Volatility has its unique complexities. Trading without the benefit of a visible volatility market is impossible at worst or, at best, it comes at significant cost in terms of tracking risk in real-time and minimising implicit transaction (spread) costs. To counter these adverse outcomes, the JSE has begun providing access to real-time on-screen pricing for its JSE Top 40 index options contracts, which are the second most-traded contracts after index futures in equity derivatives markets by value traded. This is an effort to increase transparency and liquidity in the index options market.

Langa Manqele, Head: Equities and Equity Derivatives at the JSE, says historically these contracts have been traded off-screen, in other words, over the phone or via data-terminal chats between counterparties and later reported to the exchange. He adds that while overall equity-derivatives market activity was up 7% as at end of March 2021, the vast majority of that activity on index options is off-screen, and trading activity has retracted by 10% over the same period. This presents certain challenges in terms of available liquidity, for example.

Manqele explains that ‘most participants in the market take a directional view – some may believe that a price of a share or index will rise, while others may have the view that it will fall. Market-makers, on the other hand, are there to take an opposite view, not necessarily because they believe in that view’.

These are typically the large banks and some electronic liquidity providers who provide a visible offer for every bid in the market and vice versa; and these market-makers are there to ensure that the market is competitive, that there is price discovery and that there is sufficient liquidity at various levels of the order book.

They are able to immediately hedge out their risk in the futures market once a trade is done. Implicit in market-making is that market-makers are always compelled to show their hand, oftentimes against a directional view, and this exposes them to adverse selection – if a market-maker sets an offer price too high, no trade could occur but if they set it too low, then others will lift the offer to their disadvantage. The requirement that these participants show their price publicly via the central order book of the JSE has necessitated a targeted market-making scheme to incentivise risk taking.

The JSE has designed its index options market-making scheme to encourage market-makers to make their competitive bid and offer prices visible on-screen, that is, in the central book of the equity derivatives market. While the exchange’s derivatives market comprises single-stock options, single-stock futures, derivatives on international stocks, index futures and index options, it is the last of these that is the focus of the exchange’s market-making scheme.

It targets options contracts based largely on the following: the JSE Top 40 Index (which references the largest 40 companies by market cap), the DTOP Index (similar to the Top 40, but with the weight of certain constituents adjusted for their non-SA shareholding), and the DCAP Top 40 Index (where exposure to a constituent is capped at a maximum of 10%).

To incentivise participation, market-makers who publish their prices on-screen and who trade a certain volume will receive a discount on their fees once the final scheme is implemented post the first pilot phase, which is currently under way.

Manqele says in Phase 1, a trial, market-makers are required to do this on a ‘best-effort’ basis. ‘This will facilitate an improvement to visible option prices, which will enable tighter bid/offer spreads and enhanced liquidity.’ They will have no formal obligation to do so, until Phase 2. Once fully implemented, there will be certain ‘time on book’, competitive spreads and volume requirements.

‘The JSE is continuously collaborating with its clients and the wider ecosystem to investigate new initiatives that enhance transparency and liquidity for market participants,’ says Manqele. ‘We are excited to work with the market, and trial an index options market-making scheme because it will promote price transparency in the options market and will drive liquidity for index options contracts in the options market.’

By Hilton Tarrant
Images: Gallo/Getty Images