Streetwise Professor

March 5, 2008

The DOJ and the Options Markets

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 9:51 am

In my earlier posts on the DOJ’s jeremiad on clearing, I questioned whether its analysis of US options markets was apposite. I have finally had a little time to research the issue, and the answer is a resounding “NO!”

In my original post pointed out a couple of possible important issues–intermarket linkages and payment for order flow–that could mean that the survival of multiple options exchanges does not imply that network effects are immaterial in financial trading. Indeed, as several SEC studies document, both features are very relevant in US options markets.

As part of the exchanges’ antitrust settlement with the government, the exchanges adopted an intermarket linkage plan and agreed to adhere to order handling rules. Though not as streamlined as those eventually adopted for the equity markets under RegNMS, these measures provided considerable linkage between the different option markets. That is, though they did not go as far as creating a central limit order book (“CLOB”), the rules did go a long way towards creating a central price discovery venue. That is, options exchanges are not competing price discovery venues; they are competing portals to a central price discovery mechanism. Linkages and order handling rules sharply reduce the centripetal forces that would otherwise induce trading to “tip” to one exchange

Moreover, the SEC studies report that a very large fraction of order flow served by the options exchanges is purchased. As I have written in my academic work, purchased order flow is typically uninformed order flow that does not contribute to price discovery. Moreover, as I have also shown in that work, multiple “cream skimming” venues servicing uninformed order flow can coexist. That is, segmented uninformed order flow does not tip. The survival of multiple exchanges servicing uninformed traders via payment-for-order-flow and internalization arrangements in no way contradicts the tipping/natural monopoly of price discovery framework.

Thus, the survival of multiple exchanges in options is not attributable solely to the fact that the industry operates a cooperative clearing “utility” as the DOJ claims. Rather, this survival reflects the facts that (a) linkage and order handling rules have effectively socialized order flow and created a central price discovery venue, and (b) much of the uninformed order flow is “skimmed” and segmented, and thus not susceptible to tipping.

This implies that creation of a clearing cooperative is NOT sufficient to lead to competition in execution, and the survival of multiple, competing price discovery venues as the DOJ letter asserts. Much more radical steps are required. Specifically, no execution venue can be allowed to own and control its order flow. Absent any obligation to redirect order flow to another market offering a better price, and the creation of technological linkages that make this redirection quick and efficient, trading activity will tip to the market that offers the best expected terms of trade. This becomes a self-fulfilling process, resulting in the survival of a single market.

Now, there is an argument to be made that such rules and linkages are efficient; in fact, I’ve made it in my JLEO article “Security Market Macrostructure.” But the DOJ does not make that argument–or even provide any inkling that it even understands the issue. It merrily suggests that cutting the baby in half–splitting execution and clearing–alone will allow the proliferation of many competing execution venues. Wrong. Wrong. Wrong. Look at the history of equity trading 1975-2005 for abundant proof of that. If the formation of a clearing cooperative was sufficient to create competition in execution, why did the SEC feel it necessary to push ahead with RegNMS and its socialization of order flow decades after the creation of a securities clearing cooperative?

Indeed, if followed, the DOJ’s prescription could be very damaging, leading to no improvement in competition in exchanges, but resulting in reductions in efficiency due to double marginalization, and higher transactions costs. Without measures to break the network effect–to socialize order flow through mandated market linkages and order handling rules, or the creation of a CLOB–shearing clearinghouses from exchanges will do nothing–zip, nada, zero–to increase in competition in execution, but it will lead to wasteful “friction” at the interface between the independent clearer and exchange. All pain. No gain.

It is also interesting to note something that the DOJ ignores altogether. Not only is exchange ownership of futures clearinghouses the standard worldwide, it is actually increasing in importance. ICE has brought its clearing in-house in the US, and is endeavoring to do so in the UK, though that is running into some obstacles–regulatory and in implementation. As another example, LIFFE, which had historically secured clearing from LCH (and subsequently LCH.Clearnet) is now moving to integrate clearing. This is quite consistent with the transactions costs arguments I have advanced.

There are two stark choices: either keep the status quo, or undertake a thorough remaking of the regulatory structure in futures markets along the lines of what has been done in equity (and latterly options) markets in the past 30 plus years. The DOJ’s nostrum either goes too far, or not far enough. Since there has been absolutely no debate regarding the organization and regulation of futures markets along the lines of that which has roiled the securities markets for decades, it is highly unlikely that the more radical alternative is in prospect any time soon. I only fear that the pressure to do “something” leads Congress and the regulators to take the DOJ’s middle ground–to the detriment of the markets and their users.

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