BATS Global Markets has a hand in both equities and options, and its options market, though relatively new, is holding its own among the growing list of options exchanges. John Lothian News’ Sarah Rudolph caught up with Kapil Rathi, a VP of options business strategy at BATS (along with Jeromee Johnson), and Bryan Harkins, BATS executive vice president and head of U.S. markets, at the Options Industry Conference in Miami Beach earlier this month, where she spoke to them about BATS’ plans for a new exchange, how to grow the pie in the options space, BATS’ new proposal for small-cap equity trading, and their take on the OCC’s capital plan.
SR: BATS Options has been building its market share. What is the next phase in the exchange’s growth?
KR: Our near-term goal is to launch a new options exchange called EDGX Options, with a customer priority/pro rata allocation model. BATS is a leader today in the price-time market, a fairly small subset of the options industry. So there is a large customer base not currently being served by BATS: the “classic” market with a pro-rata priority based model and payment for order flow. This is the model used by CBOE, Amex, MIAX and PHLX.
BH: Our expansion in options is also part of our overall plan to execute and be No. 1 in all the asset classes we touch. We try to identify large markets we can enter with our technology and our economies of scale and improve the efficiency of that market.
We’re almost just getting started in options; even though we got very respectable market share, between 9 and 10 percent this year, we haven’t started competing in the two-thirds of the pie yet.
SR: There are many challenges facing the options industry, including regulatory and technology issues. What is the biggest challenge for BATS – and for the industry as a whole?
KR: As we heard, volumes are down, and in the past four or five years we haven’t seen the retail business coming back into the market as we expected.
We still think it’s more of a cyclical event. When interest rates start improving, the options orders should come back, but in the meantime it is concerning when market makers are not as profitable, and some liquidity providers are closing up shop. People have been talking about how spreads are widening and what that means for options, and what we can do to bring back the liquidity providers into the market. I think BATS has a pretty big stake in this, and we think we can make a difference. Some of the functionality and market structure changes we can bring up, I think we have to work together to make sure the industry stays healthy.
BH: The great challenge as I see it is which exchange can solve some of these industry trends while still winning the business in a hyper-competitive space. We are all trying to fight over a fixed pie, but it is also in all our best interests to grow the pie. If an exchange can come up with solutions that are ahead of their time and that help to grow the overall pie, if it can get the industry behind it and win the business, then I think that exchange will be the leader of the pack.
KR: BATS just released an equity proposal yesterday that is sort of a sample of the leadership position we want to take in both the equity and options space. But beyond BATS, we want to look at what we can do to take a leadership position to help the market be a better experience for investors and to help the retail traders become more confident with options.
SR: What is BATS’ equity proposal?
BH: We believe that the market serves large cap stocks very well. However, when you move down the list of stocks and get to the bottom 500 or 1,000 names, they do not trade nearly as well. The tick pilot the SEC just approved was related to the JOBS Act, which involves the idea that you can help small companies grow. We think the current Reg NMS system of one- size-fits-all large cap and small cap names all trading under the same rules is probably worth tweaking. We have put it out to the industry that we think all of these small cap names should trade in one spot, a primary exchange such as Nasdaq, NYSE, or Arca. That will better aggregate liquidity at one point as opposed to fragmenting it all throughout the industry, and that might help attract investor interest.
A lot of people ask, “Why would you do that, because you don’t have a corporate listings business and you’re giving up the trading of those names?” We at BATS believe that if you take the long view and do what’s right for the market at large and for investors, that’s a winning strategy and that’s good for the markets.
SR: BATS has asked the SEC to review the OCC’s capital plan again. What stage is that in?
BH: We appealed the SEC’s approval and our appeal triggered an automatic stay of the approval. We and the other exchanges are all awaiting a decision. We felt that under the rule filing process the OCC’s plan did not address the burden on competition. Secondly, the OCC needs to raise capital, nobody is arguing with that. But when the rate of return to the OCC shareholders that are ponying up the capital equates to somewhere between 15 and 20 percent, we think that’s not a fair cost of capital. I think anybody would sign up for that rate of return. Thirdly, we think the process was not transparent, so with a designated SIFMU like the OCC, we feel there could have been alternatives considered. OCC says they considered multiple plans, but those might have been behind closed doors at the board level.
KR: To add to that, the aggressive cost of capital for some of these owner exchanges is eventually going to translate into extra cost for the members. We believe they can have a better process to keep the rate of returns at a reasonable level.
SR: What would be your ideal outcome for this situation?
BH: We realize the sensitivity around timing and that the SEC and also the Fed want to see OCC better capitalized sooner rather than later. However, we don’t think that a more competitive process has to be that dragged out. If you were to open it up to other exchanges and market participants alike, we think that in 90 – 120 days we can come up with a better outcome for the industry – a better cost of capital, and one that is spread out, so it’s not just a few exchanges that are ponying up the capital – market participants could participate as well. The more people competing on that rate of return, the more palatable the cost of capital for the industry.
SR: How big is the threat of regulatory overstepping?
KR: Regulatory costs are always a concern for every trading house, but I think the SEC is doing a pretty good job in making sure the market structure is efficient. They are taking input from participants. At the end of the day, there should be someone accountable for making sure that serious market breakdowns don’t happen. For example, Reg SCI was meant to take care of the systemic risks inherent in the market. We at BATS are confident that we are ready to comply with Reg SCI. It will add some cost to us, but it’s not really concerning. And we support the market structure ideas that the SEC is bringing and their generally proactive management.
BH: Reg SCI really just codifies what we have already been doing. The SEC’s ARP – automated review process – is essentially the agency’s IT guidelines on how to make sure an exchange is resilient and has enough redundancy and sound information security. But ARP was really just guidelines rather than law. Now it’s law. And actually we all welcome it because it instills further confidence in our exchange. It probably affects brokers more than it affects the exchanges, who are already doing it. Some brokers who don’t have big budgets may have to rethink their businesses and whether it’s worth it to be as large as they are or offer the products that qualify under SCI.
KR: We must also give credit to the OCC. They have come up with their definition of some pre-trade risk checks which they are asking all the exchanges to comply with.
SR: And BATS already has those in place?
KR: Yes, BATS is already fully compliant. But that speaks to how industry is taking a proactive approach to managing these risks, whether from a fat finger or systematic issue or messaging. I think those are good ideas. To improve investors’ confidence in the integrity of the market, if all the exchanges can join together and create a more common framework, that might be the next step. And it is a good start that OCC is now taking a role in this.