NQLX vs. OneChicago: Will Market Structure Tip the Balance
If competition is the lifeblood of innovation, then the futures industry should thank its lucky stars for the invention of single stock futures. Rarely in the history of financial products have customers had such a wide variety of choices among exchanges offering the same new product at the same time.
At one end, Island ECN, one of the fastest-growing systems for trading stocks, has created a new electronic exchange dedicated to the trading of futures on individual stocks and narrow stock indices at the lowest cost and the highest speed.
At the other end, the American Stock Exchange, the second largest options exchange and the creator of the hugely successful exchange-traded funds, has announced its intention to use the tried-and-true method of open outcry, putting single stock futures among the options pits on its trading floor.
And in between, the two ground-breaking joint ventures, Nasdaq Liffe Markets (NQLX) and OneChicago, widely viewed as the primary competitors for this new business, are trying to find the best combination of features from the wide range of market structures in use at existing securities and futures exchanges.
With the full array of rules and regulations still under development in Washington, it is too early to pick any winners among these four exchanges, but one key to success has already become evident. Customers will go to whichever exchange offers the greatest liquidity, and to get that liquidity some of these exchanges are preparing to give special treatment to certain firms in return for their services as market makers.
Critics say this type of market structure undermines competition and ultimately results in higher costs for customers. But the exchanges that have chosen this approach, namely OneChicago and AMEX, say this market is so new that they have to provide incentives to get trading started.
“It’s going to be very interesting to see what happens,” says Joe Murphy, chief executive of Refco Global Futures. “From the customer perspective, the NQLX model offers a purer form of price discovery. On the other hand, with a brand new product, the DPM model ensures liquidity from day one.”
Ensuring Liquidity
Virtually every exchange has some form of market maker, i.e., a firm that survives and hopefully thrives by taking the opposite side of customer trades. The difference is that some exchanges give certain market makers specific privileges over the rest of the crowd in return for a binding commitment to enhance the liquidity of the marketplace.
At the stock exchanges, these are known as specialists; in the options world, they are known as primary market makers; and at OneChicago they will be known as lead market makers (LMMs). What they all have in common is something called “participation rights,” which typically means that they get a percentage of all the trading in the contracts that they have been allocated. In return, they agree to maintain “continuous two-sided markets,” which effectively means that they promise to match customer orders at all times and keep the spread between the bid and offer within a certain size.
Historically, U.S. futures exchanges have not used this kind of market structure, but in the last year the practice has been adopted occasionally to help launch new contracts. For example, in February the Chicago Board of Trade designated ABN AMRO to act as “primary market maker” (PMM) for its recently launched 10-year swaps futures contract.
Under the terms worked out by the two sides, ABN AMRO is obligated to provide a market no lower than 250 contracts with bid/offer spreads not to exceed 4/32. In return, ABN AMRO gets the right to participate in 25 percent of the order flow. CBOT staffers say this program has been an important element in helping make this contract one of the best new product launches in several years.
CBOT staffers are careful to point out that their program differs in several crucial ways from the system employed at their sister exchange in the options world, the Chicago Board Options Exchange. At the CBOT, primary market makers cannot act as both principal and agent, which means that once a firm is tapped as a PMM for a particular contract, it can’t handle customer orders in that same contract. Second, a firm can’t hold onto PMM status in perpetuity, and it cannot transfer that status to another firm. The contract with ABN AMRO, for example, lasts only one year and then comes up for renewal.
The contrast with CBOE is no accident. CBOE, the largest options exchange in the U.S., started out in the early 1970s as a spin-off from CBOT, when the futures exchange realized that it would be better to put equity options on a separate exchange than to bring the entire floor under SEC supervision.
At first, CBOE stuck to the futures way of doing business and simply relied on a crowd of locals to provide liquidity, but it was forced to change in the late 1980s, when options exchanges started listing a lot of new companies. CBOE needed someone to trade these relatively unknown names, so the exchange copied one of the features of its rivals in the equity world and decided to allocate these names to “designated primary market makers” (DPMs) in return for a percentage of the order flow.
