04.23.2013
By Terry Flanagan

Market Makers Feel Squeeze

Broad headwinds buffet the sector, but micro-level initiatives show promise

The bar to succeed as an options market makers keeps rising, as tepid order flow damps profit opportunities at the same time deeper pockets are needed to stay in business.

“Cost continues to go up while market makers struggle to compete in this low-volatility environment,” said Kevin Murphy, head of U.S. options electronic execution at Citigroup. “Options market makers love volatility, so they’re getting the worst of both worlds right now.”

“It takes a significant amount of capital to compete in today’s complex electronic option marketplace – Kevin Murphy, head of U.S. options electronic execution at Citigroup”

U.S. options volume slipped 3.2% in the first quarter of 2013 compared with the year-earlier period. Full-year 2012 trading declined by 12%, breaking a string of nine consecutive annual increases. Activity remains strong on a historical basis, but the options industry had expanded along with volume, so a retrenchment does not come without dislocation.

The difference between the bid price and the offer price has narrowed to as little as a penny for some of the more actively traded options. “In a way it’s amazing that these guys are trading with markets as tight as they are,” said Jason Stamer, director of business development at MEB Options in Chicago. “It’s a tough spot right now, but it’s great for the retail customer.”

The business of making options markets has been in flux for almost a decade. The evolution from floor-based to electronic trading was a major shift, and new regulations opened up competition and fragmented the exchange landscape. The changes have served to reduce the number of options market makers and bifurcate the space, squeezing out smaller players and putting more influence in the hands of Bulge-Bracket banks and other large firms.

Large options market-making firms spend an average of $28.8 million annually on technology, while small firms spend an average $2.9 million, or 90% less, according to Tabb Group. A market maker ostensibly could have managed with such a comparatively tiny tech spend in a floor-based era, but much less so since technology has become so critical for best trade execution, which entails low latency and high speed.

Bifurcated Market
“It takes a significant amount of capital to compete in today’s complex electronic option marketplace,” Murphy said. “There are a number of factors working against smaller option market makers — one is the cost of technology to compete as an options market maker across multiple exchanges.”

International Securities Exchange plans to launch a second exchange in the second quarter, which would increase the number of U.S. options exchanges to 12. Some market makers expressed skepticism regarding the burgeoning exchange sector; the specific issue is that the newer, smaller players with no more than a few percentage points’ market share may not be meaningful in an order-flow sense, but they need to be connected to and therefore represent an added cost.

“We have to spend dollars and resources to make sure we’re connected on day one, and there’s also compliance, as another exchange means another exchange that our compliance officers have to monitor,” said Jon Werts, head of broker-dealer execution services for Bank of America Merrill Lynch.

Jon Werts, Head of Broker-Deal- ER Execution Services for Bank of America Merrill Lynch

Jon Werts, Head of Broker-Dealer Execution Services for Bank of America Merrill Lynch

“Exchanges will continue to look for ways to incentivize and motivate market makers to provide capital.”

Werts distinguished between the fixed costs of a market maker, which include technology and connectivity, and variable costs, such as trade fees. There has been some relief in this latter bucket, as a byproduct of more exchanges. “You’re starting to see the price competition amongst exchanges make a noticeable difference,” he said. “The variable fees have become a little less onerous.”

Market participants note that the role of the market maker is more important in options than equity. For every stock issue, there may be dozens of associated option series, and the multitude of little-traded names need the attention of a specialist. Exchanges need market makers to bring in business, and end users of options need market makers for price discovery and execution.

Market makers are “not alone in facing challenges, as the whole industry is in an environment where volumes are not growing at the rate they were,” said Steve Crutchfield, executive vice president and head of U.S. options at NYSE Euronext. “In a lower-volatility environment it is more challenging for market makers who are looking to provide liquidity while also extracting some sort of edge for their service.”

“We very much believe in the value that market makers provide to the industry,” Crutchfield told Markets Media. “To a much greater extent than is the case in equities, we need to have market makers and we need to support market makers, and ensure that although they need to meet quoting obligations which are in some cases rather strict, in return they need to derive some benefit.”

