Industry Opinions and Perceptions of US Options Market · These challenges result in significant...

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Confidential – Do Not Reproduce

Knowledge Inspires SM

Industry Opinions and

Perceptions of US

Options Market

Structure

SIFMA Listed Options

Symposium

November 15, 2018


2© 2018 Burton-Taylor International Consulting | Confidential – Do Not Reproduce


• Introduction

• Industry Drivers

• What the Industry Did Right

• What the Industry Did Wrong

• The Remaining Challenges

• Strategic Environment for Market Makers

• Looking Ahead

Agenda




• US options markets have seen significant structural change as shifting investor demand, regulatory

requirements and the exchange landscape has reinforced the role of technology.

• Exchange evolution has supported the creation of an environment where low latency and speed are critical for

success.• Launch of ISE in 1999; first all electronic exchange

• Introduction of penny price increments in 2007

• Maker/taking pricing introduced on Arca in 2007

• Expansion of multi-listed weekly options in 2010

• Launch of MIAX in 2012

• Increasingly sophisticated end-user trading strategies require more powerful analytics and intelligent order

routing capabilities to support access• Institutional investors are using more complex strategies involving multiple legs and shorter expirations

• Brokers facilitating client orders are dynamically routing flow

• Retail investors are becoming more sophisticated as brokers provide more powerful analytics and trading platforms

• Market makers are dependent on technology to support the complex trading landscape• Using technology to manage risk exposure across multiple exchanges in real-time

• Increasingly working more closely with exchanges to support risk protection requirements

• Technology costs can be prohibitive and have created a tiered market structure

Market Structure Overview – Industry Drivers




• Stronger risk protections were identified as the most important structural improvement implemented by exchanges,

especially as the industry increasingly relies on technology to support the complex market environment.

• Exchanges are also getting high marks for listening to the industry and addressing a number of structural challenges.

Structural Improvements – What the industry has gotten right

What have options exchanges gotten right over the past 3 years?

Source:: Burton-Taylor International Consulting

32%

16%

11%

11%

11%

5%

5%

5%

5%

5%

5%

5%

Risk Protections

Consolidation

Responsiveness

Working together

Complex Order Logic

Payment for order flow programs

Competiton

Auction Rules

Lower Transaction fees

Exposing Orders

Education

New products




Structural Challenges – What the industry has gotten wrong

What have options exchanges gotten wrong over the past 3 years?

• The proliferation of exchanges has increased the complexity of options markets and raised costs for the industry.

• Price improvement auctions have created a tiered market structure with retail order flow internalized in auction mechanisms.

• Liquidity has become fragmented across exchanges, across symbols and within restricted pools of liquidity.


42%

32%

26%

16%

11%

11%

5%

5%

5%

5%

Launching New Exchanges

Auctions

Fee Structures

Too Many Products

Supporting Growth

Supporting Market Makers

Internal Communication

Tech Support

Harmonized Rules

Not Enough Education




• The proliferation of new exchanges, fragmentation of liquidity and internalization are the biggest issues facing the options

industry.

• These challenges result in significant inefficiencies, with institutions facing difficulties in sourcing liquidity.

Industry Challenges – The work left to do


What is the biggest market structure issue facing U.S. listed options markets?

32%

32%

32%

26%

26%

21%

21%

21%

16%

16%

11%

Exchange Proliferation

Too Many Series

Auctions/Internalization

Fragmentation

Finding Liquidity

Capital

Technology Costs

Lack of quoting

RWA

Health of Market Maker Community

Market Data Costs




Number of messages in millions.

Source:: Options Price Reporting Authority

• The options exchange trading landscape includes

15 different options exchanges offering trading in

more than 900,000 different series.

• Market complexity is characterized by rising

levels of trade and quote messages.

• Peak daily transactions messages reached a

record 30.6 billion in Q118.

• Peak transaction message rates reached a

record 15.7 million per second in August 2018.

OPRA Peak Number of Transactions Messages per Second in U.S. Listed Options Markets

OPRA Peak Number of Transactions Messages per day

in U.S. Listed Options Markets

Billions of transactions per day.

Source: Options Price Reporting Authority

1.4 1.7 2.0 2.2 2.6 3.7 3.9 3.9 4.6 4.6 4.6 5.0

6.8 6.8 6.8 6.8 7.5 7.9 7.9 9.6 10.2

8.7 9.8 9.9

11.1 11.3 10.4

14.5

10.5 11.0 12.9

10.9

13.5 13.0 12.9

15.7

12.0 13.9

9.9

15.2

11.0 10.1

18.0 15.3

23.1

14.7 15.0 17.7

11.4

16.4 15.4 13.9

30.6 27.5

22.2 23.4

A symptom of the complexity




• Market makers with consolidation operations and

scalability have a considerable advantage• Trading volume allows firms to leverage exchange

tiered pricing schedules.

• Technology investments are scalable across

businesses and exchanges, with global firms able to

scale internationally.

• Profitability is being pressured as costs rise and

access to profitable order flow continues to decline.• Technology investment is a constant requirement

• Capital costs are restricting activity.

• Exchange fees for market data and connectivity only

going up.

