Over the past decade the US options markets have seen a stagnation from 2011-2017, followed by a small and volatile growth spike in 2018 and then record-breaking volumes in 2020. The period of stagnation was due to a quick transition from manual to electronic markets that made high-end technology, like nanosecond level trading, a necessity. These new latency demands placed a strain on firms’ R&D budgets and left many unable to compete. But a boom in retail trading that came to fruition in 2020 changed the landscape of US equities options, creating liquidity and opportunity. Retail trading surged due to several factors that arose during COVID: stay-at-home orders, social media awareness, payment for order flow (PFOF) which facilitates zero-commission trading, and other trading incentives on mobile apps.
Before this surge in retail trading, the US options market was dominated by buy-side firms that engaged in electronic market-making (EMM) strategies. Those firms managed to remain competitive during a period of shrinking revenues and rising operation costs as systems changed from software to hardware and then from fiber to wireless networks, resulting in about a 100x acceleration of trade execution. The US options market went from operating at 10 microseconds to about 100 nanoseconds. It’s no wonder some firms fell behind—that order of magnitude difference is hard to grasp and even harder to achieve. Firms might risk years of development and invest millions of dollars trying to get there. We’ve displayed current nanosecond trading speeds against the speed of light in the graphic below to demonstrate just how fast firms need to move to be competitive.
From Microseconds to Nanosecond Level Trading
To put this in perspective, the average speed of trade execution mid-size market-making firms are capable of is about 12 microseconds. Meanwhile, the fastest EMMs in US options are operating around 120 nanoseconds. This is a significant advantage; those operating in microseconds can only move defensively while nanosecond players can execute making, canceling, and aggressing algorithms—a make-or-break competitive factor.
Electronic Market Makers
Since only large and specialized technology companies could keep up, those with nanosecond electronic market-making (EMM) capabilities are now responsible for 50% of the US equities market share. The development of custom-built, ultra-low latency hardware opened a tech divide between the haves (large, specialized firms with healthy R&D budgets) and have nots, who struggled to compete. This is especially prevalent in US options where EMMs took an interest in volatility trading and the presence of these quant firms re-defined options market making entirely.
The CEO of Citadel securities acknowledged this and, saying in 2018, “In the market-making space, a new generation of analytically driven and technologically advanced market makers has emerged, competing against the legacy manual intermediaries that once controlled the markets.”
US options markets didn’t see any meaningful growth in the 2010s, staying steady at around 4 billion contracts traded all the way up until 2018. Partly due to the Dodd-Frank Act that followed the financial crisis of 2008, firms not only had to deal with rising operational costs and increased competition, but also new regulatory requirements. This led a number of banks including Goldman Sachs and Barclays to restructure and sell their options market-making businesses.
Now just three years later, derivatives markets have exceeded 7 billion contracts traded as reported by the OCC— the US’ largest options clearing house. With the advent of stay-at-home orders and social media platforms, retail traders have reentered derivatives. This was evident with the GameStop frenzy and Reddit group r/WallStreetBets, which continues to hold sway over market movements.
Those currently in the options market-making space are leveraging that increased activity by participating in payment for order flow (PFOF) provided by online investment apps. PFOF is a system in which market makers purchase the right to fulfill the order flow of a specific brokerage (such as Robinhood). The market maker then profits from more opportunities to capture the spread between the national best bid and offer when filling large volumes of smaller retail orders. This facilitates zero-commission trading for retail traders, which some see as breaking down the barrier to entry and creating more liquidity overall.
In March 2021 more than 900 million contracts were cleared, breaking previous volume records. A substantial portion of these trades can be accredited to retail traders. UBS’ signal that tracks retail investment estimated that about 42% of options trades in January of 2021 were less than 10 contracts in size. This flurry of activity has a snowball effect, attracting more retail and now professional participants wanting to take advantage of the increased opportunity in the space.
However, while opportunity and liquidity are on the rise, firms still need to break the speed barrier to compete. Those with legacy systems in place cannot simply install faster servers or update their software. Reaching nanosecond speeds requires expert-level design and optimization of bespoke hardware using Hardware Description Languages (HDLs). There have been some advantages in tools that allow software to be compiled into Field-Programmable Gate Array (FPGA) circuits, but this has not yielded 100 nanosecond-level speeds. Even if a firm could afford the multimillion-dollar investment in a FPGA team, tools and equipment, they would wait years for that team to produce a working model.
Competing is Surviving
Fortunately, as we noted in our last post, a reliable trend in financial markets provides a solution for firms. At first, new tech disrupts the markets (nanosecond trading) and gives an advantage to large firms with expansive R&D budgets (EMMs currently dominating US options) then the tech becomes productized by specialized vendors and distributed to a broader selection of firms, subsequently creating a more competitive marketplace.
The Xero Volatility Trading Engine (VTE) is the vanguard of this cycle. The Xero VTE is the fastest and only commercially available trading platform of its kind; cancelling and aggressing algorithms operate under 120 nanoseconds, while more complex making algorithms run less than 250 nanoseconds. The appliance is designed to be scalable, capable of handling up to 64,000 contracts per appliance with the ability of multiple appliances to work in parallel.
The Xero VTE provides firms the ability to compete with and even outperform incumbents. Many EMMs currently in the space are using systems with outdated designs that would require an overhaul of their trading technology and possibly research teams to keep up with Xero VTE’s modern design. With Xero VTE firms can compete and expand their strategies, going from simply cancelling outdated quotes, to more sophisticated making and aggressing.
Our trading platform is complete with a configurable set of algorithms already designed for volatility trading and an easy-to-use interface that can be integrated with existing trading stacks all while keeping strategies confidential. The Xero VTE comes as a turnkey solution ready-to-go off-the-shelf. It is currently available for use on the Chicago Mercantile Exchange (CME) and will be rolled out to Cboe shortly.
The Xero VTE allows firms to enter the competition and capture every opportunity without waiting for R&D teams or expansive funding. Its modern design not only appeals to those thinking about entering the space, but those already in it. Instead of hiring a team of FPGA specialists to perform a hardware overhaul, a firm can employ the Xero VTE now for a fraction of the cost. Its interfaces are designed to seamlessly integrate with legacy software systems—allowing firms to operate their existing strategies and workflows.
To learn more about the power of the Xero VTE and Exegy’s other trading solutions consult our experts for free.