What I Learned at Burgenstock

December 20, 2016

I recently participated in a panel discussion on equity options at the International Commodities & Derivatives Association annual “Burgenstock” meeting in Geneva, Switzerland. I was joined by Patrice Henault, Director and Head of Futures and Listed Options at Saxo Bank, and Breon Byrne, Head of Options Trading at market maker Susquehanna. Here is what I learned.

Market consolidation
U.S. equity options exchange CBOE has announced plans to acquire rival exchange BATS. If approved, this acquisition will generate synergies from BATS’ extensive exchange activities, which overlap little with those of CBOE. BATS is the largest equity exchange in Europe and its technology is also seen as first class. Also, U.S. equity options exchange Nasdaq completed its purchase of International Securities Exchange (ISE) from Deutsche Börse Group.

In Europe, Deutsche Börse and London Stock Exchange Group are pursuing a merger, which has yet to be approved by EU competition authorities. The proposed merger will generate operational efficiencies for market participants and perhaps also some form of margin offset, but the big question remains as to what impact it could have on competition in the European equity option market.

The "utility" model for clearing houses, typified by U.S. exchange-traded equity options clearinghouse OCC, which currently serves 14 U.S. options exchanges, enables exchanges to focus on innovation, technology and capital efficiencies in addition to providing risk management, clearing and settlement services. Contracts are netted at the clearing house, meaning that margin offsets can be achieved. Positions in most contracts can be opened via one exchange and closed by an offsetting transaction at another exchange. By contrast, the "vertical" model for clearing houses, typical in continental Europe, is where an exchange owns its own clearing house, which clears only its products. There are no offsets with similar products traded at other exchanges. This can increase the cost of holding a position and also hinders competition.

Typical Strategies
Given the current low interest rate environment, investors are focusing on income generation strategies, examples being covered call writing, cash secured puts and credit spreads.

Structured products offering similar outcomes are also popular. There has been sharp growth in the auto-callable market, a structured product that can be called by the issuer if the underlying asset is at or above a specified level. If called by the issuer, the investor receives the principal amount of their investment plus a pre-determined premium.

The listed equity options markets are facing many regulatory changes which market participants must implement and adhere to, such as new regulations under Section 871(m) of the Internal Revenue Code; EMIR, MiFID 2 and the proposed Key Information Document (KID), which would provide investors with important product information. The KID deadline has been extended but still offers a real challenge to firms offering option products. Firstly, it is not clear what level of detail will be needed. Secondly, the time frame is still ambitious. Further, Basel III, the Volcker Rule and Dodd-Frank legislation have all had the effect of reducing liquidity and the number of participants in the market. Ten years ago in the over-the-counter (OTC) equity options market in Europe, there were 10 major liquidity providing banks. Now there are about half that number. Market makers are also under great cost pressure.

The net impacts of these changes and proposals are fewer participants, capital scarcity, increased costs of set-up and operation, and a further concentration of liquidity. The market is increasingly fragmented and electronic.

Structured products offer investors another route into an options-style product, but investors need to ensure that they are not over-paying. Structured products often benefit from first mover advantage as their time to market is often shorter. Many structured products can be replicated with exchange-traded options.

In Europe, there is also tax free competition from products like contracts for difference (CFDs) and spread betting. Investors should beware of excessive leverage and also counterparty risk with these types of products.

Education plays a key role in helping investors to make better and more informed decisions on how to use equity options to help manage their financial risk. Websites such as OIC’s — — offer extensive free and unbiased educational material. Investors need to be aware of upside potential, downside risk and alternative strategies.

There is much innovation going on in Europe. In addition to exchange consolidation, as in the CBOE/BATS proposed merger, we are seeing new products coming to market. CBOE, for example, now offers extended European trading hours for its key U.S. equity option products; and Eurex’s VSTOXX options and futures have been a success on the back of increased and often diverging volatility between the U.S. and Europe, extended trading hours and the participation of US customers. Additionally, Euronext now offers short lead-time special situation "Spotlight" options; ETF option volumes are growing and weekly expiration options continue to be popular.

As recent political events have shown, the world continues to change. This offers both challenges and opportunities for investors, both of which were highlighted on our panel. The availability of liquidity, ease of access, product selection and easy-to-understand educational tools will continue to be key driving principles as investors search for higher returns and a higher degree of confidence in their risk management products.

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