Tim Brennan built his first automated options trading platform back in 2000, when he was a trader with Morgan Stanley. At the time, he was part of a team preparing the big brokerage for the brand-new world of electronic trading at the soon-to-be-launched International Securities Exchange. Flash forward seven years and Morgan Stanley is one of the largest options dealers in the country, and one of only seven primary market makers or specialists at the hugely successful ISE.
As for Brennan, he’s at it again. This time it’s at Automated Trading Desk, a successful equities wholesaler. ATD hired Brennan last year to build its options market-making platform and steer the firm into the business.
The difference between then and now is that now the game is a whole lot harder. “The players aren’t all new anymore,” Brennan tells Traders Magazine. “That used to be the case. Today you have to be a little smarter. The competition is tough.”
In 2000, when Brennan was working with the quants and systems professionals at Morgan, the barrier to entry was high from a systems-and-cost perspective, he explains. But it was “not nearly as high from an intellectual capital perspective.”
“Today you must have a very solid idea of what you are using your prices for,” Brennan says of quoting, “and offer a value-added proposition. And I believe that is what ATD will offer.”
Hired Gun
Brennan is something of a hired gun in the options industry. Since leaving Morgan Stanley three years ago, the former trader has taken the lead in the options initiatives at three small shops.
His first stop after Morgan (where he spent a total of 17 years) was Citadel Executions Services, the broker-dealer arm of the large hedge fund. He joined the Chicago-based firm in early 2004 and focused on the business end of things, dealing with exchanges and customers.
Then, in 2005, Brennan moved to a small institutional brokerage called Fox River Financial Resources, also in Chicago, where he spent six months working on the build-out of its automated options market-making platform.
He joined ATD last March and is now one of three executive vice presidents reporting to chief executive Steve Swanson.
Back in 2000, when Brennan first began building a trading system for Morgan Stanley, ATD wasn’t even a speck on the market-making landscape. It was a prop shop trading equities on electronic communications systems for a handful of investors out of offices in South Carolina.
In early 2003, though, it made its move, applying its trading and technology savvy to the business of making markets in Nasdaq stocks for retail brokerages.
The timing was not propitious. Decimalization had recently kicked in, cratering spreads and the profits of many old-line wholesalers as well.
But ATD persevered and eventually prospered. The 100-person broker-dealer is now one of the 15 largest equities trading houses, according to data from Thomson’s AutEx BlockDATA service and Nasdaq.
Rapid Climb
AutEx reports show ATD traded a combined 133 million shares in listed and Nasdaq securities per day on average in the last six months of 2006.
Those figures cover only trades in the top 100 securities, ATD says. Its broker-dealer unit is actually trading closer to 250 million shares per day in combined Nasdaq and listed flow.
In any event, ATD’s rapid climb stems from a growing roster of retail brokerage clients. It now counts over 100 customers, including some of the biggest discounters.
ATD handles about a quarter of Ameritrade’s listed orders (of fewer than 10,000 shares) and 18 percent of its Nasdaq orders. The wholesaler processes 12 percent of E*Trade’s listed orders and 8 percent of its Nasdaq orders.
ATD’s plan is to start trading options in the next few months and then register as a market maker at various exchanges sometime in the second quarter. It intends to enter the business of “routing,” or intermediating between order senders and exchanges, at the end of the year.
The firm is anxious to move beyond equities. The firm plans to build out a multi-asset class trading business using as its foundations its customer base and proven trading technology.
Options are the first step of a long journey. “This is part of our long-term strategy,” Swanson says. “We are targeting many, if not most, of the various asset classes.”
More Complexity
Options may look like just another tradable commodity, but success in equities does not guarantee success in options, industry execs say. Players must shoulder greater trading risks and deploy much more complex technology.
“The technology you need for options is dramatically more complicated than that for stocks,” says Bill McGowan, a managing director responsible for sales and marketing at Interactive Brokers/ Timber Hill. “That’s especially true of the algorithms supporting your smart order routing.”
