Competition among nine U.S. options exchanges following regulatory changes aimed at saving money for investors is causing some of the biggest participants to reduce their trading, a Tabb Group LLC report said.
Hedge funds and proprietary firms account for a smaller share of volume and are examining their strategies as exchanges battle for orders with increasingly complex pricing, the New York-based research firm said in a study. The competition is the result of 1-cent price increments that were begun by the U.S. Securities and Exchange Commission in January 2007, said Andy Nybo, the author and a principal at Tabb.
While exchange price models should follow a standard with clearer descriptions of fees, competition for orders is likely to increase, causing further confusion about the costs of trading, the report said. Some institutions are becoming “jaded” as the nine exchanges alter their rules and pricing for executing options, Tabb said.
“We trade with market makers and they’ve backed off on their volume quite a bit,” said Mike Horn, managing partner at KCM Options, a Chicago-based firm. He estimated KCM is trading about the same amount or slightly less than it was this time last year. “We find it hard to enact trades.”
Almost 406 million options traded on U.S. exchanges in May, the highest for the year. Since then, the monthly average has fallen to 311 million, including a low of 277 million in July, according to data from the Options Clearing Corp. in Chicago.
The interplay between high-frequency traders, who use strategies that may resemble market makers’ without the same obligations, brokers and end-users can be confusing, said Nybo. Complexity is increased by rules, protocols and economic incentives, including a practice called payment for order flow, employed to attract volume, he said. Different fees are used to entice different firms to venues.
The shift to penny increments led exchanges such as NYSE Arca, owned by NYSE Euronext, to start paying firms to post bids and offers on their platforms. Under the system, known as maker- taker pricing, those executing against the quotes are charged a fee. On exchanges that relied almost exclusively on market makers, customers such as individual investors and mutual funds traded for free.
Compounding the complexity, some markets such as Nasdaq OMX PHLX and the International Securities Exchange have adopted hybrid regimes with some rules catering to market makers and newer pricing geared toward actively traded contracts.
NYSE Euronext, Nasdaq OMX Group Inc. and ISE, owned by Frankfurt-based Eurex, have their headquarters in New York.
“Blame for part of the problem can be placed squarely on the methods used by exchanges, which are relentless in their efforts to alter pricing and trading protocols in an effort to attract order flow,” the report said. The changes, sometimes on a daily basis, are “taxing options traders’ ability to understand the most attractive -- and profitable -- trading opportunities once all fees, charges and assessments are considered. The result is a game of market-share musical chairs played to a broken record.”
This year’s options volume through November was 3.58 billion contracts, nearing last year’s 3.61 billion total, according to Chicago-based Options Clearing Corp., which settles all trading of exchange-listed contracts. Tabb said the participation of hedge funds and some high-frequency traders, which have been an “engine of growth” in the markets, is now less certain.
Last year, total options volume climbed less than 1 percent after rising more than 20 percent in the previous three years. This year’s volume, which Nybo predicted would reach 3.8 billion contracts, would represent a 6 percent increase from 2009.
While exchanges’ fee changes are often geared to high- frequency firms with the ability to program price tweaks into computers and a willingness to move orders from one market to another, those firms also trade more in volatile times, Nybo said. The CBOE Volatility Index, or VIX, which measures the cost of using options as insurance against declines in the Standard & Poor’s 500 Index, has averaged 22.9 this year, down from 31.5 last year.
Andrew Brenner, president of U.S. operations at Electronic Brokerage Systems, a division of Toronto-based Belzberg Technologies LLC, says reduced volatility rather than changes in the structure of markets is affecting volume.
“The increase in the number of options exchanges and the change in pricing schemes are designed for the more aggressive, higher-frequency trading firms,” New York-based Brenner said. His firm provides an electronic trading platform for equities and options. “If anything, they would embrace these changes, not shy away from them,” he said.
The prospect of regulatory shifts may also be damping the use of options. Uncertainty about what the SEC will decide about proposed rules limiting the fees that exchanges can charge to access their bids and offers and the 15-month-long discussion about so-called flash orders are making options less attractive to some firms, Nybo said.
The fight over fee caps is a concern to firms that may earn lower payments for posting bids and offers, which are funded from the charges imposed on those trading with them. Lower rebates may make it harder to provide better prices and put maker-taker exchanges at a disadvantage to venues managing programs that offer brokers other monetary incentives, automated trading firm Getco LLC told the SEC in a June 23 letter.
The SEC reopened the public comment period in July for flash messages in options, in which order information is shown to some firms and not others for a second or less. The orders are used by securities exchanges to keep trades on their venues, potentially saving retail brokers money, instead of sending them to rival markets with better quoted prices and higher fees. Their use hurts firms placing bids and offers on maker-taker options exchanges by reducing the likelihood they will be executed against retail and institutional clients, Nybo said.
Exacerbating the skirmish over market share is exchanges’ desire to position themselves for new regulations that could affect their trading attractiveness and profitability.
CBOE Holdings Inc., which operates the largest venue for equity derivatives, introduced C2 Options Exchange in October to provide a market with rules and pricing geared toward high- frequency firms whose computer servers are based in northern New Jersey instead of Chicago. C2 is the ninth options venue. Nasdaq OMX Group, NYSE Euronext and CBOE each operate a pair of equity derivatives platforms. The International Securities Exchange, the third-largest exchange by volume, has one venue.
“Ultimately 10 exchanges operating 10 different rules sets and pricing structures is simply too many exchanges,” Nybo said. While competition and markets with different trading models are good for investors, ever-increasing complexity can be a turnoff to firms, he said.
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