This article first appeared in the magazine of the STA’s 84th Annual Market Structure Conference, which was held Sep. 13-15 in Washington, D.C.

For exchanges, trade handlers and technology providers, the U.S. options market recently has been the equivalent to a three-star restaurant review on Yelp: the meal was okay, it had its moments and there was no big problem, but overall it wasn’t anything to get excited about.

The issues keeping options from four or five stars have been pretty much the same for several years now.

Flat volumes. A fragmented marketplace. Liquidity challenges. Subdued market volatility. Increased operating costs.

“A lot of people are in bunkers,” said Paul Jiganti, managing director at electronic market maker IMC Financial Markets. “If you’re not trying to acquire or be acquired, you’re just trying to shore everything up until there’s a more lucrative marketplace.”

Average daily options volume for the first half of 2017 increased 1% to 16.6 million contracts, according to OCC. Numbers for the preceding full years are strikingly similar: 16.4 million contracts per day in 2015, 16.9 million in 2014, 16.3 million in 2013.

Optimists note the big picture, which is that options volumes remain near record levels reached in 2011. This means that the heady gains of 10-20% per year in the mid/late 2000s were not given back.

But much of the options build-out over the past decade was predicated on expectations that the market would continue to expand, at least modestly. So the flatlining of the past few years has put many market practitioners back on their heels.

“Niche firms should be doing okay, and the really big firms that have economies of scale are making a go of it,” Jiganti told Markets Media. “But the small, non-niche firms — the old-fashioned market makers — are having a rough time.”

Order Flow Wanted

Market makers are indeed feeling the squeeze. There isn’t enough order flow from end users to keep everyone busy; liquidity is dispersed over 15 exchanges, up from 10 five years ago; and an increase in systematic trading, as well as a persistent lack of volatility, have served to constrain profit opportunities.

Interactive Brokers Chief Executive Thomas Peterffy, a 40-year market veteran and a pioneer of electronic market making in options, was remarkably candid in explaining IB’s decision to exit market making by selling its Timber Hill unit to broker-dealer Two Sigma Securities.

“It’s been painful for me to see it deteriorating in the last few years,” Peterffy said in a March 8 press release. “But we do not have a choice in this matter. Today retail order-flow is purchased by large order internalizers and joining them would represent a conflict we do not wish to have. On the other hand, providing liquidity to sophisticated, professional synthesizers of short-term fundamental, technical and big data is not a profitable activity.”

On the flip side, Two Sigma Securities’ purchase underscored its own optimism that the options industry is worthy of investment. Aside from integrating the business and Timber Hill employees, TSS Chief Executive Thomas Yates said, “We will also be actively engaging with the exchanges, other market participants and regulators to be part of the dialogue around growing a healthy options industry.”

‘Exchange creep’ continues to be an issue. Most every market constituency — including exchanges — would agree that the steadily rising number of exchanges impairs market quality, broadly speaking. But exchange operators are for-profit enterprises, so if there’s an opportunity to grab a percentage point or two of market share by tweaking a business model and launching a new venue, it’s done. Market participants just have to deal with the added cost and complexity.

This past February, Miami International Holdings launched Miax Pearl, which deploys a price-time allocation model with a maker-taker pricing structure, as its second venue. These days, new exchanges are met with groans; Miax Pearl isn’t necessarily better or worse than its 14 U.S. rivals in the eyes of market participants, but given the unwieldy field, it’s extraordinarily difficult for a new exchange to truly differentiate itself.

“If you ask anybody, ‘how many exchanges would you like to have?’, I can’t imagine anyone coming close to 15,” Jiganti said. “For liquidity providers, it’s tough to put your liquidity out on 15 exchanges, and be as aggressive as you would if there were five. Risk protections and tools are not robust across exchanges.”

The market’s fragmentation and complexity have bifurcated liquidity. “Today close to 50% of the overall market volume is traded in the top 20 products, whereas three years ago it was more like the top 50 products,” said Peter Maragos, chief executive officer of Dash Financial Technologies.

“All of this has created significant liquidity challenges for investors, but at the same time it has also created opportunities for technology-led firms,” Maragos continued. “Investors today have access to extremely powerful trading technologies and transparency tools that are fundamentally changing the way the buy side interacts with the markets. That has been a major win for investors and will only increase as more brokers adopt these technologies and business models.”

One cross-asset trend evident in the options space is that of end users taking more control of their trading. “Buy-side traders have never been more sophisticated,” Maragos said. “Whereas ten years ago TCA reports were a ‘tick the box’ exercise for many, today most are looking to analyze full order execution reports that show not just fills but every venue that the ‘child’ slices touched along the way and the fees they incurred. Full order routing transparency is expected.”

