In January, Amsterdam-based pan-European trading platform, The Order Machine (TOM), began trading options based on the AEX-Index, using its own smart order router to compare prices, putting the firm head to head with NYSE Liffe Amsterdam. It comes just a year after TOM launched with a handful of single stock options, which it expanded in October to all major Dutch stocks.
During 2012, TOM took 15% market share from competitor exchange, NYSE Liffe in Dutch single stock equity options listed on both markets. Chief executive officer, Willem Meijer believes this is just the start: “We are the first MTF to challenge the incumbent in the options area and we expect market share in options to reach 30% to 40% by the end of the year [sic]. We know this because we know our client base and our figures are based on the volume currently done by our clients on Euronext. Turnover will move to us.”
It is tough talking. Nonetheless, while new platforms will face a tough job to unseat the top two exchanges, Eurex and NYSE Liffe—the AEX-Index option, already accounts for half of all index option volume on NYSE Liffe. “For the first time, incumbents should not take the new competition lightly,” says a new report from Celent. Eurex traded 765.6m equity index contracts in 2012, down from 954.7m in 2011, but still retains more than 60% of the market. NYSE Liffe in Amsterdam, Paris and London combined accounts for a further 22%, while NASDAQ OMX traded 46m contracts in 2010.
Meijer believes MTFs will take over more options market share from incumbent exchanges than they have done in equities, but he says if an MTF took market share of above 50% the incumbent exchanges would feel the burden of their vertical silo clearing models. “All of a sudden, it might be to their advantage to create an “open” open-interest pool. As soon as real competition opens up and there is a chance of losing market share, then change will come.”
One difference between the Amsterdam model and other countries’ lies in the amount of retail flow which is traded. In the Netherlands, retail flow makes up 25-30% of NYSE Liffe trading. Meijer believes that as retail flow is captured on TOM, professional market makers will follow.
The length of maturity and risk of an option will also have a bearing on where an end-user takes a contract. Ade Cordell, executive director, head of equity derivatives, NYSE Euronext, says: “We believe that end users are more inclined to place options that have lengthy maturities, say the FTSE five-year index option, on trusted established platforms rather than on MTFs.”
BATS Global Markets, which famously launched with a loss-making strategy, opened an options exchange in the US in 2010, but in Europe, BATS Chi-X Europe is still eyeing demand before it decides to move into listed equity options. Turquoise, the London Stock Exchange’s MTF, has both an equities and a derivatives platform, trading single stock, index and dividend derivatives based on pan-European and International Order Book equities.
Of the larger exchanges, CME Group confirmed in August it will introduce other asset classes after it launches CME Europe to trade FX products and CBOE is to establish a futures hub in London later this year. ICE, the Intercontinental Exchange, is buying NYSE Euronext for $8.2bn, with NYSE Liffe, the London International Financial Futures and Options Exchange, the jewel in the options crown.
ICE has its own London-based clearing house—ICE Clear Europe—which NYSE Liffe will move clearing to. Bystanders believe the merger will have implications throughout the derivatives industry including options as equity volumes continue to shrink and as diversification offers new revenue streams.
Furthermore, the NASDAQ OMX purchase of TOM, as it expands its shareholding to 50.1% in the future, is expected to lead to technological innovations in equity and options trading with low latency connectivity and greater order-processing capacity.
In spite of a 36% compound annual growth rate in the value of listed options globally between 2009 and 2011, latest figures from the World Federation of Exchanges show that for the first time since 2004, the number of on-exchange equity derivatives contracts traded in 2012 fell by 20.4% to 14.9bn. The WFE pins the probable blame on the ‘significant’ decrease in volatility during the year. Volumes tend to be positively correlated with volatility and last year saw a sharp drop in the Chicago Board of Options Exchange Volatility Index (VIX), closing down 26% year-on-year. The drop also mirrors a decline in electronic order book share trading, down 22.5% among its members.
Gary Wishnow, managing director, derivatives sales and trading, Rosenblatt Securities, says: “Equities has seen three straight years of falling volumes, but I would be surprised if we saw another drop in the US options market. Any bump in volatility, whether driven by the Fed raising interest rates or other macro events, should result in increased activity and that should once again return the options market to its pattern of year-on-year gains.”
Europe made up 10.2% of global options volume of 14.5bn contracts in 2011, according to TABB Group. Compare the US, which then had a 47.1% market share and its biggest year on record. Last year it drew breath slightly as ADV slid 12.5%, but still recorded its second biggest year with 4bn options contracts traded. Indeed, while the US market experienced a 19% compound average growth rate in the decade to 2011, Europe’s CAGR was just 6%.
