In a series of articles, we’re exploring liquidity protection – the measures offered by exchanges to ensure that market makers are able to quote without taking excessive risk. Effective liquidity protection is, in our view, fundamental for facilitating price discovery in liquid, electronic options markets.
Interest in options has rarely been as high as it is today. Volumes in single-stock and index contracts continue to soar in parts of the world, while new options products are rolled out regularly. An often-overlooked reason for this is the liquidity that’s available to options traders, which has allowed these instruments to become global barometers for investor sentiment.
This liquidity doesn’t happen by magic. Market makers in options post consistent two-sided quotes in thousands of instruments, an effort that involves considerable investment in technology, pricing capabilities and thorough risk management, as well as the liquidity protection mechanisms available at exchanges.
In a series of articles, we’ll explore the different types of liquidity protection offered by exchanges to market makers, with the goal of educating market participants about these measures. We conclude that liquidity protection improves options markets – and that a combination of these measures is the most effective way to ensure our markets continue to function smoothly for the benefit of all.
What is liquidity protection?
Liquidity protection aims to address the structural disadvantages faced by liquidity providers in the options market. It does so by safeguarding market makers against excessive risk. Because liquidity providers maintain hundreds of quotes on a given underlying at any one time, a sudden market move can leave them vulnerable to showing stale, or outdated, quotes. So-called liquidity takers can target stale quotes via multiple paths, with limited risk should they fail. Liquidity providers on the other hand can often send only a single cancel or amend message at a time, putting them at a disadvantage and exposing them to potentially major losses if they’re unable to amend or cancel quotes before they get executed.
Without robust liquidity protection mechanisms to protect against these risks, market makers may be forced to widen their spreads, show less liquidity or simply exit the market. Overall market quality can deteriorate as a result, and investors suffer when it becomes too expensive to transact or they’re prevented from transacting altogether. In sum, liquidity protection mechanisms are vital for achieving a healthy balance between liquidity providers and liquidity takers in the options market.
What tools are available?
Many options exchanges have already responded to this situation by putting in place market maker protections for post-trade risk management. Market maker protections (MMPs) allow liquidity providers to set limits on the amount of executions they receive as a way to help them manage the aggregate risk of their positions. In addition to MMPs, there are a handful of complementary measures that we believe to be effective at levelling the playing field between liquidity takers and liquidity providers:
- Mass cancellations, which allow liquidity providers to simultaneously cancel (a subset of) resting orders, which we believe should apply across sessions
- Purge ports, which physically provide a dedicated path to the matching engine to simultaneously cancel resting orders
- Asymmetric speed bumps, or a defined time delay on all aggressive orders, which in certain contexts or markets can prove effective
In October 2022 we wrote in support of Eurex’s passive liquidity protection (PLP) mechanism in EURO STOXX 50 Index Options. Since then, PLP has been shown to improve price setting competition and top of book liquidity at the exchange. PLP and similar liquidity protection measures are being more widely embraced, as demonstrated in Acuiti’s Proprietary Trading Report.
Effective liquidity protection is, in our view, fundamental for facilitating price discovery in liquid, electronic options markets. We believe a combination of these measures – including MMPs, purge ports and mass cancellations, and in specific cases asymmetric speed bumps– will help ensure that options markets remain healthy and liquid on screen.
Read next: Market-Maker Protections
To discuss this paper – or any other market structure topic – reach out to the Optiver Corporate Strategy team at [email protected]
DISCLAIMER: Optiver V.O.F. or “Optiver” is a market maker licensed by the Dutch authority for the financial markets to conduct the investment activity of dealing on own account. This communication and all information contained herein does not constitute investment advice, investment research, financial analysis, or constitute any activity other than dealing on own account.