Regulatory requirements that dealers keep more capital on their balance sheets is squeezing options liquidity for institutional traders, who buy and sell the equity derivatives to generate alpha and hedge long- and short-term exposures in their portfolios.

“The regulatory environment is affecting liquidity and pricing for investors in option markets,” said John Burrello, senior trader at Invesco. “Basel III, Volcker, and Dodd-Frank have made broker-dealer balance sheet capacity more expensive – and that is being passed onto investors through wider bid/ask spreads and less capital commitment.”

The introduction of the leverage ratio – which has a target ratio of 3.0% under Basel III – is a hallmark risk-based capital requirement. Starting in 2015, banks will be required to disclose the leverage ratio, with a view to migrating it to a Pillar 1 requirement by 2018 after a final calibration.

Basel III will have a significant impact on banks and force changes in the way trading and prime brokerage desks operate. Although these measures are aimed at the banking sector specifically, repercussions will be felt throughout the network of market and counterparty relationships which make up the global financial system.

This is especially true for investors looking to hedge longer-term exposures, “because dealers have to tie up that risk on their balance sheets,” said Burrello. “It has also affected even short-term tail hedging, because dealer stress-tests account for potential capital needed to take the other side of downside tail events.”

At the same time, custodians and prime brokers have started asking clients to hedge tail risk more aggressively in order to avoid increased collateral requirements. “As in other markets, like treasuries and credit, equity options could potentially become less liquid as a result of decreased broker-dealer balance sheet capacity,” Burrello said.

Liquidity in the U.S. options market is fragmented across a dozen exchanges, with no options exchange clearly dominating the market. “Traders’ response to being traded around—having their order represented on one option exchange only to have trading occur on a different one—has been to leverage tactical algorithms that work orders,” according to a February 2015 briefing report by Bloomberg Tradebook’s Gary Stone, chief strategy officer and John Gardner, equity derivatives sales trader.

During 2014, Bloomberg Tradebook saw dramatic shifts in buy-side trader behavior as they tried to adjust to the changing liquidity landscape. “Traders were clearly taking greater control over their orders, trying new technologies and execution implementation strategies to get the liquidity they need,” said Stone and Gardner.

The biggest problem facing options traders is a lack of sufficient liquidity when they need to execute larger trades, with 42% of institutional firms citing a lack of liquidity as the biggest change in the options markets in 2014, according to Andy Nybo, head of derivatives research at Tabb Group and author of a report, “US Options Trading 2014/15: The Buy-side’s Insatiable Thirst for Liquidity.”

An upshot is increasing use of direct market access (DMA) and algorithmic tools. In 2014, asset managers routed 32% of their total contract volume through electronic trading tools, more than double the 15% proportion in 2013, according to Nybo.

Bloomberg Tradebook’s B-Smart was the most used algorithm in 2014 by U.S. option traders, according to Stone and Gardner, with almost 23% of all orders leveraging the algorithm’s liquidity heat-mapping and dynamic order posting/positioning capabilities to seek more optimal placement of orders on the most active exchanges.

B-Smart intelligently layers orders and posts liquidity simultaneously on multiple (most active) exchanges, they said. Additionally, when one exchange becomes active in filling an order, B-Smart will pull the child orders represented on less active exchanges and repost the liquidity on the more active ones.

Featured image by Galyna Andrushko/Dollar Photo Club