The dramatic growth in institutional
investors’ demand for options trading presents a
big opportunity for brokers, argues Chris Kelley
of Fidessa. But the market is changing
so fast that if they want to compete, brokers face daunting
technological challenges. The equity markets offer a partial
If you’ve been watching the cash equities market
structure in recent years, you might be experiencing a sense of
déjà vu. The listed options market now appears to
be following a remarkably similar path, giving brokers new
Much of the increase in options volumes can be attributed to
institutional investors, looking for both improved alpha and
risk management strategies.
But it is not just the investors that seem familiar. Market
fragmentation, penny pricing, the introduction of intermarket
sweep orders (ISOs) and the prospect of much tighter regulation
are all areas where the market for options appears to be
echoing the cash market’s recent past.
The economics of options trading are in flux. The transition to
penny pricing has resulted in much narrower bid/offer spreads,
smaller national best bid or offer (NBBO) quote sizes, and the
dispersion of liquidity across more trading venues.
There is virtually no payment for order flow in penny-priced
options. To keep this business profitable, brokers must find
ways to increase execution volumes without raising
Automate to survive
The fallout from the decimalisation of the cash equities
markets offers some useful survival tips. Early adopters of
automated solutions managed to remain profitable, despite
earning less per trade.
Sophisticated order management workflow solutions, seamlessly
integrated market access applications and electronic interfaces
to investors all allowed firms to operate more efficiently on a
The growing number of options exchanges mirrors the
proliferation of share trading venues some years ago. As
options liquidity becomes more diffuse, smart order routing
solutions that can quickly root out liquidity wherever it
resides become increasingly essential.
In the equities world, this once-rarefied technology is now
commonplace and it seems assured that the options markets will
follow a parallel track.
Another factor pushing smart routers on to options
brokers’ must-have lists is the recent
introduction of the ISO order type. Without ISOs, smart routers
are bound by the options market’s trade-through
rule, which effectively prohibits simultaneous access to
multiple markets at multiple price levels. With this
restriction now removed, smart routers are even more
Lastly, the emergence of an Order Audit Trail System-style
audit requirement for options seems likely. Even while this
remains uncertain, brokers’ increasingly
influential audit and compliance staff are requiring similar
information to be captured and stored for internal
The economic factors discussed earlier are driving the options
markets toward fully automated trading solutions; an OATS-like
rule for options would accelerate this evolution
These parallels with the cash equity markets offer valuable
insights to options brokers. However, the options markets also
offer some entirely unprecedented challenges.
The most obvious is the proliferation of complex orders.
Brokers are expected to execute each leg of these orders in
perfect proportion, even when one leg is an order for the
underlying equity. Brokers must also be able to accept and
record these orders – with the legs appropriately
linked – both verbally and via FIX, and then pass them
intact to floor brokers and electronic venues.
Even this level of sophistication around complex orders may
soon begin to look old-fashioned. Increasingly, options brokers
are investing in their own legging technology, which allows the
broker himself to work each leg of an order individually on
whichever markets are optimal for that particular leg, while
still ensuring that the legs execute in proportion.
Options clearing workflows also pose unique challenges. Options
trades clear the next day (T+1), while cash markets are
At the same time, clearing member trade agreements, whereby
'multi-prime’ investors (those with more than one
prime broker) clear all or part of a trade with a broker other
than the executing broker, are commonplace.
What’s more, these multi-prime customers often
divide a single trade among several CMTA brokers, and all
involved parties (executing brokers, clearing brokers, trading
venues) must have the same understanding of the trade mechanics
to avoid a break on T+1. When such arrangements are used for
complex orders, the clearing challenges are
Yet the traditional tolerance for breaks resulting from these
intricacies is rapidly eroding in the face of shrinking
per-trade margins and investors’ mounting service
demands, further driving the need for front-to-back
The options markets are evolving rapidly on many fronts at
once, and brokers could be forgiven for being daunted by the
pace of change and its technological imperatives.
However, the time is ripe for ambitious brokers to establish a
firm foothold in a market that continues to grow in value. An
awareness of the history of the cash markets, an appreciation
of the singularities of the options markets and an appetite for
meeting the growing demands of clients across both of these
asset classes are the prerequisites for success.