Sun rises on Miami Options Exchange:
http://www.jlnoptions.com/2013/05/sun-rises-on-miami-options-exchange.html
Shelly Brown and Doug Schafer talk about the new Miami Options Exchange
The much anticipated Miami Options Exchange launched December 7, 2013, making it the 11th options exchange in the United States. Jim Kharouf, editor-in-chief of John Lothian News, spoke with Shelly Brown, senior vice president, strategic planning and operations with MIAX Options, and Doug Schafer, executive vice president, chief information officer and director of the exchange at the Options Industry Conference in Las Vegas last week. They say MIAX’s 72-person team has two things that differentiate it from the pack – speed and a regulator approval-pending order function that’s designed to tighten quotes and reward market makers for tighter quoting. They also touched on its next two exchanges that will be based in Miami, with a Latin American view.
Q: You launched on December 7. Can you tell us about the rollout since then for MIAX?
SB: We launched with single symbol on December 7, 2012 and then added two more, two weeks later. We worked with the SEC to have a very conservative schedule to start with. We believed the system was very solid and confident. We did a tremendous amount of stress testing, but at the same time did not want to be a disruption to the marketplace. We ran those three symbols until the end of December and did that for several reasons. All three of those symbols were running on the same trading engine. Our system runs on 24 trading engines.
In January we started adding additional symbols and we were up to 100 symbols on more engines. Then we reevaluated which symbols to roll out with our specialists and added another 100 or so in January through February. In March, we added another 250 names and rolled out more in April. We now have about 610 or so.
Q: What is the market structure and market maker system you have in place?
SB: When we looked at the options market, we saw that pro-rata exchanges held about 75 percent of the market. So it made a lot more sense to go after that part of the market, rather than the price-time exchanges. I was at Susquehanna before I joined MIAX and Doug was at PHLX [Philadelphia Options Exchange] before coming here. One thing that was different about PHLX from the other pro-rata exchanges is that they have two allocation tiers – public customers first and then professionals in a pro-rata model. PHLX was a different allocation model altogether with three allocation tiers – public customers first, market makers second, then professional traders. So there is a better incentive for market makers to make better markets at PHLX than at other exchanges because they are not competing with the pros on the pro-rata allocation. We chose that path, so we’re most like PHLX.
We have nine market makers, all top tier firms.
Q: There are a lot of exchanges out there today. What did you have to do to convince them to come on board with PHLX?
SB: All market makers want to trade against retail order flow. Some firms that we’ve named as our members have retail order flow available to them through an affiliated router, consolidated order flow or buying other firms’ internal order flow. Those market makers are looking to trade against their order flow in a fair fashion. This isn’t designed for pure internalization. It’s designed with a directed order flow model, so they can direct orders to themselves and capture 40 percent of an order when they are on the market.
We looked at the allocation models of all the pro-rata exchanges and tried to take the best of each of those models and combine them in a single place to give them the opportunity to trade against as much of that order flow as possible, but still have a competitive market against that flow. For example, for our PLMMs or version of a specialist, if an order is directed to them, or if one comes in that is non-directed and is a 5-lot or under, they get 100 percent of that order. The same program exists at ISE and PHLX, CBOE and I believe AMEX has it.
With the directed model, if an order is directed to a market maker and he is matching another single market maker he gets the greater of pro-rata, or 60 percent. If he is matching two or more market makers, he gets the greater of pro-rata or 40 percent.
Then we did something different. We had a huge advantage coming in starting from scratch, specifically designing and building a system for options trading, and building a new rule set with no existing constituents. We asked, “What could we do to support the market making community to help them make the best markets, trade against their own flow and protect themselves?”
We built a system that is incredibly fast – many times faster than our closest competitor. And its not just a speed advantage for market makers from a high frequency perspective, but a speed advantage when something happens. How do you reduce negative expectancy and optimize the ability to trade with the profitable order flow? Speed is a huge thing and when S&Ps make a major move up or down, market makers need to be able to play defense as well as offense.
The second thing is that we have single-sided quotes instead of double-sided quotes. Say you want to submit a quote to CBOE or PHLX on SPIDERS, with a front-month on the option of $5 to $5.03 and then make a big jump to the upside. I want to get my $5.03 offer out of the way as fast as I can. Well, at the other exchanges, you have to put in a two-sided quote in, say, $5.05 to $5.25 offer. MIAX quotes are single sided, so traders can move all their call offers up and put bids down and play defense before they move their call bids up or put offers down to play offense.
DS: Basically, no matter how fast you are, you are still at a disadvantage to some by not making a continuous market to all the products. So you need to be as smart as you can, as quick as you can, to get out of the way. That’s what we are shooting for.
