Options Market Structure Outpacing Underlying Technology
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/)