Eurex is preparing to test a "passive liquidity protection" mechanism to encourage more market making in its French and German equity options market.
Beginning June 3, this mechanism will slow down all aggressive orders—transactions that are executable upon arrival at the matching engine—by three milliseconds for options on French equities and one millisecond for options on German equities.
The test will continue for at least six months. During that time, executives at the Frankfurt exchange will monitor the impact on the market and tweak the delay times if they feel an adjustment is necessary. The pilot phase may be extended if they decide extra time is necessary to gather more data.
Eurex is one of several futures exchanges that are exploring this type of mechanism, which historically has been more common in equity markets. ICE has proposed a "passive order protection functionality" to delay aggressive orders in certain gold and silver futures, and London Metal Exchange has proposed a "fixed minimum delay" on orders flowing into its LMEPrecious trading venue.
Some market participants have pushed back, however, saying these mechanisms will add a layer of complexity to the trading process, especially if they proliferate across the marketplace. They also have questioned the rationale for slowing down some types of order messages but not others, and warn that it will make it harder for end-users to understand how their orders are being filled.
Eurex executives explain that their speed bump is designed primarily to encourage more trading in certain products that have almost no liquidity in the central limit order book. They argue that certain trading practices are reducing liquidity in thinly traded equity options by discouraging other traders from posting quotes in the order book.
When an underlying stock price moves, liquidity providers need to update hundreds of prices for the related options. That can allow a very fast trader to trade against a quote that has not yet been updated, explained Randolf Roth, a member of the Eurex executive board, and a leader of the project.
"The problem is made worse by the fact that not all liquidity providers use the same technology. If you have 20 liquidity providers—20 market makers—they have different infrastructures, which make them respond with different speeds. One or two firms are faster than anybody else; another five are almost as fast; and seven to eight are markedly slower, microseconds different," Roth said.
Over time, slower players have learned to behave defensively, either by sticking to complex market orders, which are conducted by telephone, or by posting quotes with wider spreads.
The upshot: less liquidity in the market, and less efficient pricing, according to Roth. “The real damage of this situation is that people do not provide their best prices in the order book for the benefit of the investing public,” Roth said.