In March, the Chicago Board Options Exchange asked the Securities and Exchange Commission to permit CBOE members to hedge an options position before actually taking on the position. The practice, known as "anticipatory hedging" or pre-hedging, has long been barred on the nation’s options exchanges due to concerns about front-running. Traders can hedge their options positions with stocks or other instruments after taking them on, but not before.
The CBOE argued that increased volatility and decreased liquidity due to penny trading combined with exchange exposure rules make it necessary to allow brokers to pre-hedge. If they can’t pre-hedge, they won’t bring their crosses to the exchange. They will trade them over the counter.
That’s the rub and that’s the main reason why the CBOE is trying to win an exception to its anticipatory hedging rule. More and more trading is being done away from the exchanges and in the over-the-counter market. The exchanges are trying to win back the blocks.
"The exchanges need to eliminate all of the obstacles that make the OTC market more attractive than the listed market," says Ed Tilly, a CBOE executive vice chairman. "The difference between the two should only come down to the SEC’s exposure requirement."
The exposure requirement means traders who wish to cross a paired order on an exchange must open up trading to all members. That’s a hurdle too high for many traders as exposure leads to break-ups, which impair the economics of the trade.
The exchanges have little choice but to remove obstacles if they want to continue to service block orders. Trading in penny increments, introduced in a pilot two years ago, has decimated size on the screen, driving money managers and their brokers to the OTC market to source liquidity. An expansion of the pilot that would likely drive more trades OTC is in the offing.
The over-the-counter market is a bilateral trading environment where brokers commit capital to facilitate their customers’ orders. Both parties to the transaction clear and settle their trades themselves without the involvement of the Options Clearing Corp., the central clearing organization owned by the exchanges. The market is controlled by a handful of large brokers including Goldman Sachs, Morgan Stanley and Citi.
The OTC market is half the size of the listed market, but is growing faster, according to data provided by the Bank for International Settlements and the OCC. At year-end 2008, open interest in the listed market totaled about $1.95 trillion in notional value, according to a report from Standard & Poor’s, based on OCC data. The comparable number for the OTC market was $986 billion, according to the BIS.
Growth in both markets has been swift this decade. The value of outstanding contracts on the listed side has jumped threefold since 2001 when notional value was pegged at $650 billion. On the OTC side, over the same time period, it grew nearly fourfold, from $265 billion in notional value outstanding.
OTC Blocks
Growth on the OTC side has come on the back of large institutional orders and at the expense of the listed market. Perhaps 20 percent of the volume in the listed market is traded in blocks, sources estimate. All of the volume on the OTC side is from blocks. A block is often defined as an order of 500 contracts or more.
While many trades are done OTC because a comparable contract does not exist in the listed market-so-called non-standardized contracts–most are done because the listed market can’t accommodate them.
"Over-the-counter trading of options has grown quite rapidly because of the lack of large block liquidity available on the exchanges," Rob Newhouse, chief executive at agency brokerage Ballista Securities, said at this year’s Options Industry Conference in Weston, Fla. "The exchanges are primarily a retail development."
There can be significant liquidity displayed at the top of the book in the popular contracts, but size at other price levels and strikes tends to disappear when large orders enter the market.
The liquidity problem has been exacerbated since the industry began trading 63 series in penny increments in the past two years. About half of industry volume is now traded in penny increments. The move has cut spreads, and therefore, costs on small orders, but decreased size at the inside.
"There is a tremendous amount of on-the-touch liquidity," said Armando Diaz, Citi’s head of franchise trading, "but all the other price points and all the other strikes adjust immediately to any kind of inline trading. All the near-term liquidity evaporates or freezes until everybody looks around."
Diaz added: "Unlike stocks, which ratchet up or down gradually in the price-discovery process, options are more binary and sudden in their price discovery. They clear on the touch or trade to that level."
Matt Andresen, the former head of options market-making houses Citadel Derivatives, seconds Diaz. "Liquidity is gone once the market maker vanishes," he told Traders Magazine. "You can only get it at the touch. So even though people say liquidity is at those other price points, it will vanish when a big order comes in."
Some brokerage executives maintain that algorithms and smart order routing are the answer to the large lot trader’s dilemma. By feeding a large order into the market in small pieces, traders can move size without impacting price.
While some traders say it’s impossible to trade options without algorithms, they caution that the technology is no silver bullet. Due to the nature of price discovery in options, trading large blocks via algorithms is a slow process, they say.
