Options Market Structure 101
This week I chose to unlock a paid post published back in October about the inner workings of the US options market. If you enjoy this post please consider subscribing to Front Month Premium, the paid portion of this newsletter where I dive into market structure topics like this. Thank you for your support!
Certain industries don’t cross the public’s mind until something goes wrong. The world of market structure is one of those industries.
How many of us had heard of the DTCC before GameStop blew up? How many talked about CME futures position limits before the Bitwise ETF launch? If the general public is concerned with the intricacies of clearing or the tactics of a high frequency trader, it’s more likely than not because the system isn’t working as it should.
Take payment for order flow for example. Before Robinhood disrupted the retail broker commission model, PFOF was an afterthought. Brokers didn’t build their business model around it & the public didn’t endlessly debate the topic. As commission-free trading became the norm & Robinhood went public, the conversation quickly changed.
One thing I find puzzling about the public market structure debate is how narrowly focused it is on one asset class - equities. Plenty of words & ink are spilled explaining US equity market structure in great detail to argue how it’s broken & how it can be fixed. I believe there are plenty of other markets that deserve our attention.
Take options for example. US options volumes have exploded to record highs since COVID began, leading many to argue that options activity - not their underlying stocks - are what now drive prices. The amount of money involved in options payment for order flow is larger than equities. Exchanges now generate equal, if not more revenue from their options businesses than equities. Tectonic plates have shifted under the market’s feet to make options market structure a much bigger deal than it’s been in the past.
Despite these monumental changes, the options market is still as opaque, over-looked and under-followed as ever. I consistently have trouble finding accurate data & information that tells me how the options market works, how different participants are incentivized, and where we should be challenging the system’s design.
This post tries to solve that very issue. After speaking with multiple traders, market makers & exchanges about options market structure from their perspective, I’ve been able to build a picture of the system that few in the media talk about or seem to understand. My hope is that by explaining how the system works in greater detail we can start talking about the truly important changes that need to be made rather than squabbling over politics or red herrings.
Consider this post a detailed, wholistic primer on options market structure that I wish had existed when first starting out. I’ll first explain the structure by tracking a retail order from broker to exchange to clearing & settlement. I’ll then work backwards through the same trade, highlighting the complexities & angles of debate throughout the industry at each point in the cycle.
Let’s start at the source - imagine Joe Retail logs into his Robinhood account & submits an order to buy one call option in a popular name like $TSLA or $AAPL.
(Source)
Robinhood accepts the order & takes responsibility for routing it to the venue with the best price, in line with required best execution laws. This responsibility is much harder & more complex than it may seem on first glance. Robinhood would need to maintain expensive connections to each of the 16 active options exchanges, pay extra for high speed data feeds to make sure they see the market for Joe Retail’s options contract in real time, and face serious consequences if they make a routing mistake along the way. The more complex the market becomes, the more burden is placed on Robinhood & other brokers to navigate it.
OR, they can outsource this entire process to a wholesaler and get paid substantial fees to do so. The term “wholesaler” comes from the complete, wholesale experience these firms provide to brokers who partner with them. Wholesalers will handle a broker’s order routing, trade execution & regulatory compliance while giving their customers a competitive price & paying the brokers for the privilege.
A stunning 80% of retail options order flow gets routed to just four wholesalers, Citadel Securities & Susquehanna the top among them. Let’s say Robinhood selects Citadel Securities to route Joe Retail’s options order, receiving a small fee in return. In the equities world, CitSec could simply match the order with an offsetting one in its inventory & send it to the DTCC for clearing, completely bypassing the exchange. This isn’t the case with options.
The first big difference between options & equities market structure is the mandate that all options orders be executed on an exchange. Wholesalers can’t circumvent the exchange to handle their broker’s retail order flow, and dark pools & off-exchange venues don’t exist in the US options world. Every options contract ultimately makes its way to a lit exchange where any firm can compete to execute any order at any time. This makes the options world seem less complex & generally healthier than equities, an argument I think has merit. Institutional orders that reach the exchange can interact with retail volume & create better prices & tighter bid-ask spreads for all market participants, something that doesn’t happen in equities today.
(Source)
The story doesn’t end there, however. Because wholesalers control such a dominant share of retail order flow they’re able to exert significant power over exchanges to tilt the competitive landscape in their favor over other market making firms. There are five exchange groups that compete heavily for market share - Nasdaq & CBOE lead the race with about a third of the market each, followed closely by the NYSE & MIAX; BOX exchange is a distant fifth with <5% market share. These exchanges try to gain advantages over each other by making top wholesalers happy & attracting more of their retail volume.
Exchanges compete for wholesaler order flow in a variety of ways. The first is through “marketing fees” - non-wholesaler market makers are charged fees by the exchange which are pooled & paid to wholesalers for order flow. Through the marketing fee structure, non-wholesaler market makers directly subsidize wholesaler order flow.
The second way exchanges compete for wholesaler order flow is through a mechanism called “price improvement auctions”. To explain let’s revisit Joe Retail’s options order. When Citadel Securities sends Joe’s order to an exchange it will signal the order’s arrival and ask for market makers to submit their best price to execute the trade. Citadel Securities has a separate on-exchange market making entity that will compete against other firms to win its own order. While any market maker can win the auction, Citadel Securities has an advantage because exchanges give the wholesaler a 90% discount on trading fees vs. on-exchange competitors. Because of this fee discrepancy market makers without an affiliated wholesaler have a much larger hurdle to overcome if they want to win Joe Retail’s order.