And as far as the system, its also about reliability. It’s one thing for the market maker or even someone sending an order into the system to say you are fast, but if you are not consistently fast and dependably fast, then people won’t count on it. What we hear back is that when participants need to be fast, they are not always fast. And that’s one of the big things we solved, figuring out how to keep that dependant latency regardless of when the market is busy. That’s why we quote stats about the first 10 minutes of trading and no one else will – because they are horrible. When the market goes nuts, you are going to have the best experience from a performance standpoint with us.
Q: That is one of the big issues in the industry right now, how to deal with trading at the open. It can be a lousy customer experience.
SB: We’ve tried to deal with that too. There isn’t degradation of service under load. That reduces negative expectancy trades. Also, with the speed factor, you will see your fill on MIAX before you see your fill on any other exchange. The trade and reporting to both sides happens so fast there is a hedging advantage if you are sweeping all the markets. You will be able to hedge what you did on MIAX before you even know you traded on some of the other exchanges.
So much has been taken away from the market makers over the years. Granted the pendulum was way too far over 20 years ago, but the reality is that technology has leveled the playing field in a lot of ways. Non-market makers have become far more sophisticated, better educated and have far better technology. Some order flow can be very toxic, so you want to reduce that for market makers.
We want fair markets and are 100 percent in alignment with the SEC. But at the same time, we can build a system that allows market makers to be more aggressive than they otherwise could be.
And there are risk protections we have for market makers. When I was on the trading floor on the CBOE making markets in the OEX, I was making markets in 1,000 options but I could only make markets one trade at a time. We built that logic into the trading system so a market maker can say, “I only want to trade 200 percent of my quoted volume in a class.” So if he is 100 up in quoted options, 300 up in the out-of-the-monies, 50 up in the in-the-monies, and he trades 50 in-the-monies, that’s 100 percent of his quote and his new count. If he trades 50 of his 100 at-the-monies, that’s another 50 percent, so now he’s up to 150 percent. If he makes another trade that takes him over his threshold, we’d have to take all his quotes out of the marketplace in that stock and he has to come into the market with fresh quotes. That gives him the chance to refresh his quote book. That’s not unique. Other exchanges have a similar mechanism, but ours is built within the trade mechanism. It’s extremely fast, reliable and it has protections.
Q: How about customer protections?
SB: We will never have an obvious error. The trade engine won’t allow that trade to happen. One of the ways we do that is what we call a collar. When an order comes in, it can trade at the NBBO, or routed away to the NBBO, or one-tick through the NBBO if we’ve cleared the other markets, but we will never go more than one tick. When we were at PHLX, probably 90 percent of our errors were the result of an oversized order that was entered into the market, trading at a price and the market makers going $5 wide and then it traded at the $5 away price. Everyone knew that occurrence was happening. If the customer doesn’t know about it within 20 minutes and calls the exchange about an obvious error, he gets screwed. It shouldn’t have happened.
And if they review it inside 20 minutes and bust, now you have a market maker who just got out of the way. He didn’t do anything wrong but he did a trade and hedged it, and now you’re going to take that trade away and he has a naked hedge. And he could lose without that hedge.
Our perspective is, we don’t make a lot of money per contract; we’re not traders. We’re providing a service and you can see it in our fee schedule. If a 1,000 lot comes in and the last 300 lots are way outside, let the order go back to the broker and make a second responsible decision about where that order should go and at what price it should trade. If you want to send it back to us, that’s fine. But we don’t want to put your customer at risk at a price that is likely not their intent.
Our system will never let that trade happen. We’ll give the order back to the firm and give them a choice about what they want to do. Some firms have asked if we can make it 2 ticks wide, or 10 cents, so we are looking at possibly enhancing the system to do those sorts of things. As Thomas Peterffy (CEO of Interactive Brokers) said, “If your rules can define obvious errors, why don’t you just build your obvious error rule into the system?”
Q: What’s next on the priority list?
SB: In our rules we have something called priority quotes. As the rule is currently written, that is any market maker quote that is two-sided and no wider than $5. It’s a very loose standard. So we’re matching the behavior of the other exchanges. You can quote as wide as you want, be on the NBBO quote and offer it away if you just want to be a volatility buyer.
The intent is to modify that priority quote rule to incentivize market makers to quote tighter. So take an option that quotes in nickel increments. This is still being discussed, but we may look at the bid/ask spread at the NBBO of the prior day. And let’s say 80 percent of the day it was a nickel wide and the other 20 percent of the day it was a dime wide. So you have an average spread of about 6 cents. We may say, for today, the bid/ask spread for priority quotes in that option is 10 cents.
