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Market Regulation

Passive liquidity protection

August 20, 2020

The anticipated rollout of passive liquidity protection (PLP) to DAX Index Options and the remaining equity option segments on Eurex, presents the potential to benefit end-investors by minimising latency arbitrage and resulting in healthier order books. However, implementation details will be key as additional complexity could have the opposite effect.

OPTIVER’S VIEW ON LIQUIDITY PROTECTION IN OPTIONS

On 24 August, Eurex will be rolling out an asymmetric speed bump[1] that aims to improve market efficiency by protecting liquidity providers from latency arbitragers through the introduction of a time penalty of 1.5 milliseconds on aggressive orders in the DAX options.

Liquidity protection is key to creating healthy order books, which are a sign of an efficient market that benefits end investors.  When liquidity providers cannot adequately protect themselves from adverse selection – in particular those lacking the resources to invest in latency – they end-up widening their spreads, showing less liquidity or simply exiting the market.  

Liquidity providers are often more at risk in the options market as multiple latency arbitragers can target liquidity via more than one path, with limited risk should they fail. The provider on the other hand, is on its own and can often send only one cancel or amend message, exposing it to adverse selection when failing to pull in time. Thereby the cost of getting adversely selected often significantly outweighs the benefit of capturing the spread as liquidity provider. Therefore, the main goal of liquidity protection is to offer the liquidity providers protection against latency arbitrage.

When aiming to improve market structure, exchanges should first and foremost understand the demands of end-investors, who require liquid markets with deep order books that enables them to execute their orders efficiently. In Optiver’s view, exchanges can achieve this in the options space through accurately determined (premium dependent) tick sizes, well-designed market making programs that incentivize liquidity provision and price setting and liquidity protection, of which PLP on Eurex is an example.

The design and parameters of liquidity protection are however key in determining its effectiveness and value add to the market and end investors. The guiding principle should be for both buyer and seller to be happy with the price at the time of trade. While it is important for liquidity provision to be stimulated to create healthy and attractive order books with a diverse range of participants, it is Optiver’s belief that it should also be balanced with liquidity taking strategies.

Liquidity takers may no longer be willing to do certain trades if the proposed delay of 1.5 milliseconds on aggressing orders in DAX options leads to a loss of control over orders. If liquidity takers are unable to cancel orders in the deferral queue, it may result in dissatisfaction with the price at the time of trade. The large delay on aggressive orders can further disadvantage liquidity takers by offering liquidity providers free optionality, to pick and choose when to cancel or amend orders.

Although Optiver supports certain protection for liquidity providers, we question whether the proposed implementation of PLP is the right solution as it could result in additional complexity that will reduce market transparency, which will negatively impact end investors in the long run. We believe that a simpler and more effective form of liquidity protection is for exchanges to offer a fast and efficient mass cancel mechanism which is easy to implement and can be utilised by all market participants. The simplicity of such an approach is likely to cause fewer unintended consequences than more complex solutions.

Whether Eurex’s PLP is the right tool for protecting liquidity providers remains to be seen and is something that needs to be closely monitored by the exchange and market participants, but in our view, exchanges offering liquidity protection in the options space, is a step in the right direction for creating a healthier market structure. 

[1] An asymmetric speed bump is a (typically short) delay that an exchange applies to the processing of some, but not to all, order types