Then in 1999, the options exchanges abandoned the practice of listing certain options exclusively on one exchange and moved instead to the multiple listing of options among all the exchanges. In response, CBOE expanded the DPM system to cover the entire floor, rather than just the high-tech names that had originally needed cultivation. The exchange saw that the other exchanges were granting privileges to specialized market makers, and feared that this would give its rivals a competitive advantage in the battle for market share. It is important to remember that in the options world, there is one central clearinghouse and the contracts are fungible, which means that no exchange has the protection of a natural monopoly.
In many ways, CBOE’s experience has been the testing ground for OneChicago. Even though CBOE is only one of three partners in the joint venture, OneChicago has chosen a modified version of the DPM system as its market structure, on the thinking that this is the one sure way to bring liquidity to a new market.
Although the details have not been revealed yet, OneChicago has confirmed that it will allocate all security futures contracts to what it calls “lead market makers.” Twenty-four have been named so far, some from the options world and some from the futures world, and the expectation is that each LMM will be allocated around five contracts. As in the options world, the LMMs will be obligated to provide continuous two-way quotes within a certain size spread and with a certain depth. In return they will receive participation rights, probably around 30 percent.
The decision to use this market structure has met resistance among some people in the futures industry, but OneChicago defends its approach as the best way to launch new products.
“We decided to utilize the market maker system to ensure that our marketplace would have tight and deep and liquid markets in all our instruments right from the outset,” says William Rainer, OneChicago’s chairman and chief executive. “It would be unrealistic to expect a large group of professional market makers to take part in a comprehensive market maker system, without granting them participation rights under certain circumstances.”
Rainer stresses that the LMMs will not get the right to participate in all trades. For example, there will be no “look-back,” i.e., if the LMM does not join the best bid or best offer before the trade, then the firm does not get to exercise its participation rights, and whichever market participant made that best bid or best offer gets filled 100 percent.
OneChicago also will set a time limit on the privileges it grants to LMMs, after which both sides will decide whether or not to renew. This limitation, it is hoped, will prevent market maker privileges from becoming a perpetual right for certain firms.
A number of industry sources told FI that they feel that this market structure will give OneChicago an important advantage in the race to become the dominant exchange for security futures. With such a new market, potential users will be hesitant about making trades until they see a certain amount of activity, and in the early days the volume could be so low that some potential users may not find someone willing to take the opposite side of the trade. At OneChicago, however, customers will always find a LMM willing to trade with them as soon as the system goes live. In other words, the LMMs are committing themselves and their capital to making sure that the OneChicago screen never goes dark.
“I think the desire is to come out on opening day and for traders to have prices the first day, and they are making a reasonable investment in infrastructure to achieve that,” said Marc Seruya, executive vice president and principal at SMW Trading, one of the 24 firms tapped as LMMs.
Flat and Open
So what’s wrong with this picture? From everything that OneChicago says, it sounds like granting privileges is a fair tradeoff for getting a guaranteed liquidity commitment.
Well, that’s not the view at NQLX. In fact, the people who run NQLX are quite adamant about not giving one group of market participants any special advantages over the rest. They agree on the importance of ensuring liquidity right from day one, but they insist that they will maintain a “flat and open” market for all participants.
“This is an important distinction. We are not granting an absolute franchise,” says Tom Ascher, the recently appointed chief executive of NQLX. “When we have a market maker that engages in a name on NQLX, they will not have it to the exclusion of all other would-be participants.”
Ascher argues that granting such a franchise undermines competition among market makers, and he should know. Before joining NQLX, he was one of the top executives at Interactive Brokers, the parent company of Timber Hill, a leading market maker in the options world.
“The nature of a specialist in some markets—and I anticipate this may be the case in some of our competing markets—is that it significantly diminishes the ability of professional participants to compete in making that market,” says Ascher.
“The entitlements that a specialist receives tend to be quite absolute. Think of the participation percentage as a tax. It has a value, and in some markets it can be quite valuable, but you have to understand that granting that percentage creates a disincentive to other market makers to come into that name.