• Market makers need to invest in technology just to

remain competitive with new investment focused on

limiting adverse selection by using microwave

communications, algorithmic news feeds and ever-

faster access.

How has the competitive environment changed for market

makers?

Source: Burton-Taylor International Consulting

57%

43%

43%

29%

14%

Favors Large Players

Lower Profitability

Less Competition

Ultra Competitive

Tech Race to Zero

Market Makers – The strategic environment




• Market makers face trading constraints due to

current capital regimes• The Risk Weighted Asset (RWA) calculation based

on Current Exposure Method (CEM) restricts activity.

• Recent indications from regulators indicate a

transition to the Standardized Approach for

measuring Counterparty Credit Risk (SA-CCR)

promise capital relief

• Return on investments continue to be a struggle for

market makers, as regulation, technology needs

and competition are outweighing potential returns.• Supporting the complex market structure requires

significant technology investments, especially around

managing risk exposures.

• Costs for market data and connectivity to each

exchange continues to increase, forcing market

makers to rationalize market participation.

What are the biggest challenges you face as a market maker?


50%

25%

13%

13%

Capital

Sufficient Returns

Fragmentation

Data

Market Makers – Ongoing challenges





• Technology investment priorities shift based on

upgrade cycles and strategy evolution.

• Market data and connectivity are constant

priorities as investment directly impacts success of

strategies.

• Competition for technology staff is intense, with

market makers competing against the IT and the

FinTech industry.

How have the following technology costs changed over the past three years?

What part of your technology infrastructure has seen the

greatest investment in the past three years?


50%

25%

13%

13%

13%

Situational

Market data

Connectivity

Staff

Networking Cards

100%

100%

83%

80%

17%

20%

Market data

Personnel

Colo and Cross Connects

Connectivity

Increased Stable

Market Makers – Key technology investments




Market Makers – Picking the right exchange

What are the most important factors you evaluate when connecting to an exchange?

• Market makers balance total fixed and variable costs of participating on an exchange against opportunity to trade against

valuable order flow and generate edge.

• Technological sophistication and stability are important, especially risk protections.


89%

56%

44%

33%

33%

33%

11%

Overall Costs

Allocation Model

Risk Protection

Quality of Flow

Technology Stability

Speed

Determinism




• Market makers spend considerable resources

addressing audits and examinations from Finra

and Self-Regulatory Organizations (SROs).• Inquiries are often exploratory and not a result of

regulatory exceptions.

• Documenting activity to respond to information

requests is time-consuming.

• Identifying, accessing and reporting warehoused

transaction information.

• Market makers expect the resolution of the

current capital regime will be a drawn-out

process with little prospects for short term relief.

• Adhering to the current timeline for the SEC’s

Consolidate Audit Trail (CAT) will be expensive

with little transparency on future costs that will be

assessed on the market maker community.

What regulatory mandates raise concerns?


Market Makers – The burden of regulation

38%

38%

25%

Audits

Capital Treatment

Consolidated Audit Trail




• Although U.S. listed options exchanges have successfully addressed a number of structural challenges market

complexity is here to stay. The number of exchanges will continue to expand and market makers will remain

dependent on technology to manage the complexity.

• Exchanges are increasingly focusing on technology development to support the business of market makers.

Risk protection capabilities implemented in response to rogue algos are an important proof of success, with

exchanges focusing on refining technologies to support consistency and deterministic protocols in the

accelerated execution environment.

• Smaller market makers will use technology as a critical part of strategies in the increasingly competitive

environment, especially as they lack access to order flow controlled by the biggest market makers. There is a

limit to their future growth since scale has become a integral part of market maker business models and

ultimate profitability.

• Industry efforts to advocate improvements in the global capital regime will ultimately be successful but the

timeline will be elongated as harmonization of global regulatory approaches will be a slow moving process.

• Technology capabilities will define the leaders in U.S. option markets. Investment in technology will be a key

differentiator of success but the industry will need to rationalize technology costs against opportunity, an area

where exchanges will be both part of the challenge as well as the solution.

Looking Ahead




• Burton-Taylor clients command an estimated 80% of global revenue share in the market data space and

include the world’s largest Exchange groups, key government organizations and regulatory bodies on multiple

continents, five of the six largest advisory firms serving the industry, and more than 30 of the most active

private equity and investment companies around the world…all of which using Burton-Taylor data as their

industry benchmark.

• While accomplished in the Americas, Europe and Asia, and with a strategic approach that remains generalist,

B-T has developed substantial expertise in the global information, insurance, financial services and software

industries, with deep focus in North America, China, India and Asia.

• B-T’s Hourglass AnalysisTM process provides a proven, structured yet customizable, business consulting

approach that helps companies clearly target new opportunities, define new strategy, and plan new actions to

maximize growth.

• B-T completes custom research, varying in size from small single product or market detail reports to large

global industry and competitor sizing and profiles.

• To learn more about how Burton-Taylor International Consulting can help your company improve performance

through improved Market Intelligence, Strategic Planning and Revenue Generation activities, please call +1

646 201-4152, email: [email protected] or visit www.burton-taylor.com.

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