The evolution of options trading has followed the path blazed by equities. Like equities, options trading has grown increasingly electronic. And while decimalization has created more volume in the options market, as with equities, order sizes have been shrinking.
According to recent industry estimates, there are approximately 40 non-displayed venues where equity block orders can be matched. Only two dark pool operators, however, say they have created a market where participants can match block-size options orders anonymously: Pipeline Trading Systems, which operates the options block-crossing network Blind Bid Options Cross, or BBOX; and Ballista securities, which offers the Ballista ATS for options.
"A dark pool crossing network was necessary for the options market," says Pipeline managing director David Mortimer. "With the way the market has been changing, the options traders will have the same problems with size as equities traders."
Mortimer, a founding developer of 3D Markets' Archangel dark pool, joined Pipeline when it acquired 3D Markets last year. He continued to develop the platform, which became BBOX.
Options trading has exploded in recent years, with more than 3.5 billion contracts changing hands in 2009, according to the Options Industry Council. But trading options in the dark isn't like dark equities trading. Currently, options trades cannot execute away from exchanges. So while counterparties can come together and settle trade details on a dark pool platform, they have to route out to an exchange for execution.
"Dark pools for options is a misnomer," says Andy Nybo, principal and head of the derivatives practice at TABB Group. "You're seeing an internalization schema -- liquidity that's being matched away from the exchange floor and then brought down to the exchange floor."
According to Aite Group senior analyst Paul Zubulake, the concept of an electronic and anonymous venue for matching block options orders has merit. Unfortunately, "The market structure situation itself hasn't caught up yet," he concedes. ... "It's [going to be] an uphill battle for these venues to grow."
The market structure is not going to change anytime soon in this regard, suggests Anthony Saliba, executive managing director of BNY ConvergEx Group and CEO of LiquidPoint. "The options market has been going on for 35 years on the phone," he says. "The largest share of contracts still comes in over the phone to this day."
Launched in 2002, LiquidPoint is a hybrid routing and crossing system that processes orders electronically, over the phone or both. "Our system ranges from completely bright to gray," Saliba notes. "The options industry does not allow darkness."
But until things do change, Aite's Zubulake says, options dark pools may struggle. "I will be surprised if anyone entered the space anytime soon," he reveals. "If you look at the whole market structure for all asset classes, transparency is the way to go. [Traders] don't want to go into the dark."
According to Jeromee Johnson, head of options and VP of market development at BATS, much of the recent growth in institutional derivatives volume has come on the over-the-counter (OTC) side of their business. "What we're seeing today is the firms looking to offer crossing on one hand or algorithms on the other hand -- they're looking to help move that volume back into the listed markets," he says.
A Peak in the Dark
To address some of the risk of trading options in the dark and discourage front-running, Pipeline spent close to nine months developing a risk profile formula for options contracts that takes various risk factors into consideration. Without revealing the name of the underlying stock, the profile lists the industry sector, subsector and other quantitative information to provide risk transparency while maintaining anonymity, Pipeline's Mortimer explains.
Orders can be entered into BBOX via FIX protocol message, a secure Web interface or the Pipeline user interface. The system calculates an order's associated risk profile and then sends it to the seven liquidity providers with which Pipeline currently works, Mortimer relates. The liquidity providers then make a bid or an offer, which can be negotiated directly with the client. Once the price is agreed on, the order goes on to one of the options exchanges to be crossed, when the name of the underlying stock is revealed.
The Ballista ATS uses a different model. When traders seek liquidity, Ballista, which went live in October 2008, advertises the initiated order to its liquidity providers, which can respond via a FIX protocol message and trade the order automatically. Once the order is matched, it is sent down to an options exchange to be executed.
"Our pricing is competitive," says Ballista CEO Robert Newhouse. And "We work to level the playing field -- everyone sees the information at the same time."
In addition to matching options orders, which must be for a minimum of 500 contracts, Ballista also handles volatility trades, which allow a trader, for example, to buy a call on a stock and the stock at the same time. The liquidity providers can respond in 250-contract lots, Newhouse explains.
Both firms hope to boost their volumes. But when the majority of the new entrants to the options trading space reach for the phone rather than an electronic interface, that will be a tall order, says LiquidPoint's Saliba. "New users feel more comfortable with picking up the phone and calling someone," he contends. "They want to talk to a seasoned professional."