After decades of sustained growth, volume in the US options markets has plateaued even as volatility has surged. A number of issues are to blame for the decline, including waning investor interest, the exodus of proprietary bank trading activity, and the growing complexity of market structure.
The fragmented exchange landscape is a primary driver of market complexity, as exchanges compete through innovative trading functionality to attract order flow from market participants. One of these innovations is the price improvement auctions, which allow retail investors to get price improvement. However, their success has created challenges for the long-term viability of US options markets.
New TABB Group research, “Price Improvement Auctions: Segmenting US Options Order Flow at the Expense of the Lit Market,” examines the impact of price improvement auctions in US options markets and reviews the unique characteristics of market structure that support their evolution. According to TABB, the success of price improvement auctions has created a bifurcated trading environment with a growing proportion of the most attractive paper trading in auctions never reaching the displayed market.
“Although auctions can help brokers get better pricing for investors, they also contribute to wider bid/offer spreads and are an important factor contributing to the exodus of market makers from the options business,” says Andy Nybo (pictured), report author and head of research and consulting at TABB. “Auctions also contribute to an environment where only the largest market makers with deep technology resources and control over order flow will survive.”
The volume of trading occurring in exchange auction mechanisms has grown sharply in recent years. TABB Group estimates that 11 per cent of all trading in single-stock options occurred in the auction mechanisms in 2015, more than double the total in 2012. The research explains that as retail flow is increasingly routed into auctions, order flow that ultimately makes its way onto public exchanges is considered to have less edge.
“Though there are many positive aspects of price improvement auctions, they come at a significant cost to the industry. Winners reaping the benefits include clients of retail brokers, consolidators and the biggest exchanges that are able to capture auction flow,” continues Nybo. “The loser is the long term health of the options market.”
