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May 31, 2004

A New Era in Options

By John Gelbard

The information technology revolution is finally arriving in the inter-dealer market for listed options. Many of the largest investment banks and financial institutions are now encouraging electronic-quote messaging. Jonathan Larkin, head of U.S. electronic options trading at J.P. Morgan, says this trend is welcome. However, he notes that the U.S. lags the European markets but says the Yanks should soon catch up.

It all started with the success of European electronic platforms, from DTB/EUREX and LIFFE. This led to an explosion of inter-dealer business that was dependent on electronic communications tools. In the U.S., the shift to electronic exchanges - such as the ISE and BOX - could spark a similar transformation.

A few years ago several mid-sized London brokers experimented with private ECNs. These ventures did not succeed, but the new technology proved itself in streamlining the price discovery process for the wholesale equity derivative market.

Historically, large structured options trades - characterized by relatively low numbers of transactions with high notional amounts of contracts - were "shopped" by inter-dealer brokers through telephone conversations with interested counterparties.

With the advent of Instant Messaging, it became more convenient to disseminate orders using Internet-based IMs. With the volume and complexity of delta-neutral trades exploding, it became more difficult to evaluate these structures. They had to be manually "filtered" and keyed into the firm's pricing model for analysis.

The new systems respond to these limitations. Using Internet-based secure networks, large volumes of interests can be disseminated simultaneously to the U.S. equity derivatives community. While this data can still be viewed in the traditional manner, the "killer app" of the product is delivered through an application programming interface (API) to feed directly into the recipient's electronic environment. An unlimited number of structures can be filtered, analyzed, discarded, or reacted to instantaneously. The same information can now be broadcast to hundreds of brokers instead of a handful.

Paul Maley, business manager for Global Equity Derivatives at Deutsche Bank Securities Inc. in New York, recently said that brokers quoting electronically have become the "market standard" in Europe. "Leveraging this technology has increased significantly the amount of quotes that our traders can manage," he added. "The same efficiencies should be adopted here in the U.S. to take advantage of the increased liquidity in the broker market. As a result, we're encouraging and assisting our brokers to implement an electronic quoting system of their choice."

Recipients can filter data to select orders based on specific securities, industry groups, expiry or price, thus enhancing productivity and reducing errors. The systems have also become useful marketing tools, as clients can select interesting offers.

As no capital can be committed, this platform is an information tool only. Completed trades still have to be executed in the listed options marketplace. When a transaction is agreed, a telephone call or IM, just as before, will finalize the transaction.

As brokers migrate to electronic-quote dissemination there is a corresponding need for integrating the data with both their internal systems and other external networks. One suitable platform, which also functions as an IM "aggregator," provides templates for IM and e-mail generation. It also integrates into a Website and allows the user to import data into other systems via the platform API.

The equity markets have demonstrated the role of information technology in narrowing spreads and the explosion of transaction volume that followed. The same is ready to happen in the wholesale equity derivatives market. Other financial products based on analytical pricing models and hamstrung by inefficient price discovery processes will be next.

John Gelbard is senior vice president of I.A. Englander & Co., a New York City-based inter-dealer broker of listed and OTC stocks and derivatives.