As it is in equities, so shall it be in options. The race to zero latency being staged by the equities exchanges is now being staged by the options exchanges. The International Securities Exchange is the latest options exchange to announce a speedy new trading platform. Optimise, as it is called, will roll out in April, and reduce latency at ISE by 75 percent, ISE says. The exchange will not divulge numbers, but says Optimise will be "industry leading" when it comes to low latency. In that area, ISE will square off against several other exchanges which claim to be fast, including BATS Options, the Boston Options Exchange and the Chicago Board Options Exchange’s C2. All three boast turnaround or response times of about one millisecond or less. Optimise will also increase throughput at ISE, allowing the exchange to process more data. ISE built Optimise in partnership with its parent Deutsche Borse, which plans to use Optimise as the underlying platform for all of its exchanges.
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BATS is courting the wholesalers. The BATS Exchange Options Market is seeking approval from the Securities and Exchange Commission to offer a directed-order program. Such programs, which guarantee market makers order allocations regardless of their standing in the queue, are standard on the four "traditional" exchanges. They have been shunned by the "flat model" exchanges such as BATS, which require all members to compete for allocations based on price and queue position.
With its proposal, BATS, one of the smallest exchanges, is attempting to appeal to the market makers who dominate options trading, but at the same time stick to its price-and-time principles. Under directed-order programs, exchanges steer the orders of retail brokerages to specific market makers. Those dealers are then allowed to trade against as much as 40 percent of the order if they are quoting at the market’s best price.
Under BATS’s program, a market maker will be able to trade against 100 percent of any incoming order as long as it price-improves the order over the market’s best price. To facilitate the price-improvement process, BATS will allow all members to use a new hidden order type that price-improves any incoming order. In addition, if another member is offering the same amount of price improvement as a market maker in the program, he gets any incoming directed order, not the market maker.
Unlike the four traditional exchanges, BATS says it does not intend to start a complementary payment-for-order-flow program that helps market makers win business from the retail brokerages.
SEC approval for BATS may not be quick and easy, according to one observer. "We suspect that the new structure of the BATS program might be opposed by the other exchanges, who could see the potential program as a threat to their own directed-order programs," Richard Repetto, an analyst with Sandler O’Neill & Partners, noted in a recent report.
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Nasdaq OMX PHLX is launching a remote specialist program. Members designated as remote streaming quote traders (RSQTs) will be permitted to trade certain options as specialists without maintaining a floor presence. That will entitle them to greater benefits for some trades, but also entail stricter quoting requirements.
The new program recalls e-specialist programs operated by other floor-based exchanges, such as the Chicago Board Options Exchange and NYSE Amex Options, but will be narrowly focused. Only those options dropped by any of the Philly’s five floor-based specialists will be available to a remote specialist. Those are typically options on stocks that are in play due to a rumored or actual takeover deal.
A Philly specialist will sometimes drop an option because it doesn’t want to assume the risk of trading a volatile deal book. That hurts institutional brokers who may want to bring a large order to the floor in the name. Heretofore, if a specialist dropped the option, the Philly had to delist it.
"Deal stocks can be tough to make a market for," explained Tom Wittman, the executive in charge of Nasdaq’s two options exchanges. "The book may not fit the sweet spot for these five firms."
Specialists at the PHLX are Citi, Citadel, Susquehanna, Group One and Timber Hill. An RSQT, however, may have an interest in the name. Typically, RSQTs are midsize and large firms trading on a principal basis. Goldman Sachs, Barclays Capital, UBS and Wolverine are RSQTs.
While the new program is narrowly focused, it could be expanded. Wittman noted he would not undertake a remote specialist program in the same manner as the other exchanges have done, but that the new program "will allow us to do other things down the road if we want to."
(c) 2011 Traders Magazine and SourceMedia, Inc. All Rights Reserved.
In the battle to wrest trades from the over-the-counter market, the Chicago Board Options Exchange is making strides. During the first 10 months of last year, the CBOE traded about 10 million FLEX contracts. That’s up from 3.5 million contracts for all of 2009 and about 1 million for 2008. A FLEX contract–it stands for "flexible exchange"–is an options contract with non-standard terms that can be tailored to the non-standard needs of institutional investors. It is positioned to compete with so-called "look-alike" contracts, which represent a substantial portion of OTC options trading. CBOE pioneered the FLEX trade in 1993, but the product never caught on because of certain duration and size limitations. The gains of the past year or so are due to several changes CBOE pushed through the Securities and Exchange Commission in 2009: non-traditional expiration dates; elimination of the minimum size requirement; and an extension of maximum terms to 15 years. CBOE is not the only exchange to offer FLEX options–four do–but it has been the most aggressive in championing the product. FLEX volume is still just a drop in CBOE’s bucket: the exchange traded over 700 million options contracts through October.
