by Jim Toes
It is safe to say that there exists a broader level of understanding on what equity market makers do versus market makers in any other asset class or product. This gap, if left unchecked, could cause unnecessary harm in the form of regulatory costs to those non-equity markets where the role of market makers and liquidity providers serve investors well. As an example, we would like to highlight the role of market making and liquidity provision in listed options as compared to the equity markets and how regulation has, and may continue to, acutely impact one market versus the other.
Given the unique role that market makers and liquidity providers perform in the listed options market, the STA is concerned that harm will be done to this market and the investors it serves.
Available liquidity in equity markets is a product of several factors, but none more so than the large amounts of investable assets seeking a return on the relatively fixed number of 8,000 national market securities. These combinations allow for considerable investor to investor transactions with the market maker matching buyers with sellers at their agreed upon price.
In listed options the amount of investable assets, while growing remains less than equities and the number of securities – as measured by the numerous strike prices and expiration months per issue – is significantly higher. Today there are over 1 million strike prices on roughly 4,800 equity issues. These conditions create a regime where there is significantly less investor to investor trading which in turn requires market makers to buy from or sell to the investor who is seeking liquidity. According to the Options Clearing Corporation, in 2013 approximately 85% of all customer trades were facilitated with a listed options market maker on the other side. This nuance of investor to investor trading in the equities markets, versus investor to market maker trading in listed options, is critical to understanding the unique roles that market makers play and how listed options is a “quote” driven market whereas equities is more “order” driven. To be clear, we are not stating listed option market makers serve a more important role than equity market makers, rather we are pointing out their unique roles in facilitating investor needs.
In the aftermath of the 2007 financial crisis there have been regulatory events which have increased costs for all trading centers such as, Regulation SCI. In addition there have been unique regulatory events with corresponding costs specific to listed options market makers with additional acute impacts to a subset. These regulatory costs, while not the only factor, have contributed greatly to the decrease in the number of listed option market makers. Today, there are around 35 registered market makers which are down from over 120 who were registered with CBOE in 2012. Some may argue that less market makers does not equate to less liquidity for investors. While we would agree that the interests of investors should be paramount, one has to pause when making such a statement in the absence of data due to the rapid pace and short window of market makers exiting.
Furthermore, there exists additional foreseeable regulatory events and costs to listed options market makers and liquidity providers that if implemented could exacerbate the trend further. Given the unique role that market makers and liquidity providers perform in the listed options market, the STA is concerned that harm will be done to this market and the investors it serves. Please look for additional articles on this topic from us in the coming month.