So three of us are all market makers. We’re all trading in that option. And you’re in that option at $2.00 to $2.05, and are on the NBBO on both sides, Doug here is $2.10 on the bid but not on the offer and I’m 2 bid at $5. I’m on the bid, but I’m $3 wide. An order comes in to sell 10 at $2.00. Today the three of us would split it, with one of us getting 40 percent via pro-rata. If we had priority quotes with tighter spreads, your $2.00 to $2.05 is a priority quote, and Doug’s $2.10 is a priority quote. My 2 bid at $5 is a non-priority quote and I don’t get allocated with the market makers. I am now considered a professional interest. It enhances the allocation for the two of you, while making tight markets. It’s an incentive for you to make tight markets and becomes an incentive for better liquidity for our customers. And it rewards the market makers who are really acting like market makers by providing continuous 2-sided quotes.
It’s not an allocation change. It doesn’t give the priority any advantage. What it does is take the non-priority quoter out of the market maker allocation. In a sense, we’re redefining on the fly how a market maker is defined in our trading engine. To be clear, this is still pending SEC approval.
That is the main functional innovation that sets MIAX apart from the other exchanges. The other innovation is the technical innovation. Those two set us apart from our competitors.
Q: With several months now under your belt, what are your expectations for market share or volume?
SB: We’re really pleased with our market share today. We’ve had no errors caused by the system, no system problems to date. Our customers are happy with the speed and turnaround times, trades and routers. We knew there would be no ramp up in volume until we hit some critical mass, and I believe we’re there now. The next thing that has to happen is the firms need a reason to route orders to us. One, the order flow providers, as they do evaluation of system performance, will start to see better hit rates, better turnaround times, fewer errors – and that’s going to cause them to send more orders to MIAX.
We are long volatility in that, as volatility returns to the market and market making firms who are also order flow providers have problems on other markets due to capacity and systems speed, they will bring flow to the faster exchanges.
It may take an event for that to happen, such as a prolonged period of volatility. Until then, the volume growth will be a slow growth slope. And until we get priority quotes in place, there’s not a lot differentiating MIAX from the other exchanges, except system performance.
We have five pro-rata exchanges and I’d like 1/5th of that volume. But that’s not realistic, other than at CBOE which was the first exchange. I don’t think another new exchange got more than 2- or 3 percent in the first year. But we knew there would be some events that would be positive for us.
Q: What is your game plan now?
SB: We would love more market makers and order flow providers. We have 19 order flow providers connected already in addition to the nine market makers. Every firm has access, be it direct or through another smart router for best execution. Some key drivers are key functionality like priority quotes, rules and systems implications, additional functionality such as a price improvement auction, crossing mechanism, and complex orders. All those things are in the plans over the next 12 months or so, pending SEC approvals.
Q: Tell me about the staff and management team at MIAX.
SB: I think the amount of market knowledge that Doug and his team have is a unique knowledge set. The two of us, along with senior team members, can talk about topics that I don’t think our competitors can match. There are other great guys out there and they used to rely on their committees for that. Now that the structure of exchanges has changed, and those committees don’t exist, it’s hard to get competitors in a room together and talk about what they want. I grew up with these firms and traded on the floor with them. We can talk about what is good and bad. And with the way we’ve built the system, we can be much more agile.
DS: We’ve created a different type of culture, and it’s tied to a systems testing perspective, with our patent pending testing tool that we built. We test the system every night from midnight until 2 a.m. And part of that process of building 650,000 test scenarios is that our business development team, our trading operations desk and the systems people are all using these use cases. So it helps in a couple of ways. If we have a crisis, everyone in that room from trading ops to business strategy and systems knows how the systems work. From a customer service perspective, we built our national operation center in Princeton, NJ, that handles system security, trading operations, system and network operations. They all communicate when we have a problem.
One of the problems with other exchanges is that the network guys never understood the applications or how the business made money. But at MIAX that culture is forced because the process requires that everybody physically deliver something in the form of use cases that then get put into the system. So if the business team thinks one thing and even writes words on the requirements, until you implement the code, I don’t really know what he meant and he doesn’t know what I’m thinking. By both of us putting our use cases in, we avoid a misunderstanding.
SB: We’ve taken that to another level as well. Market regulation is input into the use cases and our legal team maps every rule to a use case. So not only does the system do what the business wants it to do, it does what the rules say its supposed to do. And that’s something very different.
Q: Lastly, you get a lot of questions about having “Miami” in your name, especially since you are headquartered in Princeton, New Jersey. Can you explain?
SB: We do get a lot of questions about the ties to Miami. We have plans to open an equities and futures exchange and that will be headquartered in Miami and will focus on Latin American listings in the US. Miami is the hub for Latin America and that was the original vision of the partners who founded the company. When Doug and I joined, it seemed the better opportunity today for profit and innovation is in options. The equity exchange will be next and it will be in Miami. We don’t have a launch date yet, as we have these items we want to complete on the options exchange first. The focus right now is, let’s perfect the options market to the best of our ability.
Nigel Kneafsey, CEO, Options
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