Options Complexity Gives Pause

Terry Flanagan

Active proprietary traders and other options market participants have mostly gone along with increasing market-structure complexity. But at a certain point, the situation needs to be closely looked at for its potential detrimental effect on market quality.

“The complexity of the market is at least contributing to the risk of serious trading issues or errors,” said Patrick Hickey, Chicago-based market-structure executive at Optiver. “Rules addressing these issues need to be harmonized.”

International Securities Exchange launched Gemini in the third quarter, making an even dozen options exchanges in the U.S. It’s unclear what is the ‘right’ number of options exchanges, but market participants say it’s less than 12.

“We’ve somehow crossed the line, where the benefits of all these venue choices are not outweighing the cost of having to deal with all of the complexities these venues bring to our business,” Hickey told Markets Media.

Aside from liquidity fragmentation and connectivity costs, other issues pertain to data feeds, risk controls, trading halts, and the redress of erroneous trades. Such concerns will be up for debate at Markets Media’s Oct. 24 Chicago Trading & Investing Summit.

Options traders have “been in a state of regulatory uncertainty for some time now,” Hickey said. “It’s harder to justify trading more, if in doing so you are exposed to more regulatory risk.”

The options industry is working toward a common ground for controls in many aspects. Firms have been encouraging exchanges to not put new rules on top of existing rules until rationalization has been more deeply explored, Hickey and other panelists slated for the Markets Media conference noted.

Constantly changing fee schedules are cited by several firms as one factor that is making business overly complex. “Each venue is cutthroat, competitively, with the others, and they are taking competition to a new level with fees,” said an operations manager at an options firm.

Adding to the complexity are shifts in eligibility requirements for volume tiers, classes covered and ways to denote participants within fee schedules.  When implemented changes don’t flow properly to the exchanges’ own data, the resulting errors vex market participants responsible for quick systems changes.

Erroneous trades in options and outages on the cash equities side that impact options pricing are other concerns.

“What rules should govern when and whether a trade gets busted or adjusted?” Hickey said, concerned that each exchange has its own unique policies. “There should be a goal where, eventually, all trades stand, because there are controls that prevent grossly erroneous trades from occurring.”

Another area in scope for needed harmonization is the penny pilot project. “Six years in, and it’s still a pilot,” said a retail firm executive.

If the pilot becomes permanent as expected, questions include how many names the program would cover, and how a name would get in.  “NYSE and ISE have each offered up proposals on how to accomplish that, which is quite constructive,” Hickey noted.

As for the mini-options concept, “it was absolutely the right intent to welcome additional retail flow from the smallest investors,” Hickey acknowledged. But instead of one share equal to one options contract, the spec is 10. “It’s no simpler (than 100 shares per contract), which added a whole new category of complex and confusing products.”

Also considered likely topics for broad discussion at the upcoming Chicago are Reg SCI clauses about disaster recovery and redundancy of systems, efforts to achieve a Consolidated Audit Trail, and the Camp proposal concerning taxation.

For now, “At our firm, there is a renewed focus on risk controls,” Hickey stated. Firms are investing in and adding to internal systems and safeguards in place against many risk scenarios including erroneous prices, too much size, too many trades, and more, he added.

Across the industry, options market participants are discussing what traders, clearers, and exchanges can do to mitigate risk.

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