Since the advent of electronic trading, options trading has taken a backward step as exchanges mutate into OTC operations.
Maybe this was the obvious corollary of exchange brokers sitting alongside OTC brokers and pit-based options market makers sitting alongside their OTC equivalents in the confines of an investment bank office. In any event it would appear that as the flow of business dries up the morons that head up these exchanges are more obsessed with attracting OTC business than focusing on ensuring the exchange trading platforms work efficiently for their traditional product sets.
It used to be the case that there was a kind of gentleman’s agreement that exchanges did not nick each other’s successful contracts. In this way the market benefited from a single pool of liquidity which is clearly to the advantage of the end-user as greater liquidity means tighter bid/ask spreads.
Getting on for 20 years ago the Germans decided to dispense with this nicety as they fought to relocate the european bund future to Eurex, the fledgling electronic exchange. Eurex won this struggle quite quickly and the Germans proved that the electronic trading of futures was a far more efficient method of trading. Unfortunately transferring options onto a screen is not quite so simple.
Options: A Special Case
A number of options expiries can be based on one future. So if you take the first three months futures on the Eurodollars there could be nine different options series, more if weeklies were to be considered. Each series has a range of strikes. Each strike has a call and a put. And then the real problem manifests itself, all of these different calls and puts can be combined to make options strategies, the simplest possibly being the call spread and put spread.
When exchanges initially went electronic computer power was not where it is now. To provide all those options on a screen or, more realistically, screens was a big ask. To then throw in the strategies was a showstopper. But nevertheless the exchanges such as LIFFE shut down their floor and options trading had to proceed via the screen, hopefully. It didn’t! Request for Quote functionality was cumbersome and flakey so brokers found it easier to pick up the phones. And, hey presto, the traditional exchange traded contracts started their morphing into OTC contracts.
Today Euronext issued a AtomX press release about AtomX which I have cut and paste below:
New service to complement existing offering and capture bespoke derivatives business that would otherwise have been conducted OTC
Amsterdam, Brussels, Lisbon, London and Paris – 26 October 2015– Euronext today launched AtomX, a flexible service that offers the efficiency and security of the regulated market and central clearing to bilaterally negotiated trades. Through AtomX investors are now able to customise and trade options and futures which will be cleared, via LCH Clearnet, in the same clearing pool as the other Euronext derivatives positions.
The regulatory agenda calls for more transparency and mitigation of the recognised systemic risk posed by over-the-counter (OTC) derivatives. At the same time market participants are looking for more efficiencies in portfolio management. AtomX facilitates this by combining the flexibility of OTC trading with the capital and operational efficiencies of the regulated market. Moreover it provides new opportunities to further develop and expand on-exchange derivatives trading, as it will appeal to a broader section of the trading community.
AtomX provides new flex functionality whereby investors can choose their own productstyle, type, strike price and expiration dates outside the standard expiry time set. The flex expiration dates are currently limited to the third Friday of the month. In a later phase a fully flexible choice of expiration dates will be available. As from today AtomX already offers reporting of trades in more than 900 flex contracts on top of all standard financial derivatives contracts available in the central order book.”
Exchanges Mutate Into OTC
With respect to options trading, mainstream exchanges abandoned the concept of transparency at the introduction of electronic trading. The exchange trading model now involves a broker ‘ring-around’ or worse still, Bloomberg ‘Chat’ in order to request a quote from a market-maker. Options trading is now executed off-exchange via the phone or Bloomberg ‘Chat’ and trades subsequently reported to the exchange. Exchange traded conventional options is now de facto an OTC market.
Function of an Exchange
The function of an exchange is to:
- provide a medium of exchange
- in turn creating a price discovery mechanism, and
- ensure an orderly market.
These functions are what the exchange user is paying fees to the exchange for. Yet the exchanges provide none of these services anymore.
This latest development I welcome; not because it gets the exchanges back on track whereby they provide these functions, but since these developments move even further away from those functions at some point regulators will step in and force exchanges to revert to their raison d’être. In particular, by designing one’s own contract it is even easier to generate strategies that are a minor difference away from the exchange listed contracts, i.e. marginally different expiries and strikes a shade different from the listed contracts.
Future of Conventional Options Trading
So the market becomes more fragmented, liquidity diminishes, business dries up, market-makers and brokers both look for alternative means of meaningful employment, liquidity dries up even further…………….. and this is the current state of the market. The markets are pretty much dead now. The options markets are just about to die completely.