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On 10 October 2022, Eurex will activate Passive Liquidity Protection (PLP) in the EURO STOXX 50® Index Options (OESX). This is the next logical step towards our goal of balancing the interests of all trading participants and improving market quality and efficiency.
Improvement of liquidity and pricing process in the order book
Passive Liquidity Protection has been found to be particularly effective for products where price discovery is dominated by underlying or exogenous markets, i.e. markets where latency arbitrage significantly affects liquidity. This is especially true in options markets, where latency arbitrageurs can exploit price effects of underlying or correlated instruments on the options. Of course, index products, where price signals can come from multiple constituents, are similarly influenced by external signals as single stock options.
Accuracy is better than speed
From the drawing board phase to implementation of PLP in 2017, it was therefore already clear that the index options area at Eurex, along with the single stock options, were the most suitable areas to benefit from PLP. For index options, this has proven successful with the activation of PLP in the DAX index options in August 2020, and Eurex has since been working hard to prepare for the rollout in its flagship product, the EURO STOXX 50 index options. In October, we will reach that milestone and introduce PLP in the OESX product. The process has taken longer than expected, but as Eurex is pioneering this new functional concept, it was agreed with trading participants to allow all those affected sufficient time for preparation and evaluation.
The heterogeneous trading community active in OESX includes numerous international banks, brokers, and securities firms, each operating with a diverse trading infrastructure that meets their individual needs. In terms of product development, it is therefore critical to understand the various drivers involved.
Ensuring a level playing field
Today, around 40 active trading participants compete daily for the professional provision of liquidity on OESX. It is critical for Eurex to ensure a level playing field where participants can focus on competing for prices and volumes in the interest of end customers. While some of these firms excel in providing high volumes at high speed, others focus on accurate pricing or transmission of information between related products or markets.
In recent years, Eurex has observed significant technological developments on the participant side, which have led to greater differences in participant setups. This has also impacted adverse selection due to latency arbitrage in various options products, which in turn has made contributing to an attractive liquidity picture challenging for some participants.
With several market participants unable to provide competitive liquidity, the liquidity of option products has consequently fallen short of its potential.
Compared to other index options traded at Eurex, for EURO STOXX 50 index options, a larger part of the volumes traded in the order book is not executed against the liquidity offered in the book but is offered and executed mid-spread. Although several factors can explain such an order book structure, Eurex is particularly interested in strengthening the visible offered liquidity.
How Passive Liquidity Protection can help solve the problem
Eurex conducts regular evaluations to determine the exact extent of latency arbitrage per product in order to conclude whether PLP can help to improve liquidity. For OESX, the extent of latency arbitrage is still moderate, but results show that it has slowly increased over the last five years. Considering the results Eurex has achieved in DAX index options, which are still visible in the product, PLP can reduce the extent of latency arbitrage not just once. It can also reverse the trend – i.e. not require significant infrastructure investments for competitive liquidity provision.
Eurex has set the PLP deferral time for OESX to 1 millisecond. While this may seem little, it is applied directly in the Eurex Matching Engine, which processes several thousand messages per second. Setting the deferral time aims to open a window of time for reaction (towards external price signals) without imposing unnecessary burdens on trading participants. Eurex has evaluated trading data from a period of more than one year to find resilient results that can be discussed with trading participants.
After the rollout of Passive Liquidity Protection (PLP) for the EURO STOXX 50 index option family in October 2022, Eurex will monitor and evaluate the results as in the past – and report them as soon as possible.
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Passive Liquidity Protection (PLP) is just one example of how we design our derivatives landscape by pioneering ingenious products and infrastructures as well as by building ‘smart’ into technology – offering a broad range of international benchmark products, operating the most liquid fixed-income markets in the world, and featuring open and low-cost electronic access. True to our mission to create better markets.
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