Fragmentation Vexes Options Market

Terry Flanagan

With the number of U.S. options exchanges now at 12, traders and exchanges are experiencing many of the technological and market structure issues associated with equities, such as fragmentation and rising networking costs.

“With more exchanges and better technology it’s getting harder to get filled when you have to fan out to multiple exchanges,” said an executive at a large U.S. options market maker, who spoke on condition of anonymity. “We’ve had to make numerous changes to our routers and our methodology to adapt to the current landscape.”

The Options Price Reporting Authority (OPRA) projected in February that firms would need a messaging capacity of 3.7 million messages per tenth of a second in July 2014, increasing to 5.0 million messages per tenth of a second in January 2016.

The average latency for OPRA is 0.8 milliseconds. Message latency is measured beginning with the time-stamp taken as an inbound message arrives at the network entrance to the OPRA environment, through processing by the system, to the time-stamp taken as the outbound message arrives at the network exit from the environment.

To some extent, exchange operators have a choice to offer all things under one roof, or to split off one or more additional venues. “They can either try to make everybody happy, or they could just try to cater to one class or segment of participants, while still offering equal services to everybody — but when it comes down to the economics of the pricing, only one segment may find that attractive,” said Pat Hickey, head of market structure at proprietary trading firm Optiver. “That might be retail, or market makers, or aggregators, or institutional. The exchanges are forced to act in the only way they feel is available to them, by establishing a new exchange with a different pricing structure.”

Noted Ed Provost, president and chief operating officer at Chicago Board Options Exchange: “Fragmentation is a bit of a price you pay for the competition and the benefits you get from competition.”

The Securities and Exchange Commission, in its 2014-2018 Strategic Plans, says that it’s considering a comprehensive review of the structure and operation of the listed options markets to promote fair, efficient, transparent, and competitive markets

Another market maker, on the outlook for further market fragmentation (or contraction), said it depends on regulation. “I doubt the SEC is ever going to say the right number of exchanges is X, but they might make it more difficult to issue medallions,” this market maker said. “What could lead to contraction is more regulatory pressure on and investigation into consolidators. Some of the new exchanges are supported not because many markets participants are there, but because they’re able to internalize more of their customer orders.”

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