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The marketwide circuit breakers in place since the 1987 crash may be getting an updating. "We are assessing whether various aspects of the broad market circuit breakers need to be modified or updated in light of today’s market structure," Securities and Exchange Commission chairman Mary Schapiro testified at a U.S. Senate hearing last month.
A change is due, said David Shillman, an associate director in the SEC’s division of trading and markets, because the market has become "faster and more electronic."
The official told the crowd at the ICI conference that the 23-year-old circuit breakers had almost never been triggered and that a change would involve "tightening the bands with a shorter duration." Today, the circuit breakers halt trading for at least 30 minutes whenever the Dow Jones Industrial Average falls by at least 10 percent.
The comments by the SEC officials follow the exchanges’ installation of circuit breakers on individual stocks after May’s "flash crash." These halt trading for five minutes if a stock moves by 10 percent or more.
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With the passage of Regulation NMS in 2005, block traders lost the right to ignore competing bids and offers in the marketplace. Under Rule 611, they have had to take out any better-priced quotes before printing their block trades. Although they sought an exemption that would allow them to trade through these quotes, the Securities and Exchange Commission nixed the idea.
The regulator maintained at the time that an exemption would discourage the use of limit orders and harm the price-discovery process. Now, five years later, at least one senior trading executive, speaking at the Investment Company Institute conference, called that decision a mistake.
"We designed a market that serves retail orders in the top 200 to 500 stocks," said Chris Concannon, formerly a senior Nasdaq OMX official, now with a proprietary trading house. "But as you move out of those stocks and increase order size, we have a flawed market."
Concannon contends that brokers are reluctant to take on block trades in small- and mid-cap stocks because Rule 611 forces them to show their hands. While the rule may not be a problem when trading blocks of highly liquid stocks, too much information is divulged when taking out the quotes of smaller names. That pushes up the cost of trading the stock.
He believes the SEC should consider an exemption for block trades in certain, but not all, symbols.
"The liquidity provider is hampered by the Reg NMS trade-through rule," Concannon said. "That makes no sense. There are no limit orders sitting there being unfairly treated."
(c) 2011 Traders Magazine and SourceMedia, Inc. All Rights Reserved.
Trading costs for institutions are lower, according to the number crunchers. The conventional wisdom holds that’s because of rule-driven market structure changes. But is that really the case? Two buyside traders offered different views on the topic at this year’s Investment Company Institute conference.
Kevin Cronin, global head of equity trading at Invesco, said lower costs are due to market structure changes. "Five years ago we had an NYSE one-size-fits-all marketplace," Cronin told the crowd at ICI during one morning panel. "Now we have more choice, and we have control over our order flow. Executions are faster and transaction costs are lower. The evolution of market structure has brought benefit to institutional investors."
Not so, said Matt Lyons, global trading manager at Capital Research and Management Company, who spoke on a later panel. Lyons agreed that trading costs have come down, but attributed the decline to a decrease in volatility. "The notion that costs have come down because of changes in market structure is spurious," Lyons told the ICI crowd. "Our costs are in line with volatility." The exec noted that costs came down even before Regulation NMS eliminated the near monopoly held by the New York Stock Exchange. "During the 2003-2006 period, when volatility came down, costs came down dramatically," Lyons said.
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Circuit breakers are in. Price collars are coming. Is "depth-of-book" next? Eric Noll, a Nasdaq OMX executive vice president in charge of transaction services, believes depth-of-book price protection should be considered to make the market more stable. The exec is not pushing hard on the controversial notion, he told Traders Magazine, but contends depth-of-book is a potential solution to whipsawing markets.
Under Regulation NMS, the market’s best, or top-of-book, quotations are protected. That means any trade done in the public markets cannot ignore them. They must take part in the trade.