McGowan says IB’s smart order routing technology outshines the competitions’ because of the way it holds “shadow” or duplicate copies of customer orders. The technique allows IB to quickly cancel and replace orders sent to one exchange if a better fill exists elsewhere.
Timber Hill is one of about half a dozen large market-making shops with ties to order senders that ATD will be going up against. Others include Citadel Execution Services, Citigroup, Goldman Sachs/ SLK-Hull Derivatives, and Susquehanna.
With the coming changeover to quoting options in pennies, rather than nickel or dime increments, many dealers say robust technology will become even more important.
Jay Knopf, a vice president with SLK-Hull, told attendees at last year’s Futures Industry Association October conference that the market makers of the future “will be the big, powerful firms [with the wherewithal] to put money into technology to make them fast enough to compete.”
ATD’s Swanson notes his firm cut its teeth in a decimalized world but acknowledges it faces technological challenges. “The automation we built in the equity marketplace doesn’t translate one-to-one to options,” Swanson allows.
Equities Expertise
Brennan notes that ATD must do more than just match its competitors’ offerings. Its added value, he says, will involve bringing “some of its equities expertise into this space for routing and order execution.”
A prominent aspect of that expertise is ATD’s predictive technology. Grounded in the science of market microstructure, ATD’s computers predict the direction of stock prices up to 30 seconds ahead.
“This will become a key component of our options pricing model,” Swanson says. “Most firms look at the underlying. We will be using our internal price prediction model.”
As for the risk, the increase on the options side stems from the fact that a dealer must hold positions for longer periods of time. In equities, dealers are often able to end each day flat, or without significant positions.
But with options they must often maintain positions for days or even weeks. That’s because of the way options contracts trade as they approach their expiration dates.
To cushion itself against any blows, ATD decided it needed to boost its capital base. The trading house toyed with the idea of selling itself to a large Wall Street firm, sources say. One interested buyer reportedly was Bear Stearns.
New Funds
ATD would neither confirm nor deny a possible sale. It did, however, drum up some funds. From Technology Crossover Ventures, a $4.7 billion private equity fund that previously financed Liquidnet, it accepted a $60 million investment.
“We look forward to a future as an independent firm,” an ATD spokesperson says.
ATD will not disclose how much of the firm TCV owns, saying only that TCV has a minority stake. For its investment, TCV will have one seat on ATD’s 11-seat board.
Not all of the TCV funds are earmarked for options. Part of the proceeds will be used to “simplify” ATD’s capital structure by reducing the number of classes of its stock. Part will be used for an expansion of its institutional equities business. And part will be used to cash out some of its shareholders.
With more change in its pockets, ATD is now ready to go. It plans to start trading options later this quarter or early in the second quarter.
The broker-dealer has permits to trade on NYSE Arca and the ISE. It also intends to apply for permits from the Chicago Board Options Exchange and the Philadelphia Stock Exchange.
ATD will not act as a bona fide market maker initially. Its status on the ISE and NYSE Arca gives it the right to post orders, hit bids and lift offers, but not partake of the benefits that accrue to registered market makers.
Sometime in the second quarter, it hopes to gain market-maker status. As such, it will operate as a so-called competitive or remote market maker, but not as a specialist.
Most options exchanges stratify market makers into two tiers. Specialists (aka lead market makers, primary market makers or designated primary market makers) inhabit the upper tier. There, the quoting obligations as well as the rewards are greater.
Competitive or remote market makers inhabit the lower tier. Their quoting obligations are less stringent, but their rewards may not be as great as those accruing to a specialist.
PHLX Program
By most accounts, the value of being a specialist has seriously diminished since 2005. That’s when the PHLX won approval from the Securities and Exchange Commission to set up its directed order flow program (see box).
To a large extent, the program transferred control over incoming orders from the exchange to the market makers.
It permitted order senders to direct their orders to specific dealers rather than the exchange, if they chose. On top of that, it gave market makers control over the disbursement of the rebates, or payments for order flow, due the order senders.
