Dark pools in options aren’t allowed, but that hasn’t prevented new crossing mechanisms that enable liquidity seekers to connect with liquidity providers from launching. Indeed, it has forced wannabe institutional liquidity pools such as Ballista and 3D Markets to work within the current options framework.
“It’s another step toward the equity markets,” said Jon Werts, head of broker-dealer sales for options and equities at Merrill Lynch. “These firms have taken some of the equity practices like crossing and internalization and are trying to chip away at the options market today.”
The firms know their limits. “For Archangel blind-bid negotiated trades, we work within the existing rule set to execute the trade on an exchange,” said Jeromee Johnson, president of 3D Markets. Archangel is the name of 3D’s crossing platform. The firm, which launched in February, brings paired trades mainly to the Chicago Board Options Exchange, International Securities Exchange and Boston Options Exchange, all of which have electronic crossing facilities.
3D and Ballista are both designed for block transactions. If a match results, the crosses will be brought by the platforms’ respective broker-dealers to options exchanges for execution. Unlike equities, the options market does not permit trade reporting facilities, making the internalization and printing of trades impossible. All options cleared by the Options Clearing Corp. must transact on an exchange.
3D’s “blind-bid auction” mechanism for large single-name trades has a minimum order size of 5,000 contracts for near-expiration and at-the-money options. Ballista, which focuses on complex block and delta-neutral volatility trades, has a minimum requirement of 500 contracts. The average execution size on exchanges is around 20 contracts.
These firms are variations on existing facilities at brokers such as BNY ConvergEx LiquidPoint and others that seek liquidity for customers and bring those crosses to options exchanges for execution. The two startups say they’re fully electronic and intended solely for block orders, but options players say that may not be enough to generate liquidity.
Anthony Saliba, president and CEO of LiquidPoint, BNY ConvergEx’s options trading subsidiary, notes that these firms have a long road ahead. “The notion that there’s lightning in a bottle, you push a button and energy is created is unrealistic,” he said. He added that his firm’s HEAT platform, which launched in 2002 and is used to find liquidity for single orders, spread trades and volatility trades, already pings the “value engines” of dozens of liquidity providers to find contra-side flow.
Robert Newhouse, CEO of Ballista, said he founded his firm last year “because of changes we saw happening in the [options] landscape” that made it easier for electronic crosses to transact on exchanges. “The equities markets were revolutionized in 1996-1997,” he added. “Options are ready to receive some of those automated technologies.” Ballista, which expects to launch this month, pending regulatory approval, plans to submit trades to the CBOE and ISE.
One constraint that platforms trying to put up prints face is that they are dependent on exchanges. “Their success is dependent on the rules, regulation and technology at the exchanges,” Merrill’s Werts said.
Crosses can get broken up at exchanges, since they must be exposed to the crowd-in these cases, usually an electronic crowd. 3D’s Johnson recognizes that this could be a turnoff for liquidity providers. However, he said, 3D’s crosses have so far lost no more than 5 to 10 percent of an order to electronic liquidity providers, which hasn’t been high enough to dissuade liquidity providers from using the system.
Interest in crosses has been growing, particularly with displayed liquidity shrinking. Exchanges have been keen to get crossing volume, and the platforms know they must work with the exchanges. The CBOE’s Ed Provost, executive vice president for business development, acknowledges that the “business initiatives of exchanges and brokerage firms like these cross at times,” but he says competition benefits the industry. “If those firms find willing parties to do a trade, ultimately they bring the trade to an exchange,” Provost said. “If we develop mechanisms to achieve the same objective, that’s good for us as well.”
Michael Khouw, a trader at broker Cantor Fitzgerald, speculated at an Options Industry Council conference in May that eventually “there probably will be some form of dark pool” in options. “There’s great magic if there’s one and we can send our liquidity into it,” he said, noting that too many could fragment the market and be a problem.
The idea of an options TRF, however, is a dicey topic, because of fragmentation concerns. The CBOE’s Provost doesn’t think the Securities and Exchange Commission is inclined to open that Pandora’s box. “If we define dark pools as mechanisms to help people find each other in an anonymous fashion, that can be a successful model in options, albeit the trade must go up on an exchange,” he said.
But if regulation changes, options platforms such as 3D, Ballista and others could be in the cat-bird seat, suggests Merrill’s Werts. “The [current] OTC networks exist largely via IM and phone calls,” he said. “If these firms have success in getting a lot of eyeballs on the screen, then they’re way ahead of the competition if regulation changes.”
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