With the U.S. options-exchange field poised to add two more venues to reach 14 by year-end, some market participants are wary of how the fragmentation will stretch already-challenged liquidity.
Simply put, more exchanges for orders to be routed to means a lower likelihood of the coalescence that’s necessary for institutional traders to buy or sell large options blocks efficiently.
“The increased number of exchanges has decreased liquidity quite a bit,” said Ali Agboatwalla, head of single-stock equity derivatives trading at Bank of America Merrill Lynch. “Now instead of a central pool of liquidity around three or four exchanges, you’ll have 14 option exchanges that stream 10 lots or one lot. Liquidity for size, which is where institutional investors come to play, is just not there at those price points.”
International Securities Exchange’s Gemini exchange launched in August 2013 as the 12th venue for U.S. listed options. Competition will ratchet up further when ISE’s Mercury and a new Bats Global Markets exchange open for business.
Dispersed liquidity pools have squeezed options market makers, some of whom have changed tacks. The dynamic has “caused a lot of market participants to shy away and not transact in the listed market any more,” Agboatwalla said. “As a result, people are more comfortable transacting over the counter, instead of listed, because liquidity for size is just not there. You're not leaving a footprint in the market, and it gives you the ability to trade over a long period of time, rather than instantaneously.”
To be sure, an expanding exchange universe isn’t the only factor that has thinned liquidity outside of the top 50 to 100 options names. One structural issue is the decimalization of the market and the narrowing of spreads to as little as one penny, which has reduced market makers’ profit margins.
“Another issue, and this is cyclical, is that because of zero interest rates in the U.S., volatility has compressed massively,” said Paul Baron, head of AMRS derivative flow sales at BoAML. “For investors who use volatility as a medium of equity risk premium, this means they're not necessarily selling it any more to generate yield.”
“There are institutional investors, called overwriters, who use elevated levels of volatility as a way to source income, or to generate yield for their portfolios,” Baron continued. “Because of the fact that volatility levels are quite compressed, there has been a lack of supply recently from the overwriting community.”
Going forward, the options-liquidity outlook is expected to remain challenged, especially as new exchanges go live. “I can't foresee a radical shift in liquidity,” Baron said. “If anything, as investors become more sophisticated and algorithms become more sophisticated, there are unintended consequences regarding the depth of liquidity due to technical advancements on the algorithmic side.”
Said Agboatwalla, “we don’t see anything changing.”
Featured image by Hortigüela/Dollar Photo Club