While broad trends crimp market-making margins, there are some areas of growth on a more granular level that are supporting order flow. These include the complex order book and weekly options, and some market participants have observed also that options exchanges and order handlers are generally more innovative than their equity counterparts, so there’s incremental value being added as well as the chance for the ‘next big thing’.

Chris Nagy, President and Founder of KOR Trading

Chris Nagy, President and Founder of KOR Trading

“The ability to grow product continues to be a real strong suit within options,” said Chris Nagy, president and founder of consultancy KOR Trading and formerly head of order routing at TD Ameritrade.

“The ability to grow product continues to be a real strong suit within options.”

“Bringing new product is very easy to do in the options world, and exchanges are coming out with a number of proprietary products. Increasing product mix is a real positive for the options market, as it absolutely helps markets grow.”

In February, Nasdaq OMX launched options on U.S. Treasuries. “ I don’t think that in particular will be overly popular, but it is another product,” Nagy said.

Strength in Complex
The options product most often cited by market makers as a vehicle for growth is the complex order book, which enables electronic trading of multipart-strategy, or spread, orders. A spread position is entered by buying and selling equal number of options of the same class on the same underlying security but with different strike prices or expiration dates.

Options traders “generally have a better experience rolling their positions at a lower cost using complex orders, rather than executing two individual legs,” said Slade Winchester, head of U.S. derivatives electronic execution sales and strategy at Citigroup. “Over time, traders are paying less bid-ask spread into the marketplace but trading more and making up for that. They’re having a better experience and market makers are able to enjoy volume growth.”

Weekly options, launched a few years ago to allow traders more precision in their hedging or speculating versus standard monthlies, have gained traction and exceeded the expectations of many market participants. Weeklies make up about 20% of options trading volume on the Chicago Board Options Exchange.

In all likelihood, traders who had been buying and selling monthly options are generating a substantial proportion of weekly volume, but market participants say the product has made the options market more attractive overall and brought in at least some incremental new customers for market makers.

“Complex order book has been very positive for us, and so have weeklies,” said Werts. “The challenge for a firm the size of BofA Merrill is a lot of operational work associated with weeklies and having expirations every week rather than monthly. But from an overall growth perspective, it’s been great.”

Most recently, Mini Options were launched in March, enabling trading in options tied to delivery of 10 shares rather than the traditional 100 shares. The idea is to allow more smaller investors to trade options on high-priced and very liquid stocks, including Amazon, Apple, and Google, as well as exchange-traded funds tied to the Standard & Poor’s 500 and the price of gold.

On the other end of the spectrum, BOX Options Exchange is seeking regulatory approval to launch ‘jumbo’ options contracts on the widely traded SPDR S&P 500 ETF. Aimed at institutional investors, jumbos would be tied to delivery to 1,000 shares.

“The good news is, we’re still seeing innovation and new ideas in the space,” Werts said. “Now it’s not likely that all of them will work, but overall I’m fairly bullish that we’re fundamentally doing new things.”

Innovation at the new-product level can bring in new order flow, but market participants say that it will not bring back the smaller market makers, many of whom were driven out of the market by structural changes over the past seven to eight years.

“You have the regular lit markets that market makers are pushing quotes on to, then you have complex order books that you need to be able to read and respond to, along with an expanding auction market,” said Winchester of Citigroup. “Order flow is extremely fragmented, and being able to follow and trade with the order flow requires bigger technology and compliance investment. It is a very complicated world for options trading.”

Last of the Indies
Mike Lipkin has been an options market maker on the Amex exchange for more than 16 years, though he indicated in today’s market his title is nominal and his current business is limited to sending out price quotes.

“The business of being an independent practically doesn’t exist,” said Lipkin, who is also an adjunct associate professor in industrial engineering and operations research at Columbia University. “I’m more or less a dinosaur. Because of the expenses, the ability to make a living doing that has basically gone away.”

According to Lipkin, regulations are onerous for independent market makers, and can cost about $120,000 per year. Independents must comply with rules that more logically apply to larger firms, such as taking examinations on the topic of money laundering. “If it’s just your money, that seems strange,” Lipkin said.

But the biggest factor in pushing independents out is the concentration of directed order flow, Lipkin told Markets Media. “The only people on the floor making markets are people working for big firms,” he said. “Much of the order flow is already ‘shopped’ before it comes down and it’s crossed, so even if you were an independent on the floor, you’d have very little to do.”

