Options Market Structure Outpacing Underlying Technology

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Recent predictions from industry groups suggest US equity option quote volumes will nearly double over the next twelve months, severely straining the technology fabric that underpins the industry’s quoting, trading and risk management systems. We see particular vulnerabilities in processes and systems that require a direct un-throttled options market data feed, such as smart routing engines, algorithmic trading engines and portfolio risk systems, as well as the infrastructure that supports these processes and systems.
Options Market data fed from Options Price Reporting Authority (OPRA) has been steadily increasing at a current annual rate of about 40%. Currently we see around 1.3 million messages per second, with a recent high-level mark at almost 1.5 million messages per second in December. The Financial Information Forum (FIF) is projecting growth to reach 1.8 million contracts in the next twelve months. The projection does not take into account the ramp up of new exchanges or any added expansion of the Penny Pilot, and we know that as these changes go into full effect, growth will only accelerate. We expect that with the new symbology, clients will be able to execute against more strikes in all underliers. The above projections also do not take into account the added granularity in striking which we anticipate will lead to more products filling our screens, adding to the technology crunch.
Given the recent OCC symbology changes, new and existing exchanges will be fighting for order flow with new products and different business models. Some new models include hybrids of payment for order flow and maker/taker for certain names. Some exchanges are trying to attract new business by introducing non-standard options that allow clients to trade options in new ways, such as binary options. More products on more exchanges will increase the need for better, more efficient technologies. The technical hurdles to maneuver this business will likely only get higher and higher as we move forward.
Firms’ needs vary from order routing through an EMS, some of which showcase advanced options analytics, to proprietary technology systems that require a huge amount of technical horse power to consume the ever growing OPRA market data feed. These systems pipe through options algorithmic orders that spawn hundreds of child orders or advanced volatility quoting strategies.
As needs grow, it will become increasingly more important for firms with trading needs to partner up with vendors and brokerdealers who have developed specialties in these spaces and who understand how to efficiently handle the sheer mass of messages being sent now in terms of orders and market data. The underlying technology has become so specialized that it’s no longer a matter of throwing money at a software or hardware problem, but to find the best combination of hardware and software.
It will also be important for all firms involved to smartly throttle the feed to certain processes that do not necessarily need every tick to ensure that sub systems are not over saturated. We expect that every single process that tries to consume OPRA market data will need to be bolstered or re-engineered for almost all existing systems. There also has been a recent push towards publishing the depth of the options market, provided as direct feeds from the exchanges, to trading front ends and algorithmic engines. The thought is that with the proliferation of pennies, the current OPRA feeds, which only reflect the tops of books at each exchange, are less useful when trying to identify liquidity for larger block executions. Besides providing more clarity into the book, direct feeds also tend to be faster than the feeds through OPRA. Tools designed to obtain blocks in the electronic markets will become important when chasing after institutional, larger block trades. There also is some thought that using the depth of book to derive analytics will provide customers clarity into where they may get filled given the depth of book feed.
With wider use and availability of depth of book, we expect to see development in pre-trade execution analytics for those clients who need more liquidity than that published at the top of book. Customers, in turn, can get a sense for the average price they are likely to achieve if they sweep the book. Over time, this should lead to increased confidence on the likelihood of filling larger block orders electronically. This will likely draw chunkier flow that is important to this business. We expect that if the market depth becomes important for execution, this will only multiply the resources needed to handle the complete options market data feed.
With each exchange center doing its best to cover the different business models to attract flow, i.e. Maker/Taker and Payment-for-Order-Flow (PFOF), we expect the number of exchanges to only expand. When BATS went live with its exchanges, we saw few executions – but they did prove that with an interesting business model, it is possible to pull out a slice of the options pie from the other, larger exchanges. Other potential exchanges are quickly following suit, and we expect as many as 4 new exchanges, 12 in total, at this time next year. It is hard to define the term “success” for each exchange, but with good technology and a thoughtful business model, it is possible to define “success” as grabbing a small sliver of the OCC volume. With additional exchanges seeking to attract order flow, you can expect to see more data crowding OPRA feeds, especially as the number of liquidity providers increases.
It also is unlikely that we will see much consolidation of exchanges, even with the many queued up exchanges in the pipeline. Each major market center is spending their time focusing on trying to cover both common business models – Maker/Taker and PFOF. With the diversity in pricing, you can expect that algorithmic engines and smart routers will need to become even smarter in terms of exchange costs in order to ensure that they are not only effectively executing, but also doing so while keeping fees to the client low. The model of more exchanges fighting over a finite number of executed contracts is not a sustainable model, you can assume the market venues that can share the fixed cost of running an exchange over two or more entities, with a large combined market share, will always win out.
With more and more exchanges popping up, brokers will need to decide to either connect to each market, or to use a centralized market link provider as a conduit to smaller exchanges. Market Makers will need to decide whether or not to participate in the new markets. Customers will expect to be able to access the new markets, and hope to find costefficient execution where possible.
As we see more volume and market data flow across the OPRA feeds, we can expect that additional flow will lead to additional message traffic entering the market place as orders and executions. One Smart/Algo order could spawn many child orders to ensure that it takes liquidity effectively in a given strategy. Each algorithm may try to take out liquidity at many market centers, only to find that liquidity providers or market makers with faster technology have already moved their quotes. This can cause these smart orders to over hit the quotes, trying to acquire liquidity that may not be there anymore. In the end, this leads to more child orders, more cancels, more replaces, and more message traffic. Add on the proliferation of pennies, which means less liquidity on the top of the book and the need to sweep through the NBBO to get blocks of liquidity, and you can expect even more child orders, executions and messages.
Firms leveraging older technology in an attempt to handle the current throughput of market data or orders/executions have quickly realized that it is not as simple as buying new versions of old technology to keep up with the problems of throughput. The demands of the marketplace have outgrown the traditional pace of technology. Interested firms now either need to dedicate more money/resources towards improving upon their current technology, or firms have to work with partners that are dedicated to creating specialized, efficient services capable of handling the needs outlined above. In this case, the US Listed Options market place and its evolution is spurring on the pace of evolution of underlying technologies. Either way, the bar has been raised for any firm who wants to actively participate in this market place.
 *SOURCE: March 2010 FIF Monthly Capacity Report (http://www.fif.com/capacity_statistics/)