"If you need to trade 10,000 to 20,000 contracts," Michael Khouw, a trader at Cantor Fitzgerald, said at OIC, "you’re not going to do that on the screens, and you will also have a hard time doing it algorithmically because of the impact on the market."
Khouw explained that algos work in the equities market because a trader can pull back and wait for prices to adjust if he believes he is affecting the price of the stock. That doesn’t happen in options, where "if you start to have an impact, you’ve just set the new level; and if you continue to interact with it, you are just going to set new levels."
Crossing
With exchange liquidity under siege it is perhaps natural that executives view crossing services as their diamonds in the rough. Just about every exchange now offers facilitation and solicitation cross mechanisms that enable upstairs traders to cross their paired orders.
Most of the crosses hitting the exchanges are facilitation trades or layoffs of facilitation trades where the broker commits capital to get the trade done. They contrast with solicitation crosses, which accommodate agency orders.
Much of the business comes from interdealer brokers such as MF Global, GFI and ICAP’s Linkbrokers. The firms service the bulge shops eager to lay off their positions.
The International Securities Exchange, tied neck and neck with the CBOE for the title of the largest options exchange, is considered the leader in the electronic crossing of large orders. It launched a solicitation cross in 2002 and a facilitation cross in 2004.
Boris Ilyevsky, Managing Director of ISE’s options exchange, says exchanges must target the facilitation trades if they are to gain any ground. "Any tug-of-war between the exchanges and the over-the-counter market has to do with the exchanges’ ability to accommodate trades that already have capital committed to them," he said.
The CBOE won’t divulge what percentage of its volume it crosses, while the ISE will only say it’s in the double digits. Executives at those exchanges acknowledge, however, that it is not an easy task to increase crossed volume. Due to the quote-driven nature of options trading and SEC rules, the advantage is with the over-the-counter market.
"The current regulatory framework for executing these types of trades on exchanges is very restrictive," Ilyevsky said. "We could come up with the right formula to make exchange trading more attractive in this area, but securing regulatory approval could remain a barrier."
To win crosses away from the OTC market, exchanges must somehow overcome a fundamental difference between the two markets. In the OTC market, trades can be kept private. In the listed market, they must be exposed to the crowd.
That fact stops a lot of brokers cold. They fear exposing their orders to the crowd because of the lost anonymity, the related information leakage and the possibility the trade will get broken up. (Also, when crossing a customer buy order with a customer sell order, they risk losing one of the two commissions if another participant steps up.)
Traders doing facilitation trades find the risk of a breakup unacceptable because it means they don’t know how much they will get. If they don’t know for how much they will be able to participate, they don’t know how much to hedge.
"The current exposure rules provide too much information to the market about orders that already have a capital commitment," Ilyevsky explained. "This provides an incentive to simply cross the order OTC."
Quote Driven
The exposure rules are the SEC’s rules, not the exchanges’. And although they are problematic for block traders, they are welcome and necessary in the options market, the CBOE’s Tilly said.
That’s because the options market is quote-driven, and not order-driven like the equities market. Quotes are supplied by market makers continuously and on both sides of the market. If brokers could exclude them from their crosses, market makers would not risk their capital to win trades.
"We applaud the SEC requiring the exposure," Tilly said. "It provides the incentive to competitively quote."
Nevertheless, the options exchanges did take steps last year to shorten the exposure period. Until last December, a cross was required to be exposed to the crowd for potential price improvement for three seconds. In December, that window was cut to one second. Exchange officials say they have no intention to lower it any further.
In recent years, the CBOE has been perhaps the most aggressive of the options exchanges in its efforts to win block crosses away from the over-the-counter market. Its efforts have not always been successful, but it keeps trying.
No Dent
It introduced FLEX ("Flexible Exchange") options in 1993 and is now one of four exchanges that offers the contracts. FLEX options make possible trading at non-standardized strike prices or expiration dates.
FLEX options target OTC "look-alike" contracts, or those contracts that are the same as or similar to standardized contracts. They represent a significant portion of the volume done OTC, sources say.
The contracts have yet to make much of a dent in the OTC market, but recent changes pursued by CBOE and approved by the SEC could make them more popular.
According to Tilly, the contracts have never gotten much traction because exchanges have not been able to offer certain expiration date features that customers can get in the OTC market. Until recently, the SEC would not allow the CBOE to offer expiration dates two days before and two days after the traditional expiration Friday.
