Welcome to Futures Industry
Rachel Koning Beals
Published 9/4/2012

For the last decade or so, the U.S. equity options business has been characterized by an exceptionally high level of competition among exchanges. While some observers expected that the forces of competition eventually would lead to consolidation, the opposite has turned out to be the case. With Nasdaq OMX powering up its third options exchange this year, the International Securities Exchange getting ready to launch a second market, and the Miami International Exchange's fully electronic challenger awaiting regulatory approval, it's getting to be a standing room-only field of competitors in the U.S. options business.

All told, the industry could see a total of 12 different venues for trading equity options. All of these venues are jostling for a share of the market at a time when total volume has been shrinking.

In several cases, exchanges have chosen to offer two venues under the same roof. The Chicago Board Options Exchange, for example, launched its C2 exchange to appeal to electronic traders. NYSE Euronext operates two options exchanges—NYSE Amex and NYSE Arca—each with its own rules and pricing model. Nasdaq OMX has now taken that a step further, launching a third options exchange in June.

The driving force behind the proliferation of trading venues has been the desire to offer different pricing models to different customer segments. The fact that the products are fungible is also a key factor—with one clearinghouse serving the entire industry, no single exchange has a stranglehold on liquidity. The regulatory environment also plays a role; the Securities and Exchange Commission's rules make it difficult to target limited segments of the market within one exchange.

"Exchanges have to provide fair access. They can't discriminate against a user," said Chris Nagy, the former head of order routing at TD Ameritrade who now is president of KOR, a consulting firm. "But all people are not created equal; different factions of the market have different price, feed, time, and liquidity needs. So the exchanges have to differentiate—within the rules."

The emergence of such a large number of exchanges didn't come about overnight. Over a decade ago, the ISE helped bring about electronic trading and the multiple listing of options, which dramatically changed how exchanges attract liquidity. About five years ago, the maker-taker model, which is designed to reward liquidity providers, came into the options world and shook up the industry again. Another innovation is the taker-maker model, which inverts the maker-taker model by providing rebates for firms who take rather than make liquidity. Penny-increment pricing has had a big impact too, in shrinking the spreads that paid the market makers. For all of these reasons and more, the options exchanges have had to reinvent and reinvent again.

Despite the relatively low barriers to entry, the incumbent exchanges have an advantage over newcomers because they can leverage their existing infrastructure.

"For the exchanges, it's all about scale. It's relatively cheap to open up a second exchange," said Edward Boyle, industry consultant and former executive vice president of NYSE Euronext, who helped develop NYSE Arca and NYSE Amex. "Your connectivity, which is a big initial cost, is already in place. Your customers know where to go. You just buy a second SRO [self-regulatory organization] license, or a third," he said. "It's much more difficult to build from scratch."

User Impact

Although the proliferation of trading venues has made trading equity options more complicated, some market users welcome the choice.

Larry Berman, director of trading for Eaton Vance subsidiary Parametric Risk Advisors, said the trend has reduced execution costs.

"For end-users, the spreads have gotten tighter and that's a benefit. Bid-and-offer quantity has grown, so it's not always time-price priority, and market makers now have to be more aggressive in pricing in order to attract order flow," said Berman, who previously was an Amex floor specialist.

Berman, who uses options for income generation and hedging for client assets, accesses the markets via direct market access platforms that show him aggregate pricing at the national best bid and offer. Berman mentioned two platforms that his firm uses—Bloomberg's EMSX and Wolverine's WEX. Alternatively, he will instant message an order to a floor broker on heavily traded contracts like the options on the S&P 500 or Procter & Gamble to see if he can get a price "between the quotes, usually around mid-market."

But the middle of the food chain feels a little differently about the stress brought on by exchange growth.

"Any time you have a market that goes from having a small number of execution venues to dramatically more, it raises costs for everyone who needs to connect to all of those venues and decide where to route their orders," said Justin Schack, managing director at Rosenblatt Securities.

Most big firms have staff dedicated to monitoring the fee schedules and matching rules at all of the venues, said Schack, who analyzes market-structure issues for the firm's clients. Every time the exchanges change the details of their pricing models—which happens on a regular basis—the firms have to tweak their order routing engines, which adds to their costs.

Jim Michuda, chief executive officer of Wolverine Execution Services, added that firms like his have to provide connectivity to all of the exchanges. "From where we sit, as a provider of execution services and market data, the proliferation of exchanges is not good for our business because of the burden on infrastructure," said Michuda. "We need to be a member of XYZ exchange no matter what because we need to offer that potential access to clients whether we actually use it or not," said Michuda.

And then there is the challenge of calculating the fees for trading on multiple platforms. "Let's put it this way, our billing system is the most complex piece of software that we run," said Michuda.