The PHLX’s move was quickly followed by similar actions at the two largest exchanges, the CBOE and the ISE. The overall effect has been to give second-tier market makers a leg up on the specialists and to partly reshape the options industry along the lines of the equities wholesaling business.
Second-tier market makers can now garner as much incoming flow, if not more, than specialists.
“In our role as a competitive market maker on the ISE,” says Matt Andresen, chief executive of Citadel Execution Services, “we trade more volume in some options classes than the specialist in that option.” Citadel is both a specialist and a competitive market maker on the ISE.
Directed order flow has been a windfall for market makers unable or unwilling to pay the often high fees required of specialists. At the ISE, for instance, it costs a minimum of $6 million a year to trade as a specialist.
“With directed order flow,” says Peter Kent, ATD’s chief operating officer, “you can become, in effect, a specialist while actually operating as a secondary market maker.”
ATD plans to become a router in late 2007 or early 2008. Its task then will be to convince a happy and growing customer base on the equities side to give it some flow on the options side.
“A positive for us,” Swanson says, “is that in many, if not most, of the firms with which we do business, the people who make the equities routing decisions are the same people who make the options routing decisions.”
ATD’s future competitors believe that might not be enough. “They have an account base,” Interactive Brokers’ McGowan says of ATD. “But they have to remember that their clients already have an options relationship someplace.”
“If their platform isn’t equal to or better than the one they have already, why would they move? It all hinges on the technology,” he adds.
ATD’s Brennan concurs. “In order for me to get their options flow,” he says, “I must have a product that does not just match the competition. That’s not reason enough [to switch].”
The exec won’t divulge specifics but emphasizes that many of the concepts used in equities are transferable to the options business.
“We’ll make the options router and execution more robust with the logic that comes from the equities side,” Brennan says. “By mid-year, we’ll have a better understanding of the options market. Then we can figure out ways that best marry the right features of equities with options.”
Philly’s Watershed
Specialists aren’t so special anymore in the options world. In 2005, the Philadelphia Stock Exchange won approval from the Securities and Exchange Commission to institute a so-called directed order flow program. The move, to a large extent, transferred control over incoming orders to market makers and away from the exchange.
Traditionally, order senders routed their orders to the exchange, which would then pass them on to the appropriate specialist (assuming he was quoting the best price).
The specialist would be entitled to trade against up to 40 percent of the order. The balance would be split among competing orders.
Under the PHLX’s new scheme, though, order senders can direct their flow to a specific market maker. That dealer-if he is at the best price-then gets to trade against 40 percent of the order.
The program made it possible for non-specialist market makers to grab more of the flow. By setting themselves up in the “routing” business, they could act as intermediaries between the exchange and the order senders.
As routers they act as brokers’ brokers, taking control of the routing decisions for the order senders. The order senders, typically retail brokers, become their customers.
As such, they utilize the dealers/routers’ “smart order routing” technology to locate the best quote against which to trade. Usually, that quote ends up being that of the market maker handling the order.
The PHLX’s plan went one step further. In addition to giving market makers more control over incoming orders, it also gave them control of the rebate.
In the options world, exchanges collect a “rebate” from market makers and distribute it to order senders. It is, in effect, payment for order flow.
Previously, the market makers had no control over the disbursement of the rebate. Now they approve which order senders get the rebates. That ensures that their customers get their fair share.
The PHLX’s move meant that competitive market makers were no longer relegated to the leftovers of incoming orders. They didn’t need to become specialists to get first dibs on those orders. And they got control over the rebates.
The PHLX scheme was immediately taken up by the CBOE and the ISE, the two largest exchanges. The total flow now earmarked for specific dealers is unknown but said to be significant.
The effect has been to diminish the value of a specialist post and partly transform the options market into a competitive market-making system a la Nasdaq.
“The Philadelphia rule filing was a watershed,” says Tony Saliba, president of LiquidPoint, one of the few routing firms that does no market making.
