For decades, they have been the cloak-and-dagger arm of Wall Street. These mysterious entities trade on behalf of secretive clients, devising elaborate strategies that move markets, and, in rare instances, cause markets to meltdown. Like most unregulated entities, they prefer to stay in the shadows, emerging on occasion to unwind or increase their positions. Every few years, one of these entities becomes so big that it can't help but draw attention to itself. Such was the case in 1998 when Long Term Capital's highly leveraged spread trading threatened to implode the global financial system.
The shockwaves from that near-disaster reverberated throughout the financial markets and focused the attention of regulators on the perceived shadowy world of hedge funds. The hedge fund industry world never be the same, and neither would the world of options.
Rogue Memories
Today, one would be hard-pressed to find a fund that refers to itself by the sinister title "hedge fund." The term carries with it far too many memories of the rogue funds of the late 90's. Instead, they now refer to themselves as "private investment funds," and their influence is being felt across a number of financial markets. Although most funds primarily trade equities, they were also among the first customers to understand the hedging power of options. Selling upside calls against stock positions has always been a popular trade in the hedge fund playbook.
However, over the past five years, the relationship between hedge funds and the options industry has evolved. "Six or seven years ago, the hedge funds were almost nonexistent in the options business due to the market's inefficiencies," says Ed Boyle, VP of Equity Derivatives at TD Securities. "Now they've built or acquired sophisticated technology while learning how to use options to decrease risk and enhancing returns. I've heard numbers that as much as 50 percent of our customer volume can be tied back to hedge funds."
Profit Center
Once seen as little more than a hedging tool, options have now become lucrative profit centers for many funds. So lucrative, in fact, that several funds have made the transition into options market makers. One of the largest funds to make the transition so far has been Citadel Investment Group, which has some $12 billion in assets.
"Three years ago, we made a decision to become options market makers instead of just options customers," says Matt Andresen, President of Citadel Execution Services and and the former chief executive of Island ECN. "The two main reasons for this were the increasingly competitive nature of the listings in the options markets and the increased efficiencies provided by electronic trading. We believe that the strength of these two trends will continue well into the future." Andresen is a trading big leaguer. Before Citadel he served as head of global trading at Sanford C. Bernstein for about a year. That was a position he took in the fall of 2002, passing up the chief operating officer job at Instinet after it bought Island. Andresen spurned Instinet because he thought Bernstein was a better career fit. Now he thinks options offer Citadel a better profitability prospect.
But this is an odd time to be entering the options fray. The options markets are locked in a state of flux as they transition away from open outcry and into a new era of electronic market making. Many large trading firms, such as Knight Trading, have decided that the high risk, low-margin world of options market making is not worth the effort.
Rapid Evolution'
However, while the evolution away from open outcry has been difficult for many traditional option firms, private investment funds have always been early adopters of trading technology. Their affinity for technology makes them uniquely suited for this new era of electronic market making. "The last few years have been a period of rapid evolution in the options industry," says Andresen. "There are opportunities today to add value in the marketplace by applying quantitative research and cutting-edge technology. However, in order to capture those higher levels of efficiency, and to capitalize on the cost structure of the business, you have to make a substantial investment in technology."
'Three years ago, we made a decision to become options market makers instead of just options customers.'
Matt Andresen, Citadel Execution Services
Unfortunately, trading pros like Andresen who are used to the efficient execution of the equity markets may be in for a rude awakening. Although the fragmentation that once plagued the options industry has been mitigated by the linkage system, execution in the options markets is still far from ideal. "The intermarket linkage between the options exchanges is woefully outdated and needs to be addressed" says Andresen. "When there is a superior advertised price on an away market, we are required to get it for our customer. However, the level of service on those away orders is spotty at best. This issue can't be fixed with technology. It's a problem of incentive. What is the incentive for an away market maker to give me a fast, efficient and reliable fill? The answer is that he has none. If anything, he has a disincentive, and that underlying problem has yet to be addressed." Raised Eyebrows The transition of private investment funds into market makers has raised more than a few eyebrows in the industry. Some skeptics question the motives of these new players, believing that their true intention is to internalize their substantial order flow without providing any real value to the marketplace. It remains to be seen whether the onset of these powerful players will result in tighter markets and better execution for customers, or yet another round of fervent internalization and payment for order flow. "It is a complex issue," says Andresen. "Payment for order flow and internalization are, at least for now, the competitive reality of the marketplace. We are faced with a situation where all of our competitors do it, so we have to as well. While we don't pay for orders directly in the options world, we do participate in the programs at the options exchanges. On the ISE, for example, the exchange collects the funds from us and the other market makers, and then distributes those funds as the specialist directs. It is just another cost of doing business in the options industry today." Citadel's entrance into the options arena marks a new era for the industry. If its early success is any indication, then the transition of funds into market makers will have profound ramifications for the options markets. Citadel claims that it is already the largest liquidity provider on the ISE and that it has made a substantial investment in the fledgling Boston Options Exchange. In addition, they currently provide liquidity on both the CBOE and PCX. Given Citadel's growing market share, it won't be long before other large funds follow its lead and enter the options fray. "We are one of the only private investment funds that I know of that currently makes markets in options," says Andresen. "I'm sure that many other funds use the options markets as customers, but I'm not aware of many that make markets in these products. Certainly not to the extent that Citadel does." If the past is prologue, Citadel will soon have company. Mark Longo is an options trader and a former member of the Chicago Board Options Exchange. E-mail: mark@marklongo.com
