Rise of the Machines - Part Two

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...continued from Part One.

SYSTEM SHOCK
The single price nature of futures should make them natural candidates for electronic trading. After all, stocks have been trading on electronic platforms for years without significant problems. Given the similarities between futures and equities, it was reasonable to assume that futures liquidity would transition smoothly to the world of ones and zeroes. Unfortunately, while the product was well suited to electronic trading, the electronic trading platforms were not well suited to the product.

The futures industry entered the electronic era years before the options industry. However, despite their significant head start, they lagged far behind the options industry when it came to electronic functionality. One prominent example is their order functionality, or lack thereof. While electronic options platforms offer a wide variety of common order types including stop orders, many futures platforms lack even this basic functionality. ìThe exchanges donít offer a good range of order types,î says OíNeil. ìFor a long time, ECBOT did not accept good-till-canceled orders. Some of the platforms still donít accept stop orders. I donít know of any that accept one-cancels-other orders. However, our customers demand this functionality. So it falls to the brokerages to develop these order types on our systems because the exchangesí systems canít handle them.î
                                                                                         

MONOPOLY VS FREE-FOR-ALL
The root of this problem can be traced back to the different types of competition in the two industries. While options exchanges trade identical products, futures exchanges trade non-fungible products. Therefore, while options exchanges must improve the functionality of their platforms to gain market share, futures exchanges simply have to increase the distributions of their platforms to gain volume. Both the CME and Chicago Board of Trade (CBOT) have allocated significant portions of their technology budgets to establishing electronic hubs in Europe and Asia. This has done a great deal to increase their global reach, but it has left many of their customers begging for more functionality.

PLAYING CATCH-UP
In the years since the ISEís launch, other options exchanges have hopped onboard the electronic bandwagon. On February 6 2004, the launch of the electronic Boston Options Exchange (BOX) raised the total number of U.S. options exchanges to six. Even the venerable CBOE, the progenitor of options trading and a strong proponent of open outcry, has joined the electronic fray. Seeking to merge their massive floor presence with electronic execution, the CBOE launched their HYBRID system in 2003. ìEvery CBOE seat can be employed in various ways. You can choose to walk onto the floor of the CBOE and stand at a physical location. Or you can call up the CBOE and tell us the options that you want to trade as a remote market maker,î says Ed Tilly, Executive Vice Chairman of the CBOE. ìWe then use a formula based on the weighted average daily volume of those products to determine how many seats the member will need to trade those products.î

The growing electronic liquidity in the options markets has attracted an entirely new set of customers and liquidity providers. Until recently, making markets in options required large investments in floor operations. If an institution wanted to trade multiple products, then they had to establish themselves in multiple trading pits, an expensive and imposing proposition. However, thanks to the efficiencies of electronic trading, that is no longer the case. By allowing instant access to multiple markets, electronic execution has made options much more attractive to institutional traders. Not surprisingly, these institutional traders are one of the ISEís primary target markets. ìOur initial vision was to recruit large institutions who had the capital and risk management expertise to trade options, but felt that creating a floor-based operation was cost-prohibitive,î says Goldberg. ìA lot of people have wanted to participate in these markets for years, but they couldnít because of the existing market structure. Our electronic market structure has finally allowed that to occur.î

SPREADING IT AROUND
With every option exchange trading identical products, the only way to differentiate themselves is through increased service and functionality. The current battleground in the electronic marketplace is in spreads. Complex spreads are some of the most difficult things to replicate in an electronic environment. As a result, complex spreads have remained one of the few areas where open outcry is still the preferred method of execution. ìThere are certain transactions that are easier to do in a face to face environment. That is just a fact,î says David Krell, President & CEO of the ISE. ìWe are trying to do whatever we can to replication those transactions in an electronic setting, but we know that we arenít going to capture 100% of the market. That is simply impossible.î

The first electronic spread book was launched in 2001. At the time, spread technology was still in its infancy and the spread book only offered a handful of products on an RFQ basis. In essence, it functioned more like a bulletin board than an actual trading book. If traders didnít want to wait for an RFQ, then their only other option was to execute each leg of their spread individually, an exceedingly risky proposition.

As the technology improved, the exchanges were able to offer one-click execution for basic option spreads such as verticals and butterflies. Today, most exchanges also offer complex spread books that allow traders to execute delta-neutral spreads and other intricate strategies. Thanks to the increased bandwidth and processing power of todayís machines, these complex spread books are able to constantly update spread strategies in real time. ìOur complex order book can handle spreads up to four legs,î says Tilly. ìSimple time spreads and other trades flow directly into our book. If the individual legs of the spread line up, even for a fraction of a second, then we execute that trade electronically. Unfortunately, we still canít articulate specific complex trades like volatility swaps or trades that are tied to the underlying. For these trades, its still a question of how do you replicate and update those strategies in a real time quoting environment.î

Continued in Part 3....
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