That changed in March, when the SEC removed the "blackout" dates. "There is now one less reason to have to go OTC," Tilly said.
In addition to its proprietary products, the CBOE is striking deals with third parties to try to crack the block market. The announcement last year of a partnership between the CBOE and the operator of an electronic crossing facility was greeted with much interest. So far, though, little has come of it.
The CBOE and the two-year-old Pipeline Archangel, formerly 3D Markets, announced their intention to offer crosses in one of the exchange’s auction mechanisms based on the so-called "gamma-weighted average price" (or GWAP) benchmark.
The two organizations hoped to mimic the success of the VWAP (volume-weighted average price) benchmark in the cash equities market. GWAP is similar in concept to VWAP. It gives traders a price to meet or beat, offering them a level of confidence in their trading.
The CBOE and Archangel signed a deal in May 2008, but the project has yet to get off the ground. Sources say the SEC has yet to sign off on the idea of a GWAP benchmark for options trading.
Still, many believe the development of a price benchmark for options trading holds promise. It could stimulate more options trading by traditional money managers, industry sources say. Currently, institutional trades are mostly done by hedge funds.
"I’m not predicting they have the mousetrap that will change the world," a sales trader told Traders Magazine, "but I do think the market is ripe for somebody to come through with a breakthrough. With Pipeline/3D, the potential breakthrough is GWAP. Now you have a benchmark you can measure your traders against and a venue that provides that for you."
Dave Mortimer founded Archangel and continues to run it under Pipeline. Yet despite the sale to Pipeline, he does not foresee a big shift in trades away from the over-the-counter market. Mortimer believes traditional asset managers will eventually drive the options market but said at the Options Industry Conference that "the industry as a whole is doing nothing to keep these guys here. They trade OTC. They can go OTC anytime. Trying to bring them back is hard."
He blamed the exchanges for their intransigence. "We’re not making the market easy for [the buyside]," he said. "They are doing creative structures and neat things in the OTC space. We aren’t."
The CBOE’s Tilly, however, is still optimistic that innovative electronic trading mechanisms that bring crosses to the exchange can work. He told attendees at this year’s Securities Industry & Financial Markets Association market structure conference that the CBOE was "in favor of encouraging ‘gray pool’ technology or off-exchange pinging for liquidity, if that is what we are lacking in a transparent marketplace, and being able to expose the orders on the exchange via an electronic mechanism."
Tilly told Traders Magazine that technology from agency brokerage BNY ConvergEx’s LiquidPoint operation and the relatively new Ballista show promise.
LiquidPoint, whose core product is an order routing network for brokers, offers a service that transmits indications of interest throughout the network, seeking to elicit buy and sell orders. When matches are found, the orders are sent to the exchanges’ electronic auctions for a cross.
For its part, Ballista is essentially an electronic IDB that matches multi-leg volatility orders laid into an open book by bulge brokers. It then transmits the order to an exchange for a cross. Ballista promises cheaper and more efficient trades through the use of technology. Its goal is to replace the IDBs whose methods it views as outmoded.
Pre-Hedging
Despite their promise, products and services such as Ballista, Archangel and Flex contracts are still only a means to bring crosses to the exchange. Once there, the brokers representing those orders must contend with exchange rules. That’s why changes such as the CBOE’s anticipatory hedge proposal are critical to any successful campaign to wrest orders from the OTC market. If crossing on the exchanges continues to be a hassle, then exotic order-capture services may not help.
The CBOE says SEC approval of its application to allow anticipatory hedging is imminent. That’s despite the fact that one of the exchanges tried and failed to win over the SEC on the issue once before. In 2003, the Philadelphia Stock Exchange (now Nasdaq OMX PHLX) sought to win approval of anticipatory hedging, but withdrew its proposal.
It’s also despite a letter of protest the ISE wrote to the SEC. The CBOE’s rival called the practice front running. It told the regulator it gives the hedger an advantage over others in the crowd, which "results in less competition and worse prices for customers." In using the underlying security to hedge, the ISE said, the broker might also move the price of the security. That would then impact the price of the option, leaving the customer with a worse price.
Tilly is undaunted. He says the CBOE addressed those concerns with the SEC. Permitting anticipatory hedging, Tilly said, "will eliminate one more hurdle in getting orders from the over-the-counter market to the listed market."
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