Revolution Calling Options Exchanges
Friday September 3, 10:04 am ET
By Steven Smith, Senior Columnist
With the holiday weekend beckoning, it's a perfect day for getting an overview of some of the changes, trends and issues shaping the option industry landscape. So let's go up, up and away in my beautiful balloon...
New, Fewer Market-Makers
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The impact of electronic trading and multiple listings is evidenced by the continued consolidation and shrinkage of specialist/market-maker firms. Over the last three years, the number of specialist firms operating on the five major option exchanges (No. 6, the Boston Option Exchange only began trading this year) has shrunk from more thanr 50 to now where about 20 handle 85% of all option transactions.
The remaining firms have sharply curtailed their floor operations in an attempt to reduce costs and focus on the more efficient electronic platforms. The Amex and Philadelphia exchanges, particularly, are behind the eight ball in terms of market share, just under 10% of overall volume each, and behind the curve in offering electronic platforms, and have therefore been the hardest hit by the retrenchment of floor operations.
"Operating a trading floor is very expensive for both the exchange and market participants," says Dale Carlson, vice president of corporate affairs for the Pacific Stock Exchange, which has recently partnered with Archipelago (AMEX:AX - News) to create its PCXPlus electronic trading system.
The latest example is Citigroup's (NYSE:C - News) purchase of Knight Trading Group's (NasdaqNM:NITE - News) derivative markets business for $225 million earlier this month. While that price was a slight premium to Knight's then current share price, it was some 45% of the valuation awarded the business four years ago when Knight bought into the derivatives business.
"The acquisition of Knight's options business is consistent with our efforts to expand our derivatives market-making capabilities, and this transaction will add significant scale to our U.S. equities business and provide Citigroup with top-tier order-routing and market-making capabilities in our growing derivatives business," James Forese, the managing director of global equities at Citigroup, said after the Knight announcement, which comes just three months after Citigroup became an e-DPM on the Chicago Board Options Exchange's newly created hybrid electronic trading platform.
Citigroup's move into equity options reflects not only institutional investors' increasing use of options to hedge and manage portfolio risk, but also shows that "profitability is increasingly becoming a function of a firm's ability to aggregate order flow to improve margins and reduce risk," opines Ned Bennett, president of online brokerage firm OptionsXpress.
Citigroup's acquisition gives it market-maker ability in 500 options classes, to which it can offer a deeper pool of liquidity than Knight was comfortable accommodating because of its limited capital base. Now Knight can focus on its equity business and -- as Bennett describes it -- "doesn't have to worry about the nuclear-waste nature of holding bad option positions, which don't go away and require constant monitoring and can chew up capital." Meanwhile, Citigroup establishes a platform in which it can service both institutional investors and its retail book in a more efficient manner.
Ultimately this speaks to the inexorable movement from floor-based operations to remote trading. Large firms such as Citigroup, Morgan Stanley (MWD - News) and Interactive Brokers, a division of specialist firm Timber Hill, are using their size to aggregate order flow and find profits in scaling volume rather then price spreads.
Standing in contrast or highlighting the margin pressure that multiple listings and exchange linkage has wrought on specialist and market-making firms is the decision by Susquehanna, one of the largest option specialist firms, to charge a transaction and handling fee for both executing and making changes (including cancellations) to options orders in which it is the listing DPM (designated primary market-maker) or specialist. Susquehanna cited "the amount of orders and quotes have increased our expenses in managing that process."
But the reality is probably that competition created through linkage has led to tighter spreads, which has been good for customers but has taken away one of the main sources of revenue for market-makers, forcing them to "revive something that was widely practiced before," according to the Susquehanna statement.
It's interesting to note that just in the last year some of the biggest critics and loudest objections -- broker/dealers such as Interactive Brokers have written the Securities and Exchange Commission questioning the legality and asking for a halt to the new fees -- are the same firms which, feeling the pinch of competition and the resulting spiraling-down of commission fees, are starting to charge their customers $1 transaction and cancellation fees on option orders.
This helps explain why specialists and market-making businesses are becoming increasingly dominated by large, well-capitalized firms. While there are some concerns about the internalization of orders, multiple listing and linkage of exchanges have been providing customers with tighter markets and cheaper execution.
Exchange fees for customers not only nearly disappeared overnight once multiple listings took hold back in 1997, but flipped it around as the competition for business gave rise to payment for order flow, or PFO, which created a new set of conflicts-of-interest issues that are just now subsiding.
Given that transaction costs have plummeted over the last five years, I think it is unreasonable for customers to expect or demand tight, deep and liquid markets for free. There are real risk costs involved in making an option market and I'd rather give the extra dollar a trade then face an extra wide spread or go back to the payment for orders.
Another important advantage to working from an electronic platform is that "the rules and regulations of the market are now coded into the trading system," explains Carlson. In other words: Trade reporting, price and time, and the paper trail are a seamless part of the transaction, which makes for better and cheaper oversight.
Stocks and Futures Are Next
The recent move toward demutualization among the option exchanges may just be a precursor to a consolidation. While five of the six major option exchanges have or are about to separate ownership from trading rights, it's doubtful the Pacific, Philadelphia or American stock exchanges will be able to survive in their current condition let alone have an initial public offering.
"We simply don't have sufficient revenue or market share to reasonably consider an IPO," Carlson admits. Instead, he foresees, or at least does not rule out, a merger with another exchange, or the purchase by a large financial institution -- especially a foreign entity looking to gain an entry into the U.S. market.
Carlson predicts that "the futures exchanges will soon undergo the type of rapid evolution that the option exchanges have," with a push toward multiple listing and electronic trading. Recent examples are the Chicago Board of Trade's listing of metal futures and the New York Mercantile Exchange's launch of electronic trading for various futures contracts. Ultimately, Carlson predicts we'll see "someone combine equities, options and futures on one platform" that will create an efficient means of cross-market order execution and hedging with reduced margins.
With the International Securities Exchange, or ISE, having filed for an IPO last month, it will have sufficient cash to both make acquisitions and push into other markets such as equity, fixed-income and commodities. ISE is the odds-on favorite to create the next big push into consolidating the industry and gaining more market share.
Some targets would include regional exchanges or even the Toronto Stock Exchange, which is sitting on more than $450 million in cash since its IPO but doesn't know what to do with it, since its bid to buy a chunk of Archipelago was rebuffed earlier this year.
Factoids and Tidbits
The Options Price Reporting Authority, or OPRA, will be upgrading its system in the next week to allow for the dissemination of nearly 70,000 messages per second (a message includes price quotes, transactions, trade reports and cancellations), which is more than double the current 30,000-message per second capacity.
At the end of June, in the wake of the last Fed meeting and jobs report, OPRA was pushing out 27,000 messages per second at its peak, so this upgrade is timely heading into what could be a volatile fall. To put this in perspective, the New York Stock Exchange currently sends out about 3,000 messages per second. But, remember, options have nearly 100,000 actively traded strikes compared with the 8,000 stocks listed across the major exchanges.
For those who carry options into expiration, be aware the Option Clearing Corp., or OCC, is reducing the automatic exercise (and therefore potential assignment) price on equity options from 75 cents in the money down to just 25 cents in the money on all equity options, effective with this September's expiration. |