Lastly, exchanges attract wholesaler order flow via specialist positions. Every ticker has a specialist market-making firm who’s in charge of opening & closing the market for that ticker & have higher quoting requirements than other market makers. In return for this service specialists get exclusive access to order flow below a certain size in that ticker as long as they quote prices at the NBBO. The overwhelming majority of specialist appointments are given to top wholesalers and are handed out solely at the exchange’s discretion.
When you combine marketing fees, price improvement auctions & specialist appointments, a once healthy & competitive exchange playing field starts to look fragmented and wholesaler-dominated. Joe Retail’s order moves from Robinhood to Citadel Securities to an exchange with the possibility, but not the probability, of competitive execution.
If you like this post & the free research I publish on a weekly basis, please consider subscribing to Front Month Premium, where I share even more detailed analysis about exchanges & market structure. I publish two paid posts per month on topics like the crypto market & NFTs, high frequency trading, market data firms & industry primers like the one you’re reading now. I genuinely appreciate your interest & support!
Reversing The Trade
How did wholesalers get so much power? Why do exchanges give them so many privileges? Why can’t other market makers compete with Citadel Securities & other wholesalers? To answer these questions, let’s look at the same Joe Retail trade in reverse, beginning with the perspective of the exchange.
Exchanges are locked in a tense standoff with each other to maintain market share - if one exchange deviates from competitors in strategy or pricing it risks losing wholesaler order flow & the benefits that come with it. More than just transaction fees, exchanges get a non-trivial amount of data revenue from their options market via proprietary data feeds & a share of the consolidated public feed known as OPRA. OPRA revenue share is calculated based on market share, which raises the competitive stakes even further given the public shareholder’s interest in data fees over transaction fees. Exchanges could make little to no trading fees from wholesaler order flow & still be happy with high market share & high amounts of data revenue, making the battle for options volume even more intense.
Let’s shift our perspective to that of an on-exchange market maker, one without an affiliated options wholesaler. There are plenty of firms that make up this role - Jane Street, Virtu, Optiver and Jump Trading among them. These firms execute institutional flow & take risk that the market moves against them to collect the bid/ask spread across the options they quote. They also compete with wholesalers for retail flow, but don’t always win trades even if they can quote the best price. How can this be fair? Shouldn’t the market maker with the best price get the trade? Why are wholesalers allowed to win trades if they don’t always provide the best price?
To answer this question we have to think of the market as the sum of its parts rather than a single ticker. Exchanges want a liquid market for all options contracts, not just a few names or the top companies. Most competent market makers can quote competitive prices & make money in stocks like Apple & Tesla, but not everyone can make money quoting every options contract listed on an exchange. Wholesalers get special privileges because they commit to provide quotes across the entire market, including the small contracts where one big order could mean serious losses for the firm quoting that ticker.
To help visualize, below is a hypothetical example of the margins a market maker can collect quoting a particular stock. Many tickers offer flat or negative margins given the volume & nature of order flow in that name, while the top tickers offer staggeringly high margins. In a perfect world a market maker would compete in the profitable names & avoid the unprofitable ones - something exchanges understand well. To make sure all markets have liquidity throughout the day, exchanges give privileges in a sort of package deal - to get the high margin names, firms have to commit to supporting the loss-making ones too.
The same logic applies when considering how retail brokers choose a wholesaler. If an on-exchange market maker wanted to compete for retail flow, it could consider entering the wholesaling business to capture flow before it reaches the exchange. It could reach out to retail brokers & commit to making competitive prices & paying competitive PFOF rates for orders, just like wholesalers do today. But, if it can’t commit to quality service across every ticker the retail broker needs, it won’t win their business. That’s the challenge of being an underdog wholesaler - firms can’t pick and choose which business they want to take from Citadel Securities or Susquehanna. They have to jump in wholesale, go from 0 to 100 immediately or get no business at all. The upfront fixed costs associated with this endeavor are incredibly high, making it prohibitively expensive for most firms to try and beat the incumbent wholesalers today. Some firms, like Virtu & Hudson River Trading, are trying. With such high barriers to entry in the space, they have their work cut out for them.
Conclusion
Following Joe Retail’s order through the intricate web of options market structure can teach us a lot about market-making economics & helps us think about future regulation. With the above primer in mind, what do you think would happen if Gary Gensler succeeds & payment for order flow is banned in the US? My guess is, while some minor parts of the structure would change, the core dominance of retail wholesalers would remain unaffected. Citadel CEO Ken Griffin said it himself a few weeks ago - the value a wholesaler brings to retail brokers is more than PFOF alone.
Exchanges, market makers & brokers all have a hand in shaping how an options order makes it through the system’s plumbing. While I think the options market is healthier & less complex than equities, I believe there are areas where regulatory action could make the system better - areas like exchange fragmentation, the specialist appointment process, and barriers to entry in retail wholesaling. Before we can change the market, we need to understand how it works. Hopefully this primer can bring us closer to that goal.
I can’t thank you enough for reading & supporting my work! It means a great deal to me. Please feel free to reach out with any questions or ways I can make this service better.
Disclaimer: I am not a financial advisor. Nothing on this site or in the Front Month newsletter should be considered investment advice. Any discussion about future results or projections may not pan out as expected. Do your own research & speak to a licensed professional before making any investment decisions. As of the publishing of this newsletter, I am long ICE, CME, TW, NDAQ, SPGI and VIRT. I am also long Solana.