Re-Introducing: Taker-Maker

But change can also bring about innovation. It's about more than the number of exchanges; it's about their capability. Under "traditional" pro rata structures, options exchanges such as the PHLX, NYSE Amex, CBOE, and the ISE charged both the providers and the takers of liquidity. Orders to liquidity providers were typically based on quote size and not position in the queue. But as more and more options moved to trading in one-cent increments, exchanges found that rebates were an effective way to attract more liquidity.

Since January 2007, when options exchanges were allowed to quote products less than $3 in one-cent price increments, venues with more traditional pricing began shifting to a hybrid structure of pro-rata and maker-taker rules. Newer exchanges such as BATS, NYSE Arca and Nasdaq's NOM made their marks with maker-taker pricing, capitalizing on penny trading as well as the involvement of automated trading firms.

The CBOE, on the other hand, uses the pro rata allocation model exclusively, which favors market makers quoting large size. With C2, the exchange operator applies the pro rata model to trading in some classes while using the price-time priority model in others. With C2, certain "overlays" grant priority to different traders, such as customers and so-called market turners.

Nasdaq OMX's late-June launch of its third platform—BX Options—marked the newest incarnation of the taker-maker approach. In this approach, the pricing model is tilted in favor of the firms that take liquidity (hitting an offer or lifting a bid) rather than the other way around.

The Boston Options Exchange, now called the BOX Options Exchange, pioneered the taker-maker pricing strategy in the options market in 2009, but it was the only exchange using it until this year. In June, ISE switched 25 options classes to taker-maker pricing.

Unlike the ISE, BX Options will offer taker-maker pricing in all options traded in penny increments and unlike BOX, it will limit the rebate strategy to customers only.

The exchange pays a rebate of 12 cents per contract for the three most actively traded ETF options (SPY, QQQ, IWM) and 32 cents in all other penny pilot names, which effectively covers the vast majority of volume. This applies only to customer orders, however. Market makers that take liquidity pay a fee of 43 cents per contract on all contracts.

With this formula (which is experimental, according to several industry insiders), the exchange attracts broker-dealers with customer order flow who generally pay fees for taking liquidity on the other exchanges. But it may also attract liquidity makers by maximizing execution possibilities with customer order flow.

Taker-maker pricing and payment-for-order-flow schemes are close cousins. The latter has historically deepened an options pool heavily reliant on retail market orders. Most retail brokers contract with intermediaries known as consolidators or smart routers: UBS, Susquehanna, Citi/ATD, for example. The retail firms deliver their orders to the consolidators and the consolidators deliver them to the exchanges. The middlemen pay the retail brokers some amount every month based on the number of contracts and the quality of flow they collect.

For the consolidators, the story changed earlier this year when CBOE instituted its Volume Incentive Program, under which it doled out extra payments to high-volume traders such as the large consolidators. For example, a firm can earn a credit of 20 cents per contract if its customer volume averages 375,000 to 650,000 contracts per day over the course of a month. The program only applies to contracts that are listed on multiple exchanges. During an August conference call with analysts, CBOE executives said the program had helped the exchange achieve "considerable market share gains."

Exchanges are adding creative layers in other ways, too. The ISE, for instance, in late July introduced a new order type, the Add Liquidity Only Order (ALO). An ALO specifies that the order can only be executed if it adds liquidity to the order book as a maker. If the order cannot be added to the book, it will be cancelled. Alternatively, it may be re-priced to rest on the book at the discretion of the firm entering the order.

Exchange Competition

In June 2012, more than 325.8 million single stock options traded in the U.S., with trading divided among nine exchanges. The chart below shows the share of the market held by each exchange during the month of June.



The Upstart in Miami

The newest potential entrant, Miami International Securities Exchange or MIAX, believes there is room for more.

"The industry is looking for innovation, which our business model will bring," said Shelly Brown, senior vice president of strategic planning and operations at MIAX. "We believe that those seeking liquidity will find MIAX to be more than competitive on execution price, execution cost, speed, reliability, and customer service."

The exchange is also going for geography, looking to be the go-to mart for growing Latin American business. Once the options exchange is operational, the parent company plans to open an equities exchange and pursue listings from Latin American companies. Sales, membership, marketing and listing operations will be in Miami, while technology development and operations are in Princeton, N.J.

The parent company filed an application to establish the options exchange with the SEC in April and hopes to launch in late September. MIAX has amassed a staff of 70 full-time employees and consultants, and developed its platform with a $20 million equipment financing deal with Dell.

