Although US equity markets are currently under the spotlight, due partly to the structure debate, the fact of the matter is that practices commonly found in the equity options market, like permanent specialist appointments, “complicated price improvement mechanisms” and “asymmetric” fees, are an even more relevant issue, according to Optiver, a global tech-focused trading firm that’s dedicated to enhancing the market.
Optiver adds that this is particularly the case for retail traders who are “forced to pay wider spreads than they would in a truly competitive market.”
During the last few years, commission-free trades are quickly becoming the norm for retail investors who are working with online brokers, Optiver added while noting that what makes this practice both possible as well as profitable is a market structure that “permits payment for order flow (PFOF).”
According to Optiver, the true or real price of these “free” trades is the “loss of best execution, market transparency and a market that favors wholesaler entities that provide routing and have an affiliated market maker (MM).”
While the PFOF debate or discussion focuses mainly on equity markets, an “overlooked” part of this issue is that the equity options market functions in the somewhat the same manner. It’s generally accepted that options are traded completely on-exchange “in comparison to approximately 52% of US equities,” the company added.
Although that’s “technically true,” in practice, the majority of retail equity options flow is “effectively locked up before it ever reaches an exchange,” Optiver explained.
The company further noted that this deviates from the “on-exchange and open for competition” narrative that our industry tends to promote. It also “inaccurately implies that maximum price improvement has taken place for an order, which in certain aspects the current market structure actually discourages,” the report from Optiver noted.
The company added:
“While it receives little attention, the majority (61%) of PFOF payments in 2020 – totaling $1.5 billion were related to options – not equities – trading. In addition, “marketing and contra response fees” are essentially another form of PFOF in the equity options space. The exchanges that charge these marketing fees understand the impact they have but are collectively unable to remedy this issue. This further skews the playing field, often forcing MMs without an affiliated wholesaler to pay a premium just for the privilege of providing price improvement for orders on-exchange.”
Optiver also noted that this structure “discourages” competition and “harms retail investors as they pay wider spreads than they would in a fully competitive environment.”
When wholesalers with an affiliated MM work cooperatively with retail brokers, they also have “a number of matching models to pick from that limit – or entirely remove – the ability of other market participants to compete for that flow,” the company wrote in its blog post.
As noted by Optiver:
“Just four wholesalers, all of which have an affiliated MM arm, dominate the market and collectively route an estimated 80% of the retail market. These firms also account for 84% of the specialist appointments on exchanges.”
Optiver realizes the potential benefits that wholesalers with affiliated MMs may offer to retail investors; MMs have the “expertise in option pricing while wholesalers provide the infrastructure to execute orders on behalf of retail brokers,” the company noted while adding that this relationship, however, “can only deliver the maximum benefit if there is genuine competition for these orders at the exchange level.”
Optiver also mentioned that this concentration and “lack of competitive pricing” results from an antiquated or outdated market structure “for promoting liquidity, competition and transparency.” With an effort led by the US Securities and Exchange Commission (SEC), the market structure may be properly updated and enhanced in several key ways, Optiver suggested.
Specialist Appointments
As mentioned in the blog post, the US equity options market structure has “evolved to tilt the playing field in favor of those who have achieved huge scale, not necessarily to those who provide the best prices.”
Although economies of scale are a part of any industry, “we have reached the point that healthy competition from new or existing MMs that focus on a handful of option symbols is nearly almost entirely excluded.” According to Optiver, this is particularly evident “by how exchanges reward breadth of coverage over all else for appointments of specialist.”
The company added that specialist appointments that are “made in perpetuity and guarantee significant order allocation for wholesalers/MMs who bring flow to an exchange – not necessarily those who provide the best pricing for the market.”
As noted by the company, tiering of MM fees, incentives, and specialist appointment processes should be “more focused on rewarding those who make the best markets rather than those who have a routing wholesale arm and are simply present everywhere.”
The Regulation National Market System should be “re-evaluated to ensure it incentivizes the correct balance between competition and complexity,” the company added.
As mentioned in the blog post:
“In general, the price improvement mechanisms embedded within exchange matching models give far too much advantage to the wholesalers with an affiliated MM, allowing them to selectively make routing decisions to give themselves the greatest possibility of internalizing orders while minimizing the price improvement they provide.”
The blog further noted:
“Conduct a bi-annual review of all price improvement auction models available focusing on: the level of price improvement achieved, fee structures, heightened allocation guarantees and auto-match features.”
According to Optiver, these reviews are specifically designed “to ensure that PIMs allow the opportunity for maximum price improvement to be achieved rather than to serve simply as a means of guaranteeing the affiliated MM of a wholesaler interaction on orders.”
Because of the proliferation of options exchanges, there’s now “fierce” competition for order flow. That’s by “no means inherently an issue, but this competition – in conjunction with the leverage that the major wholesalers have by controlling so much of the flow – has resulted in an asymmetric fee schedule,” the company claims.
It also mentioned that market makers have been forced to pay PFOF in the form of “marketing fees to the exchanges, which distribute a portion of the fees as a rebate to wholesalers, subsidizing their payments to retail brokers.”
As stated in the blog post, market makers that offer price improvement over a wholesaler’s affiliated MM through the exchange’s PIM are “often charged an additional fee to trade on an order.”
As noted by Optiver:
“In the previously mentioned price improvement mechanisms, exchanges would often lose money on transactions if not for the fees charged to the MMs who provide price improvement and often do not have a wholesale arm.”
As mentioned in the blog, there are several ways to improve and “fix” the current equity options market that may result in a healthier, more transparent, and competitive marketplace with “better pricing for investors of all sizes.”
As the industry continues to weigh the advantages and disadvantages of PFOF, internalization, and related market structures, the equity options market “should be included in that discussion,” Optiver suggested.