Alternative Market Structures for Derivatives

Abstract

In this paper, we compare option contracts from a traditional derivatives exchange to bank-issued options, also referred to as covered warrants, whose markets have grown rapidly around the world in recent years. While bank-issued option markets and traditional derivatives exchanges exhibit significant structural differences such as the absence of a central counterparty for bank-issued options, they frequently exist side-by-side, and the empirical evidence shows that there is significant overlap in their product offerings. The empirical analysis indicates that bid-ask spreads in either market are lowered by 1-2% due to competition from the other market, although options are not fungible between the two markets. We examine trading costs and liquidity for identical options in both markets and find that bank-issued options have smaller quoted percentage bid-ask spreads than traditional option contracts by an average of 4.3%. The co-existence of the two market structures can be explained by the fact that bank-issued option markets cater more towards retail investors with predominantly speculative motives while traditional derivatives exchanges cater more towards institutional investors with predominantly hedging motives. The idea of differing clienteles between the two market types is supported by various stylized facts and additional results such as smaller minimum trade sizes and average observed trade sizes in the bank-issued options market.

Keywords: Options, Market Design, Microstructure, Bid-Ask Spreads

JEL Classification: G10, G13