All eyes are on the US equity options market as exchanges and market participants evaluate the Penny Pilot. Some view the program as a great success, but there are still significant issues to be worked out.

Broader institutional participation, increased volatility, advancements in technology, remote market making and regulatory changes are driving equity options volumes to ever higher peaks. According to Aite Group, the US equity options market has grown at an annualized rate of 30 percent since 2000. Market volumes in Europe and the Asia-Pacific
region have grown at similar rates. This trend has exchanges around the world reevaluating their performance and capacity requirements.

Currently, all eyes are on the US equity options market as the exchanges and market participants come to grips with a program known as the Penny Pilot. Since the beginning of 2007, all six US equities options exchanges have participated in a test to see if pricing in one-cent increments would result in tighter spreads for investors and mitigate or eliminate certain market distortions that lead to inefficiency. At the same time, observers are interested to know the other knock-on effects of the Penny Pilot on the most competitive equity options market in the world and how the exchanges adapt to them.

The first phase of the pilot included 13 symbols – 10 equity options and three options on exchange traded funds (ETFs) – representing about 17 percent of the entire exchange traded volume of equity and index options. In September 2007, 22 more classes were added, bringing the total to 35, and 28 new names go live in March 2008.

Overall, trading volumes in Penny symbols have increased and spreads have tightened, but that has come at the expense of decreased liquidity as bids and offers are dispersed among more price points. This is a major concern for exchanges and market participants alike. Much of the growth in the equity options market over the past few years can be attributed to participation from institutional investors, for whom liquidity is critical. If these key players cannot execute size on the exchanges, they will use the OTC market instead.

Another significant effect of the Penny Pilot has been a massive increase in market data, and the rest of the world is watching to see how the exchanges cooperate as an industry to cope with it. Quote traffic in equity options is naturally higher than any other asset class simply because there are so many series. Even though the SEC required all exchanges to institute quote mitigation plans from the beginning, quote volumes have doubled.

The six US options exchanges send their best bid offer (BBO) to the Options Price Reporting Authority (OPRA), which merges this information into one feed to send out to the market. OPRA also calculates the national best bid offer (NBBO) and appends this information to the feed. In 1999 the message rate was less than 4,000 messages per second; now it stands at around 258,000 messages per second. Early in 2008 OPRA’s capacity will increase to more than 1 million messages per second, but at the rate quote traffic is growing, those limits will soon be tested. “Other markets around the world have a minimum price change of 0.01 on equity options. However, they do not have an NBBO system where all quotes are consolidated into one national feed,” says Wayne Arden, Senior Vice President, Americas, at OMX. “The US markets for equities and equity options are extremely competitive because there are multiple exchanges competing simultaneously in one consolidated market tick by tick. Many countries only have one exchange trading equities or equity options, although in Europe MiFID is increasing competition.”

US options exchanges generally do not compete primarily based on the instruments they list because basically they all list the same ones. One notable exception is the options on certain index products that are exclusively licensed to the CBOE and, therefore, are only traded on the CBOE. However, exchanges can gain market share through attractive pricing, combining related instruments into innovative offerings and creating nuances in trading models. They also can compete on speed of quoting, trade execution and liquidity.

The International Securities Exchange (ISE), for instance, has created a new depth of market product that enables investors to see bids and offers that lie underneath the BBO along with the size. The product, the first of its type on equity options in the US, is available on a subscription basis and shows the BBO as well as four levels behind the top of book. “The exchanges put the top of the book or the best bid offer through OPRA, but some investors want to see the bids and offers that lie underneath the BBO along with the size,” says Greg Maynard, System and Product Strategy Officer at the ISE. “Algorithmic traders in particular want more data and more frequent updates.”

Although some observers view the Penny Pilot as a great success, there are still significant issues to be worked out. Ultimately, the exchanges want to ensure the industry is doing the right thing for all their customers. An important part of that involves implementing sophisticated tools to ensure that capacity and performance can be maintained.

BY Sherree Decovny 

MarketView 2008:1