Market Makers and Their Perceptions of U.S. Listed Options Markets Andy Nybo, Burton-Taylor International Consulting 11 February 2019 With 15 options exchanges fighting for order flow, market makers are forced to spend considerable resources to manage operations, ultimately eroding their profitability. Some of the largest market making firms spend more than $50 million annually to maintain an edge over rivals, and these costs are only expected to continue their meteoric rise. US option market makers have seen their fair share of challenging market conditions over the past decade and although recent volatility has provided tailwinds to their trading activities, they still face numerous challenges that ultimately erode profitability. The primary challenge is the complexity of options market structure, with 15 exchanges fighting for order flow that forces market makers to spend considerable resources to manage operations. Managing risk exposure has become paramount, especially as access to capital impacts all but the largest market making firms. Liquidity is not only fragmented across the 15 exchanges and close to a million different series but access to the most profitable order flow is restricted as exchange auction mechanisms lock up retail order flow. The complexity can only be managed through the judicious use of technology, which forces market making firms to allocate significant resources to stay competitive. Some of the largest market making firms spend more than $50 million annually to maintain an edge over rivals, and these costs are only expected to continue their meteoric rise. And no surprise, market data remains a hot button, especially for firms with a broad presence across multiple exchanges and asset classes. A 2019 Resurgence? But not all is doom and gloom. Market makers are enjoying the resurgence of market volatility, especially as option trading surged in 2018, with volume reaching a record 5.2 billion contracts. Profits are on the rise and trading opportunities remain bright, especially as volatility remains a constant. Market makers are also generally in a good spot with improvements to market structure over the past year. Risk protections implemented by the exchange industry are lauded as a key structural improvement, with the ability to manage exposure across the fragmented liquidity landscape a key factor facilitating their ability to quote, both more aggressively and in greater size. Market makers are also seeing benefits from exchange consolidation. Even though there may be 15 – soon to be 16 – U. S. option exchanges, the acquisition of ISE by Nasdaq and Cboe’s acquisition of BATS have concentrated the exchanges under 5 holding companies. And although the technological mechanics of participating on 15 different exchanges is complex, the consolidation has benefited market makers by helping lower costs. Connecting and managing relationships with a holding company operating multiple exchanges is simplified, especially when connectivity becomes standardized across all the exchanges within a holding company. Exchanges have also become more attuned to the needs of market makers, working more closely with these firms in order to build the tools and systems that best supports the changing market landscape. Exchanges and market makers are working in partnership to build in market improvements, with a stronger and more resilient industry the end result. Technology Reigns Supreme The options market has seen significant structural shifts over the past two decades, all of which can be traced back to 1999, when the International Securities Exchange (ISE) launched the first all-electronic options exchange. The launch initiated a new age of trading in which technology became essential to support not only the activities of an exchange but also the activity of market makers and broker-dealers. Other notable events included the introduction of penny increments and maker-taker pricing in 2007 and the expansion of multi-listed weekly options in 2010. Each of these developments reinforced the need for technology and set the stage for a new era in options trading. Exchange operators were quick to realize the potential opportunities in the new market structure, with more than 10 exchanges launching since 2004. Each exchange seemingly offered new and better ways to trade. The end result, however, is a market structure that is strife with complexity, with the interconnected network of exchanges creating both challenges as well as opportunity. The challenges are many. Successfully navigating the options market requires considerable technical chops, for both market makers and the exchanges that are the backbone of the industry. The most successful market making firms remain focused on the advantage of speed. Not only in analytics, price calculations and market models but also in terms of access. Getting in and out of the markets faster than the competition has become critical to success. [Related: “Aiming to Capitalize on a Shifting Liquidity Landscape? Think About Your Platform”]