Evolution, Revolution or Convolution: The Changing Landscape of Exchange Market Structure in North America

Bill Gates once said, “The first rule of any technology used in a business is that automation applied to an efficient operation will magnify the efficiency. The second is that automation applied to an inefficient operation will magnify the inefficiency.”
There is some argument as to which nation created the first exchange. Was it the Venetians in the 1300’s, or the Belgians in 1500’s trading debt obligations or the Dutch who issued paper on the East India Companies that could be readily traded at coffee houses? Regardless, the exchange as a meeting place where shares could be openly bought and sold remained relatively unchanged with small incremental changes in efficiency all the way through the end of the 20^th century.

Beginning in the 1980’s, the use of computers transformed the exchange space. Thomas Peterffy, Founder and Chairman of Interactive Brokers, was a leader in the revolution to use computers to calculate prices for options while a member of the AMEX Exchange. Mind you, computers weren’t permitted on the floor of the exchange and Thomas had to print his theoretical options values and carry them down to the floor. That all changed when he won permission in 1983 to equip a small number of his traders with early handheld computers of his own design, which resembled those trays with neck straps that mid-century cigarette girls hawked tobacco products in theatres and nightclubs.

In 2000, the International Stock Exchange (ISE) had launched the first fully electronic options exchange, and led the evolution to electronic trading in the US and away from traditional floor exchanges. The very next year, the Bourse de Montreal completed a migration from its open outcry environment to a fully automated trading system, becoming the first traditional exchange in North America to complete this transformation.

The beginning of the 21^st century is where the parallel paths of Canadian and US exchanges divide. The options exchanges in the US had long embraced a gentleman’s agreement not to infringe on each other’s exchanges listings, ensuring near monopolistic pricing power. The process of selection back then was similar to an NBA draft. This all changed in 2000 when through a series of regulatory actions and settlements the SEC mandated that all US exchanges list each other’s products (multiple listing). The corresponding competition for market share among the exchanges led to a flurry of rule filings, new exchanges, and a host of other bizarre outcomes driven by the law of unintended consequences. The need for Intermarket connectivity to ensure customers received the best prices was the next technological facet of these multiple markets. Payment-for-order-flow (PFOF) was an enticement given to brokers to preference one market maker over another or one exchange’s pricing schedule over the other provided it did not violate best execution. Payment-for-order-flow, not as insidious as it sounds, was done with full regulatory approval. These payments enabled discount brokers to cut their costs and offer incredible innovations in software and trading tools for its customers.  The competition among the exchanges naturally narrowed spreads and lowered customer execution fees, but now only the most sophisticated market makers could consistently make money. For the open outcry traders this Darwinian moment was like the first snowflake on the nose of a Brontosaurus.

In 2002, Luc Bertrand, Philippe Loumeau, and William Easley of the Montreal Exchange along with several key folks from the Boston Stock Exchange approached me to lead the business development efforts of a new fully electronic options exchange in the US. The advent of multiple listing made this possible. Along with the investment and guidance of Thomas Peterffy and several large broker dealers the Boston Options Exchange (BOX) was born. This marked the first instance of a foreign exchange being responsible for all the day-to-day technical operations of an American exchange. This Canadian-American collaboration led to many comical and sometimes vexing periods as we all learned to operate within each other’s culture. The BOX was clearly an upstart and innovator, having conceived of the Price Improvement Process that allowed for auctions to take place inside the bid-ask spread. With imitation being the sincerest form of flattery, nearly every US exchange now has its own version of a price improvement auction. There has been much said that the nine exchanges that followed BOX did not offer anything unique or innovative. These new market models offered technological advancements such as increased speed of execution, colocation access to be sure, but the real enticement was the targeted pricing schema including those inside auctions.

The upside of all this change was that the options industry saw explosive growth. By 2008, 3.58 billion contracts were traded, which was equal to the total of the first 24 years of the industry. The downside, which no one could have predicted, was the creation of 14 and counting US options exchanges, each with different pricing schemes for the purpose of attracting each segment of customer and institutional business. But that was just the start; they were also only competing to enlist market makers that could provide competitive quotes. With fewer of these liquidity providers willing or able to post quotes on 15 separate venues, those once narrow spreads are again widening. One needn’t be a market structure expert to fully comprehend that a single market maker quoting all strikes across all exchanges makes that quote provider subject to catastrophic risk in the event of a pricing miscalculation or computer error. Market makers, in order to function and survive, reacted by widening not only the bid-ask spread, but also reducing the numbers of exchanges where they quote and the numbers of strikes quoted for a particular underlying. In many cases, the spread is now a mere indication of the market, while the true price discovery now takes place inside the price improvement auctions. The retail customer, however, isn’t being affected, as his lot size is generally small and there is ample liquidity, but the institutional participant is being greatly impacted by what he sees on the screen. The solution, of course, is to have more market makers, but the cost of becoming a fully automated market maker has become so dear that few options market makers have entered the game in the last six years, with many key liquidity providers having walked away due to the complexity and the risk. It is now becoming painfully obvious that having more exchanges is not universally better.

The equity markets in the US are spread out among some eleven or so exchanges and nearly fifty Alternative Trading Systems. This disperses liquidity and hurts market quality, and lower market quality leads to lower market participation. In 2015, SEC Commissioner Luis A. Aguilar issued a public statement on US Equity Market Structure: Making Our Markets Work Better for Investors https://www.sec.gov/news/statement/us-equity-market-structure.html, stating, “One overarching aspect of our market structure that has been singled out for criticism by many market participants is its highly decentralized nature.” Aguilar continued, “that at the same time, our equities markets have arguably never been subject to more strident and widespread criticism. Our markets have variously been described as “broken,” “a complete mess,“ or, perhaps most alarming of all, “rigged.” What is especially troubling about these criticisms is that they come not from uninformed outsiders, but from sophisticated industry participants.” While Aguilar’s analysis is targeted at the equity markets, the options markets operate in much the same manner and fragmentation is having a similar affect on the quality of its markets.

Technology advancements have truly made trading and investing easier for the general public more than anytime prior. Option trading, in particular, has seen sequential growth in part due to software applications that allow investors to easily diagram trades, risk and reward all from their phone or tablet. Despite all the conversation surrounding the technological achievements in financial markets, the greatest factor shaping the industry is regulation. The Financial Crisis, as we all are painfully aware of, brought a subsequent avalanche of regulations, that increased operational costs across all market participants. Ironically, one of the key objectives of Dodd-Frank was to bring OTC derivatives into the light of centralized clearing. What we are witnessing now is exactly the opposite as more OTC derivatives are being traded in part due to the absence of liquidity on listed markets, as well as being more profitable for issuers than listed exchange products.

The one proposal that could ultimately bring the whole Jenga puzzle toppling over are the Liquidity Coverage Ratios rules proposed by the Basel Committee on Banking Supervision (BCBS), that provide no margin relief for offsetting options positions. The overall options position may well be fully hedged, but are instead treated as separate long and short positions. John Fennell, executive vice president of financial risk management, OCC, recently issued a statement, “We are starting to see evidence of this evolution with a number of general clearing members (GCM) having already ceased their operations while others are re-assessing their business models.” Everyone with a stake in the industry is fighting this proposal lest the remainder of listed market participants feel the costs no longer justify the reason to be in business.

One thing is certain, by the time you have read this article the market structure in both Canada and the US will undergo change.