Displayed Quotes

Transparency continues to be a flashpoint in the options market. At NYSE’s Amex and Arca options exchanges, preserving the value of the displayed quote is a key point of emphasis. “In a quote-driven marketplace, options quotes act as an advertisement to encourage growth and participation,” said Ivan Brown, head of options at NYSE. “We focus on the displayed quote, because it drives investor confidence. Building investor confidence results in greater investor participation, which drives volume growth.”

“From our perspective there are many parallel themes between equities and options,” Brown said. “If you’re looking to protect and invest in the displayed quote, we have concerns about things traded off-exchange, in the case of equities, or (in options) exclusively in an auction that comes at the expense of the displayed quote.”

A venue sticking point for some market participants is that exchanges with very low market shares — probably too low to be viable standalone businesses on a going-concern basis — can operate ad infinitum, requiring connectivity to and liquidity search on each. In July, fully eight exchanges had market shares of less than 5%; four (Nasdaq’s Mercury and BX, Miami Pearl, and CBOE’s EDGX) were below 2%.

One potential way to rein in the exchange population is via the Options Regulatory Fee, a pass-through fee that exchanges assess on their members to recover a portion of the costs related to market supervision and regulation. Exchanges generally charge their ORF fees on members’ total options trades, not only the trades a member executes on the exchange assessing the fee.

The Securities Industry and Financial Markets Association is considering an ‘eat what you kill’ model for the ORF model, which would mean market participants get charged regulatory fees by an exchange only to the extent they trade on that exchange. “So if you’re a 1% (market share) exchange, you’d either have to charge a very high rate, which may be untenable to your customers, or eat some of that fee out of your operating costs,” Jiganti said. “Exchanges doing less than 1% of the volume may rethink their reasons for being in business.”

With a bit more than 2% market share, BOX Options Exchange is the 11th-largest U.S. options venue, but it’s causing a stir with its proposal to launch a new open-outcry trading floor in Chicago.

Electronic trading took the options market by storm about a decade ago, increasing from 47% of all U.S. options trading in 2005 to 85% in 2010, industry figures show. But since then, electronic share has ratcheted higher only marginally — market participants say there will always be a role for floor traders to find a better price for very large or complex orders in less-liquid contracts.

BOX’s plan is opposed by some options brokers and exchanges, who cite concerns regarding investor protection, market structure, and fragmentation. On Aug. 2, the U.S. Securities and Exchange Commission approved BOX’s plan to build a new trading floor, the the exchange operator said it would have it up and running by the end of August.

Given a subdued market environment and capital constraints, options firms are looking to contain costs any way possible. One way to do this is by acquiring analytics as a service, i.e. in an all-inclusive data feed, rather than by acquiring libraries from vendors and plugging your own data into that.

That’s according to Jerry Hanweck, founder and CEO of his eponymous risk-analytics firm. “The benefits of keeping the risk organization fully in-house have gone away, and there’s a bigger trend toward risk analytics as a service,” he said. “It’s more cost-effective than trying to build it yourself, it’s more efficient, and it’s potentially more accurate, in the sense that you get many eyeballs looking at the same data.”

“A more market-related trend is that we are in a very low-volatility period, or at least more conventional measures of volatility like VIX are low,” Hanweck continued. “This is causing people to search for alternative indicators, or alternative analytical data to assess their risks and their exposures, and where they can possibly squeak out some more alpha. People are looking at other kinds of information that they can glean from the options market, not just vols and VIX.”

M&A

In June, Vela Trading Technologies bought OptionsCity Software, whose technology powers the trading, risk management, and analytics of futures and options traders. Similar to TSS – Timber Hill and Nasdaq’s 2016 purchase of International Securities Exchange, it shows that people continue to sink money into the space, with some expectation that better days are ahead.

“It’s probably a good thing overall for the industry to try to lower costs and squeeze out some efficiencies,” Hanweck said. “Volume trends are kind of sideways but that I think in general people are pretty upbeat about the prospects in the options industry, longer-term.”

Sideways volumes can be seen as a glass-half-full scenario, given the persistently low volatility of the market. Also, tighter regulations and increased technology and data costs have driven some market makers out of the business — this is another reality that could have made for a sizable decline in trading.

“The firms that are left are trying to make markets across a much wider array of contracts, which creates shallow puddles of liquidity rather than the deep pools investors hope for,” said Maragos of Dash. Given the landscape, “I think flat volume should be looked at as a huge win.”

One possible advantage of a period of absent growth is that it can shake out weaker hands, and push surviving market participants to raise their own games. That in turn can improve the experience of options end users.

“When there’s flat volumes, you cannot take growth for granted. You have to find other areas for growth,” NYSE’s Brown said. “It forces all of us, whether on the participant side or on the exchange side, to think about what are the problems that exist in the marketplace and can we employ new and different strategies to help solve problems. So you’re engaging new participants or re-engaging existing participants in a new or different way.”