US options exchanges submitted a total of 375 filings relating to options trading, a pace of almost two filings per day. Rule filings can be intricately nuanced in their objectives, which creates uncertainty for options trading firms and market makers whose survival depends on anticipating a new rule’s impact.”

Penny options’ growing penetration has contributed to the development of a dual market structure with more-liquid options trading through order-driven protocols emanating from trading firms employing a strategy leveraging technology, latency and sophisticated quantitative analytics.

However, he points out, the constantly changing trading environment and lack of clarity are having an inordinate impact on more-aggressive high-frequency trading strategies that were just beginning to gain a foothold in the industry. “Their participation has failed to live up to expectations in recent months, as they stand on the sidelines anticipating a more certain environment. These proprietary trading firms are estimated to account for 8% of trading activity in 2010 with future growth dependent on regulatory decisions covering fee caps, flash orders and short sale rules from the SEC.”

The 26-page report with 13 exhibits analyzes how the options trading environment has changed in recent years as a result of both the shifting regulatory landscape and the new investor segments that are increasingly attracted to options as a trading vehicle. The report also examines how exchanges are altering market models and trading protocols in an attempt to both meet existing investor needs as well as to attract new types of firms entering the marketplace.

Other recent derivatives research from TABB includes: The Global Risk Transfer Market: Developments in OTC and Exchange-Traded Derivatives; The Future of OTC Derivatives: Swap Execution Facilities and the New Dealer; OTC Valuation Services: How You Know If the Price is Right; Trading in Asian Derivatives: Opportunities Near and Far; The Alternative Emerging Market: Equity Swaps and Synthetic Prime; : European Derivatives 2010: The Buy-Side Perspective on Equity Options, Futures and Swaps; Centrally Cleared CFDs: The Buy-side Perspective; and US Electronic Options Trading 2010: Algorithms, DMA and Crossing Networks.

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