The significant concern in the US equity options market is the underpinning market structure, which favors the wholesalers with an affiliated market making arm, according to Optiver.
On August 11, Optiver, a proprietary trading firm and market maker for various exchange-listed financial instruments, released a series of papers highlighting concerns about the state of the U.S equity options market.
Optiver followed closely the SEC’s recent remarks on payment for order flow (PFOF) and the agency’s review of the equity market.
“We believe that transparency and fair competition are the foundation for a healthy market,” Michael Golding, Head of Trading, Optiver US, said.
“We applaud the SEC for highlighting its concerns about market structure issues, which often unfairly rewards wholesalers who route retail flow with an affiliated market making arm,” he said.
However, the equity market is only one part of the issue, according to Optiver.
“While equity markets are under the spotlight in the current US equity market structure debate, the reality is that practices common in the equity options market, such as permanent specialist appointments, complicated price improvement mechanisms and asymmetric fees, are an even more significant issue, particularly for retail traders who are forced to pay wider spreads than they would in a truly competitive market,” Golding said.
Over the past two years, commission-free trades have become the norm for retail investors using an online broker.
What makes this practice possible – and profitable – is a market structure that permits payment for order flow (PFOF), according to Optiver.
“In our opinion, the true price of these “free” trades is the loss of best execution, market transparency and a market that favors wholesaler entities that provide routing and have an affiliated market maker (MM),” Golding said.
A review of the public 606 order routing form disclosures from the eight broker-dealers that are most active in the equity options market showed that just four firms collectively route an estimated 80% of the retail market, according to Optiver.
These firms also account for 84% of the 40,000 specialist appointments on 11 exchanges.
Optiver acknowledges the potential benefits that wholesalers with affiliated MMs can provide to retail investors.
“MMs have the expertise in option pricing while wholesalers provide the infrastructure to execute orders on behalf of retail brokers. This relationship, however, can only deliver the maximum benefit if there is genuine competition for these orders at the exchange level,” Golding said.
Options exchange fees that were designed to attract order flow from retail wholesalers create the same market structure issues as PFOF.
“These fees have created a pay to play situation that is more likely to reward affiliated MMs than the MMs that offer the best price.”
“We believe this market structure can be addressed, but it will require an effort led by the SEC as exchanges are unable to coordinate a collective change due to anti-competitive restrictions.”
In its ongoing review of the impact of technology on market structure, Optiver urges the SEC to broaden its examination to consider the impact of these and other practices not only on the U.S. stock markets, but also on the equity options market.
“As our industry continues to debate the pros and cons of PFOF, internalization, and related market structures, the equity options should be included in that discussion,” Golding said.
