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Options Market Structure: Fragmented Reality
Traders Magazine Online News, May 16, 2017
Some experts are debating whether the complexity of the listed U.S. options market structure is hurting liquidity providers and driving some market makers out of the business.
Options market makers are navigating a fragmented liquidity landscape, rising technology costs, and an arms race around high speed trading. Some electronic market makers, like pioneer Interactive Broker’s Timber Hill unit, have dropped out, citing diminished opportunities for profitability.
Sluggish trading volumes have become a concern. Year-to-date, average daily options volume in exchange-listed equity options is down 2.3 % from 2016 with 16. 4 million contracts, according to Options Clearing Corp. In April, total equity options contract volume fell by 10.3% to 269.6 million from 300.6 million the prior year. At the same time, ETF options volume rose 3.53% and index options volume surged 28.4% in April over the prior year.
“The US options market currently has 15 lit exchanges, four flash mechanisms, eight different auctions, seven complex order books or a total of 37 places to source liquidity,” said Jason Lichten, director, equity and listed derivatives trading strategies, Wolverine Execution Services, who spoke on a call hosted by the Security Traders Association in April.
The state of the options market structure has become a controversial topic. “It’s a pretty tangled web that we’ve woven for ourselves here,” said Lichten, who spoke about institutional trading in options and bringing transparency in a complex market.
Ever since Regulation NMS was implemented in 2006, there’s been an explosion in the number of options exchanges launching electronic matching engines, a cause of fragmentation.
Options exchanges have continued to create new venues to cater to the specific needs of options traders, such as speed, price or who gets priority in the trade. Since 2008, nine options exchanges have been rolled out to offer investors more choice.
Last year, MIAX Pearl made its debut raising the number to 15. Experts are expecting one more exchange to launch in 2017, bringing the total up to 16 exchanges, which will further bifurcate the landscape for liquidity.
Each exchange is betting that competing market structures can co-exist under the same roof, appealing to distinct customer segments. However, each exchange has a similar model, whether pro-rata or price/time priority, said WEX’s Lichten. Options exchanges have also adopted make-take, in which a trader is paid a rebate for posting a limit order, or charged a fee for removing liquidity. Another model in reverse is taker-maker in which a trader is paid a rebate for removing liquidity because this attracts high-speed traders who are charged a fee per contract for posting liquidity.
Even with the inroads made by maker-taker options exchanges, according to Lichten, pro-rata exchanges represent about two-thirds or 66% while price-time had 34% of the total volume.
Consolidation?
Options traders have also seen a wave of consolidation hit the exchange landscape, but this is not expected to result in fewer trading venues.
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