In Europe every market is different from its neighbour. With little multiple listings of the same option and little liquidity in some options, traders are led to pick up the phone and trade OTC. In fact three-quarters of trading in Europe is OTC, with just 25% on exchange. In the US which has 11 options exchanges, the figures are reversed.
While options trading has more variables—strike price, put, call—unlike a straightforward cash equities transaction, technology is ready for electronic trading, says Des Peck, head of product at technology firm TMX Atrium: “A lot of the information required to calculate and trade, already exists within existing mathematical functions such as deltas and gammas. So you can set up a strategy using combinations of individual elements. We will see an increase in electronic trading of options.”
Currently, European investors conduct 10% of listed equity options trading in the US, according to Andy Nybo, principal and head of derivatives research, TABB Group. In his paper, European demand for US listed equity options, he finds they are drawn by the attractiveness of using centrally-cleared exchange-traded instruments, reduced counterparty risk, deeper liquidity, broader participation; transparency and depth of market as well as tighter spreads.
While the strength of the US market is not about to be overturned any time soon, 90% of those interviewed by Nybo did not think the development of the European options markets and alternative instruments would make any impact on US flow. Even so, the European options market is changing, led largely by changes in the clearing space.
As new EU regulations force ‘eligible’ derivatives on to trading platforms and standardised over-the-counter (OTC) options to central clearing, competition will come into the clearing space, although not before mid-2014, according to latest estimates from the European Securities and Markets Authority (ESMA) with implications for infrastructure developments. The ‘vertical silos’ in Europe mean that trading an option on one exchange will bind the trader to that exchange for clearing and for returning at expiry. “This can consolidate liquidity, but it stifles competition and innovation,” says Nybo.
As options move on to exchange, technology vendors are gearing up to deal with the new world. TMX Atrium’s managing director, Emmanuel Carjat, says: “Technology is needed to measure exposure to risk. So much OTC is stored on paper or Excel spreadsheets in a bank. So regulators want an overall transparent view which is part of the reason for the move to interoperability of clearing houses.”
Gary Delany, European director, Options Industry Council, believes it will be the speed with which clearing houses react to the new rules which will determine how fast options catch up: “Clearing houses are starting to make progress on interoperability, but progress takes time. Also, most clearing houses in Europe are owned by exchanges and thus generate an important income stream. The more clearing houses involved in a trade, then the higher the capital commitment tends to be if there are no offsets available. Conducting a multi-asset trade using multiple clearing houses will require more capital than if just one clearing house had been involved.”
In this situation, cross-margining is becoming critical, according to Peck. “We are seeing regulators saying you must hold sufficient margin in place to do the trade. If this is a multi-asset trade and if you are able to clear on multiple venues you can post less margin under cross-margining. So, trading participants are very keen on this.”
Carjat adds: “We are seeing a convergence of the technology which initially was quite different in terms of venues and software to represent the evolution and pricing of instruments. We are seeing more and more multi asset strategies. So you have a number of platforms starting to provide multi-asset classes so they can respond to the needs of clients. It’s critical that you don’t have to move to another screen if you are operating arbitrage strategies and if you have one leg in equities and one in options. At the back-end you want to be able to connect to venues in a similar fashion.
Several trends could come together to drive the options market this year. First there are more asset managers using options. In the US, for example, they accounted for one fifth of the listed options markets in 2011, compared to 5% in 2006, according to TABB. This growing demand for options will accelerate as the buy side continues to use options for risk management and exposure.
Another trend is the growing use of weekly expiration options, which made up 8.3% of all listed equity options volume in the US in 2011 with peak months of just under 12%. Volumes of S&P 500 weekly options, the most actively traded index options in the US, grew by 270% compared to 2010, and accounted for 10% of the average daily volume of all S&P 500 options.
Shorter duration options, some with a daily expiration date, are expected to pick up in popularity as exchanges expand their lists. NYSE Liffe, for example offers daily options on the AEX index. It also offers weekly contracts on a number of blue-chip stocks.
Furthermore, the International Securities Exchange, ISE, has confirmed it will start trading mini-options on March 18th, 2013. Mini options represent 10 shares of the underlying stock, whereas standard contacts usually represent 100 shares.
Although some believe short-term and mini options are too speculative, Wishnow is more positive: “These initiatives may help stop the drop in volume and encourage new entrants into the options market place, including retail participation.”