Options Market Makers Face Squeeze

Terry Flanagan

The options industry is getting more complex thanks to new order types and decimalization, both of which have made a deep impact on market makers.

“Market-making activity is all driven by algorithms now,” said William Floersch, a director of ABN Amro Clearing, who worked as an options market maker on the Chicago Board Options Exchange from 1974 to 1997, and served as vice chairman of CBOE for the last six of those years.

“What has changed radically is the liquidity providers are different now, the people with electronic capability are providing the liquidity in the markets, and there’s more volume associated with it than there used to be,” Floersch said. “It has shifted from thousands of individual market makers on five or six options trading floors to a few dozen electronic-oriented market makers.”

Competitive pressures are causing market-making firms to examine their current business models and explore different ways to grow their business, Tabb Group said in a 2013 report. Confronted by rising technology costs to support their activities where minimizing latency has become a key to success, the report said, while competition from high-frequency trading firms is forcing market makers to invest significant resources in IT systems to support ever faster trading protocols.

Decimalization “has reduced on-screen liquidity, but tightened spreads,” said Boris Ilyevsky, managing director at International Securities Exchange, who is responsible for market and fee structure, as well as the technological and strategic direction of the two options exchanges that ISE operates. “It forced people to change the way they traded.”

At the same time, new exchange pricing models came into effect, notably maker-taker. “Things that came from the equity side — maker taker pricing, for example–really began with decimalization,” Ilyevsky said.

Six of the twelve option exchanges employ some kind of maker taker-style pricing. “Back in 2007, it was something brand new in the options industry, but today, it’s a fairly significant segment of the marke,” Ilyevsky said. “Not as significant, obviously, as it is on the cash side, where the vast majority of exchange pricing is maker/taker.”

The number of U.S. options exchanges has doubled in the last ten years, with 12 exchanges and seven exchange operators. “We run two markets,” said Ilyevsky. “Liquidity has become somewhat fragmented.”

Fragmentation has also created opportunities for different market structures and fee models, and technology has progressed dramatically over the last ten years.

“Especially on the retail side, the experience is the best it has ever been and continues to improve,” Ilyevsky said. “It forces the markets to be tighter and prices lower, simply because all the exchanges are competing very aggressively. We’re trying to provide the best incentives for our market participants to put up the best markets they possibly can.”

On the institutional side, complexity has presented challenges, but institutions have benefited from advances such as algorithmic trading.

“If you’re an institutional investor, ten years ago, maybe there were fewer places and it was a little bit easier to source liquidity for a large order,” said Ilyevsky. “But we see large prints go up all the time. It seems like the major market participants and their customers have figured out how to deal with it quite well.”

Feature image via iStock

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