Killing Our Frankensteins

More than two centuries ago, the gothic novel, Frankenstein, also known as The Modern Prometheus, was anonymously published in Britain. A few years later in 1823, readers would discover that the gifted author was Mary Shelley, who at the age of 18 began writing the novel in a competition among peers about who could write the best horror story. The character of the monster, brought to life by Dr. Victor Frankenstein, remains one of the most recognized icons in horror fiction. It is also one of the few fictional characters who have managed to find a place in the Merriam-Webster dictionary. According to Merriam-Webster, Frankenstein is “a monstrous creation, especially: a work or agency that ruins its originator.”

Our industry, at times, creates its own Frankensteins. We promulgate rules, policies and practices that when introduced into this hypercompetitive and highly-technological marketplace, may result in unintended negative consequences that seem to take on a life of their own. Thankfully our markets possess a natural ability to self-correct in such situations; however, this self-correction process can itself be costly and highly disruptive.

A Frankenstein Around the Corner

The listed options market is a highly competitive, quote-driven marketplace. From a technology perspective, it is extremely efficient as proven by its ability to manage the risk and quoting activity associated with the more than 900,000 strikes on approximately 4,000 underlying, or root, securities. The technological requirements, particularly during periods of high volatility, are massive and costly to maintain. Those costs are about to increase with the impending industry-wide implementation of the Consolidated Audit Trail (CAT).

While official data is not yet publicly available, figures being mentioned in the public domain are that of the 100 billion data points being captured on daily basis, more than 40% are related to options activity. If these figures are correct, then a 40% allocation of CAT expenses to the listed options markets would be a Frankensteinian event.

The most simplistic description of the CAT is that it is a giant data warehouse, one that will store information on quote updates and trades that occur in the equity and listed derivatives markets. The cost of building the CAT warehouse will be determined by how much data it needs to store. The cost allocation per firm will be related to how much data is sent to the CAT. This reality presents issues for options market participants because the ratio of quote updates to actual trades, which normally have revenue associated with them, is several times higher compared to equities. Industry experts estimate there are more than 17,000 quote updates for every trade that occurs in listed options. In equities, the ratio is less than 40:1.

This past summer, the exchanges began reporting listed option quotes on the 900,000 strikes to FINRA CAT. While official data is not yet publicly available, figures being mentioned in the public domain are that of the 100 billion data points being captured on daily basis, more than 40% are related to options activity. If these figures are correct, then a 40% allocation of CAT expenses to the listed options market could be a Frankensteinian event.

Options Listings Participant Plan

With its implementation approaching, a clear first benefit of CAT would be a rationalization of how strikes are listed. The benefits associated with strike rationalization go beyond the cost implications of CAT. These benefits include reducing costs tied to monitoring risk, enhanced allocations of capital and creating a more simplistic market for investors.

The proliferation of strikes is primarily attributed to the absence of a coordinated process for determining the appropriate number of strikes per underlying issue, exacerbated by the growing popularity of short-term options commonly referred to as “Weeklies.” The Options Listing Procedures Plan, or OLPP, is a national market system plan that defines procedures for introducing new options series into the listed marketplace. Unfortunately, OLPP is silent on certain key aspects which prevent it from making modifications or adjustments.

In our letter to the Securities and Exchange Commission earlier this year, STA expressed our belief that the listed options industry can resolve the excessive proliferation of strikes; however, doing so requires an initial dialogue among and between interested parties. Due to antitrust laws, the options exchanges are prohibited from engaging in any collective activity without proper authorization from the SEC. Given the importance of this issue and the potential Frankenstein it would create in a CAT reporting regime, STA continues to recommend that the Commission take whatever action is needed to provide the necessary authorization to the exchanges. Our industry is better off avoiding such types of creations because eradicating them after they have been created is both difficult and costly.

Other article of interest: “Measuring the Influence of Regulation