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March 7, 2008

Handing Over the Keys

The Sellside Puts Options Trading on Buyside Desktops

By Nina Mehta

As institutional investors come to dominate options trading, a growing number are asking their brokers for electronic capabilities to do the trading themselves. That has some brokers scrambling to put direct-market-access tools and execution algorithms on buyside desktops.

"As brokers roll out better tools, more people join the marketplace, and exchanges present incentives to provide liquidity, institutions will be able to trade more electronically," says J.P. Xenakis, vice president at Goldman Sachs Electronic Trading. "It's cheaper and it's anonymous." Big-lot traders, he adds, will soon begin asking for more-sophisticated quantitative tools.

Goldman Sachs, Credit Suisse, UBS and other large banks are rolling out agency options execution algorithms for institutional customers. All plan to launch new algorithmic strategies this year. Banc of America Securities, Lehman Brothers, Merrill Lynch and Morgan Stanley have options algos in production. Many of these are geared toward options quoted in pennies as part of a pilot the Securities and Exchange Commission foisted on the industry more than a year ago. The algos aim to reaggregate increasingly fragmented liquidity across the six exchanges, often at different prices, and over a period of time.

Customer Demand

Agency brokers are also getting into the game. Instead of building their own options trading functionality from scratch, several have opted to buy existing options trading platforms. ITG last year spent $22 million to acquire RedSky Financial, a Chicago-based broker and listed derivatives execution platform vendor for institutional traders. BNY ConvergEx Group, which has a lot of hedge fund and institutional clients, bought Chicago-based options trading platform LiquidPoint last fall.

ITG grabbed RedSky to get a better foothold in the options market for its core customer base of indexers and passive funds. "We wouldn't have done it unless there was strong customer demand to trade options," says Tony Huck, who oversees ITG Derivatives, the renamed RedSky entity. Many of ITG's traditional customers, which trade index futures as part of transitions or to put cash to work immediately, are now eyeing options. RedSky's options trading platform is likely to be incorporated into ITG's Radical EMS, which supports single-equity options but doesn't have the same level of derivatives trading capabilities.

The immediate stimulus for bulge-bracket firms as well as agency brokers revving up their electronic trading capabilities is the penny pilot. Launched in January 2007, the pilot will absorb another 28 names later this month, encompassing a total of 63 options classes. Pilot options series priced under $3 are quoted in penny increments, while those $3 or higher are quoted in nickels. (The liquid QQQQs are quoted in 1-cent increments across all series.)

The pilot, these brokers are betting, will magnify the resemblance of options trading to fast-paced electronic equities trading. As expected, smaller quoting increments have already resulted in narrower spreads. For all but the most liquid options in the pilot, tighter spreads have also led to dramatically less liquidity at the inside market and more price movement. That represents fertile ground for algos that can capture liquidity dispersed across more price points.