There are currently “extremely high barriers to entry” in the options market-making space, said Dan DeRose, managing member at GetSmart GRC, a consultancy for governance, risk, and compliance.

About 70% of all options trading is in just 100 names, a liquidity imbalance that is exacerbated by the paucity of independent market makers, said DeRose, who was formerly an options market maker and a compliance officer at a broker-dealer.

“Rule changes have concentrated power in the hands of a small group of players,” DeRose told Markets Media. As a result, “symbols that need robust markets the most don’t have liquidity providers…The whole principle of capital formation is affected.”

DeRose noted the Jumpstart Our Business Startups (JOBS) Act calls for a study of decimalization in market making, potentially a positive sign for the business of options market making. Aside from that, grass-roots efforts are necessary to address market structure issues, he said.

Exchange fragmentation and operating costs are the biggest challenge facing options market makers, said Nagy of KOR Trading. Costs “have been on the rise and that absolutely directly inhibits market-maker profitability,” he said.
Rising costs include those associated with payment for order flow, Nagy noted. “A lot of the big retail providers have put added pressure on PFOF onto market makers,” he said. “Essentially the payment-for-order-flow pressure is large providers demanding increased payment rates, which impacts overall profitability.”

Market makers are being hit with higher costs from multiple directions.The Options Regulatory Fee has increased to as much as 5 cents per contract per trade side, up from 0.5 cents when the industry introduced the fee a few years ago.

“While that fee is not borne by market makers, it is borne by end users and the problem that brings for market makers is less order flow,” Nagy said.

There are also Section 31 transaction fees, which have quadrupled compared with four years ago, and fees to trade the new mini options. The Section 31 fee “is still small, but when you’re out there in the markets every single day, those costs add up,” Nagy said. Fees and fee increases are “coming at you from so many different angles,” he said.

“This environment will continue to weed out market makers who do not have the resources to stay the course and be able to weather low volatility in the marketplace,” said Murphy of Citigroup.

Regulatory Comp
“One of the best analogies is Dodd-Frank and the impact Dodd-Frank is having” on financial-market firms, Murphy said. “Either you have the resources to comply fully with Dodd-Frank, or you don’t. If you don’t, you’re going to have to exit certain businesses that you wouldn’t otherwise have exited. It’s similar in options market making — as it gets more fragmented and more costly, either you’re able to make the changes and upgrades and keep your business current, or you will need to exit the business.”

Citigroup has leveraged this dynamic to its advantage, according to Murphy, gaining market share in options via the breadth of its offering and the diversity of its trading clientele. “We offer liquidity from an upstairs, institutional-desk standpoint and from an automated options market-making standpoint,” Murphy said. “Firms with a diverse clientele and the ability to offer both execution quality and liquidity, should be able to retain their customers and be in the business for the long term.”

Added Winchster, “Citi invests in understanding market structure and is able to leverage market-structure trends so customers can find liquidity more efficiently. We leverage this understanding for both our routing business and our market maker. The market maker can’t be on every single exchange or every trading mechanism, (instead) you need to strategically say ‘what trends do I see longer-term for where flow will end up, and what mechanisms should our market maker invest in providing liquidity?’”

Bulge-Bracket competitor Bank of America Merrill Lynch is another market maker that has its own ‘natural’ order flow and has benefited from the evolution of options market structure. “The larger firms are able to weather the storm better than smaller and mid-tier firms, as they’ve got the resources to throw behind it,” Werts said. “It’s really becoming a scale game — as volume decreases and spreads narrow, revenue per contracts drops so you have to be in more and more names to compensate. This really plays much more to the larger firms with a global mandate and significant technology resources.”

Werts expects more pressure on smaller firms, noting that one potential survival strategy would be to find the right niche, rather than trying to be all things to all people. “For example, maybe just trade ETFs, or a certain sector,” he said.

Looking further out, Werts likes what he sees. “I’m very positive on the space long-term,” he said. “It is different from equities. You need to have registered market makers in the options space, as there are a lot of products and unique series. Exchanges will continue to look for ways to incentivize and motivate market makers to provide capital…I see short-term pain continuing probably for this year as well, but overall it is still an asset class that is growing.”

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