“We say to our participants that we will be thrilled if they deploy some of their risk capital and bring in orders, and we will look at giving entitlements for that, but we will not grant carte blanche participation rights to whatever comes through the door, whomever brings it.”
What NQLX is offering instead is a version of the so-called CLOB system, with an overlay of market-making. CLOB stands for central limit order book, and the term represents a system where orders are placed on a purely electronic order book and matched by strict price-time priority.
Ascher declined to provide any details on exactly what incentives NQLX will provide to encourage liquidity on its system, but industry sources told FI that at least three firms have already signed up to act as primary market makers for all the names listed on that exchange. One possibility is that NQLX will give its primary market makers a cut of its revenues. That is what LIFFE, one of the two exchanges backing the joint venture, does with the firms acting as market makers for the security futures that it trades in London.
LIFFE offers futures on more than 100 stocks, and every contract has a market maker assigned to it. As in the U.S., the market makers are contractually obligated to provide a continuous two-way market with a maximum spread in a minimum size. LIFFE uses the term “designated market maker“ to describe these firms, but in contrast to the CBOE it does not grant them participation rights. Instead it gives them a 20 percent share of the revenues that the exchange earns.
One industry source with extensive experience in the options market-making business said he views NQLX as a much more open platform than OneChicago. “My preference is for NQLX, because the existence of a permanent advantage reduces competition. At NQLX, there is no allocation—the best bid gets the whole order.”
Not everyone agrees, however. Another industry source with experience in managing both options and futures trading desks said he thinks OneChicago’s efforts to line up a large group of market makers right from day one will give it an important advantage in the first few months of trading. “OneChicago’s market structure is a better format for bringing new products to the market, getting the street involved, and compensating people for committing capital. Whereas NQLX seems to be saying, ‘Let’s just hope people show up.’”
A Balance of Factors
Market structure isn’t the only key to success, of course. As customers assess which platform will be better, they are also going to compare such issues as technology, where NQLX appears to have an advantage. The LIFFE CONNECT system is widely considered one of the best platforms in the world for trading futures, and most if not all the major trading houses are already familiar with it. In contrast, OneChicago is relying on CBOEdirect, a relatively new and untested platform that currently is used only when CBOE’s floor is closed.
NQLX also appears to be closer to being ready to launch trading, although opinions differ on how far behind OneChicago is. Some say six months to a year; others say three months and closing fast. One thing that is certain, however, is that NQLX has already had dress rehearsals to work out the bugs and familiarize the industry with its system, while OneChicago is still working on connection issues.
Still unknown is whether AMEX will provide a significant platform for trading security futures. It is the only one of the four that will not be electronic, and some market participants are doubtful that it will be able to compete.
Michael Bickford, senior vice president, said AMEX is simply planning to list single stock futures alongside its options trading in the open outcry pits. “We’ll simply put stock futures in our options crowds,” he says.
Like other options exchanges, AMEX grants participation rights in exchange for a commitment to make two-sided markets. Its hope is that the liquidity already existing on the floor will simply flow to security futures.
What happens once security futures become established? Will all these incentives and privileges still be needed? Some hold the view that as the market matures, the market itself will compress the spreads, and at that point the competitive advantage could shift to the most open platform of all—Island Futures Exchange.
“Island has a very good system. I think Island will blow the rest away once the market takes on a life of its own, with liquidity and depth that supercede what the specialists provide,” said one executive who oversees futures and options trading for a major brokerage firm.
Chris Concannon, vice president for business development at Island and the point man for its futures exchange, said Island will not have a market maker program for security futures, but it will provide incentives to what it calls “liquidity providers.”
“Our strategy is to be the lowest cost provider. We don’t recognize any market structure privileges, but we pay for liquidity and charge for liquidity takers. If you put an order on the book and it is taken, you get paid, and the taker gets charged.”
“For an equities trade, for instance, the taker pays 0.19 cents per share, and we pay 0.11 cents per share to the provider,” Concannon said. “We are looking to provide the same type of pricing structure on the futures side.”
“We believe in dealers, but we don’t extend any special privileges because we are trying to level the playing field in terms of market structure. Anyone can be a dealer, or an order flow provider, or a taker. |