Spearheading the efforts is Thomas Gallagher, a founding partner of the Princeton, N.J.-based law firm Gallagher, Briody & Butler, where he's counseled on debt and equity financings and other transactions for the past 25 years. Matt Rotella, the head of trading systems development and operations, and Frank Ziegler, head of the technology infrastructure, both previously worked at Nasdaq OMX PHLX. Brown previously worked at PEAK, a Chicago-based firm that specialized in trading options, and before that worked at PHLX.

Exchange Expansion

This year, the 10th (and counting) options exchanges fire up another all-electronic platform. What brings distinction within this growing roster? Mostly access and pricing.

BATS OptionsBATS Global Markets, Inc.2010Fully electronic/multiply listed equity optionsPrice-Time Priority/Maker-Taker/Penny Price Improvement
BOX Options Exchange
TMX Group and seven broker-dealers**2004Some 1,500 option classesTaker-Maker/Price-Time Priority/Price Improvement (PIP)
Chicago Board Options Exchange—CBOE
CBOE Holdings, Inc.1973Equity, index and ETF options, incl. S&P 500 (SPX); CBOE Volatility Index (VIX)®Pro Rata
C2 Options Exchange
CBOE Holdings, Inc.2010Electronic/multiply listed equity options/CBOE licensed productsMaker-Taker/Pro RataModified Price-Time
International Securities Exchange—ISE
ISE Holdings, Inc./Deutsche Borse Group's Eurex2000Options trading on over 2,000 underlying equity, ETF, indexand FX productsMaker-Taker/Pro RataModified Price-Time

ISE (Second Platform)

ISE Holdings, Inc./Deutsche Borse Group's Eurex 2012, pending SEC approval Options on underlying equity, ETF, index and FX productsProposed Combined Model
Miami International Holdings, Inc. 2012, pending SEC approvalPlans to operate electronic platform to buy or sell securities with continuous, automated matching function.N/A
Nasdaq BX Options
Nasdaq OMX2012Equity and equity index options on securities listed listed on NASDAQ, NYSE, NYSE Amex and NYSE Arca.Taker-Maker/Price-Time Priority/Penny Pilot
Nasdaq Options Market—NOM
Nasdaq OMX2008Equity and equity index options on securities listed listed on NASDAQ, NYSE, NYSE Amex and NYSE Arca. Maker-Taker/Price-Time Priority/Penny Pricing
Nasdaq PHLXNasdaq OMX Nasdaq OMX bought PHLX in 2008Over 2,600 equity options, sector index options and U.S. dollar-settled currency optionsPro Rata/Maker-Taker
NYSE EuronextNYSE Euronext completed Amex Acquisition in 2008 Equity and equity index optionsPro Rata Customer Priority for Floor/ Price-Time for Electronic
NYSE Arca NYSE Euronext Archipelago and NYSE merge 2006/ Combines Pacific Exchange and AmexEquity and equity index options, hybrid floor and electronic platformsPrice-Time Blend With Lead Market Maker/Penny Pilot
*Exchange-provided description     **Achieved SRO status in April to eliminate Nasdaq regulation
Source: OCC


Dynamic Market

For much of the past decade, increasing volume provided a tailwind to industry expansion. The total number of single stock equity options traded on U.S. exchanges rose from 1.37 billion contracts in 2005 to 3.61 billion in 2010—m ore than double the volume in just five years.

This year, however, the level of trading activity is slumping. During the first half of the year, 1.92 million equity options changed hands, down 6.9% from 2.07 million in the first half of 2011. Tabb Group, a consulting firm, expects options volume to decline by as much as 10% this year before resuming an uptrend.

"The options market pie itself has been growing and will continue to grow, though perhaps not at the double-digit figures of the 2000s," said Howard Kramer, a partner in the asset management group at the law firm of Willkie Farr & Gallagher LLP. "But the story is about multiplicity and growth, and perhaps if we didn't have market growth [over recent years], then it would have been tougher to launch these new exchanges."

Kramer is uncertain as to wh ether there is room for more. "Do we have the market structure that can support eight to 10 exchanges? Maybe. Do we have the environment that can support 12 to 15? I seriously doubt it," he said.

"There's clearly still upside left in the marketplace," said KOR's Nagy. "Nasdaq BX overnight gained 1% market share, that's an incredible feat and they talked about it on their earnings call. Cost little, payoff pretty good. You don't need to have days of old when exchanges would need 30% market share. Technology has made bricks-and-mortar exchanges more competitive, so even they're not necessarily looking for 30%-40%. Now maybe 10% to 11% is okay because they're scaling the technology."

Battle for Market Share

U.S. Equity Options Volume by Exchange: 2005 to the Present
This graph shows the changes in the market share of U.S. equity options exchanges, based on the number of single stock options
traded per month.

Rachel Koning Beals is a freelance reporter.
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