All other prices, however, can be ignored. The idea of protecting these lower-rung, or depth-of-book, prices was mooted during the discussions surrounding Regulation NMS, but ultimately rejected. Those opposed said a depth-of-book rule would effectively create a government-mandated central limit order book, unnecessarily constrict competition between exchanges and be costly to implement.
Given the turmoil of May 6, however, Noll believes the idea of depth-of-book protection should be revisited. "We need to think of ways to change the web of the national market system in a way that will provide more stable liquidity, so events like a future sell-off don’t cause a crack in the system so that it falls apart," Noll said at the ICI conference.
Part of the reason the market toppled on May 6 was because traders exhausted liquidity on exchanges that had little to exhaust. Because they were not required to route their orders to exchanges with more liquidity at more price points, they pushed prices down needlessly, Noll explained.
The Nasdaq official noted that on May 6, when trading on the New York Stock Exchange triggered its circuit breakers, traders went elsewhere. "The books elsewhere were thinner," Noll said, "and people ate right through them."
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The Securities and Exchange Commission is considering rules covering the use of algorithms. In the wake of the SEC’s May 6 "flash crash" report, which implicated a solitary algorithmic trade as the catalyst for the event, the regulator is talking about requiring brokers to take more responsibility for their algorithms.
"We’re thinking about whether there should be some risk controls on algorithms," said David Shillman, an associate director in the SEC’s Division of Trading and Markets, at the Investment Company Institute’s annual equity markets conference last month. "That may involve a question or an override if the algorithm is operating too aggressively."
In its report on the events of May 6, the SEC identified a series of algorithmic trades in the futures market done by a single mutual fund, now known to be Waddell & Reed, as the trigger for the cascade of sell orders that briefly slammed the equities market.
In considering rules for algo usage, the SEC is attempting to address "situations where the algorithms are so aggressive that the result may not be what is intended by the user and could have a destructive effect on the market," Shillman said.
The SEC wants brokers to "double-check" before sending out an algorithmic order and perhaps throttle back if the algorithm is stressing the market, he noted.
The official’s comments follow similar probing by the Commodity Futures Trading Commission. The CFTC, which regulates the futures market, is seeking comment as to whether brokers should be held liable for market disruptions due to trades done on behalf of their customers.
Shillman noted that there may be a section in the Securities Exchange Act of 1934 that permits the SEC to place obligations on brokers, giving them a duty to the market. Right now brokers only have a duty to their customers to get "best execution."
The SEC is not seeking to "heavily regulate" the use of algorithms, Shillman said. Nor is it interested in regulating the buyside’s level of aggressiveness when using algorithms. The commission only wants brokers to think twice before sending out an algorithm that might threaten the stability of the market.
At least one big broker agrees with the SEC that more must be done to contain any damage to the market from the use of algorithms. Greg Tusar, a managing director in the equities division of Goldman Sachs, told the ICI crowd that brokers need to engage their clients in an ongoing dialogue about the impact of their order-handling practices, especially in "abnormal circumstances."
"What happens if I move the stock by 3 percent," Tusar asked rhetorically. "What about 5 percent? What sorts of limits should be in place? How should the algorithm behave? We need to reinvigorate that dialogue."
Tusar noted that such conversations, once at the center of the relationship between the sales trader and the buyside trader, are occurring less often in the era of algorithms. "That dialogue needs to increase a lot from where it is today," he said.
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Agency brokerage Investment Technology Group rolled out its new pairs trading algorithm, Hedge Pro, which lets the buyside trade across regions.
ITG developed its new algo to save traders time by calculating different currency values in real time. The conversions should help maximize profits and shorten trade time.
Pairs and other arbitrage strategies profit from small pricing discrepancies–they involve buying one instrument and selling another correlated security. Demand for the algo stems primarily from hedge funds.
According to Hitesh Mittal, head of liquidity management at ITG, the algorithm allows traders to execute any North American equities pairs combination using strategies such as risk arbitrage, statistical arbitrage and cross-border trades. Putting on trades and hedging are handled automatically using continuous monitoring and signaling from individual quote ticks.
"You can also specify different levels of aggressiveness on how the algorithm executes orders," Mittal said.
Hedge Pro is currently available only via ITG’s Triton execution management system. By early 2011, it will be available on other third-party systems, such as Bloomberg.
Mittal said several of ITG’s hedge-fund and long-only clients are already using Hedge Pro.
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