Block trades in options markets

• Author: Sayee Srinivasan,Eleni Gousgounis
• Published date: 01 August 2019
• DOI: http://doi.org/10.1002/fut.22014
• Date: 01 August 2019

Received: 4 April 2019

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Accepted: 4 April 2019

DOI: 10.1002/fut.22014

RESEARCH ARTICLE

Block trades in options markets

Eleni Gousgounis

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Sayee Srinivasan

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1

Department of Economics and Finance,

Kania School of Management, University

of Scranton, Scranton, PA

2

Office of the Chief Economist, U.S.

Commodity Futures Trading

Commission, Washington, DC

Correspondence

Eleni Gousgounis, University of Scranton,

800 Linden Street, Scranton, PA 18510

and Commodity Futures Trading

Commission Three Lafayette Centre 1155

21st Street, NW Washington, DC 20581.

Email: eleni.gousgounis@scranton.edu

Abstract

Block trading, which was sparse before the reduction of the minimum

permissible block size threshold in October 2012, currently accounts for about

30% of the trading volume in WTI crude oil options. Block orders share similar

characteristics to those routed at the pit, but they have lower information

content and face higher execution costs, due to high search costs. However, our

results show that such block orders would have been costlier to execute at the

pit, which suggests that some pit order flow may have migrated to the upstairs

market, contributing to the eventual demise of energy options pits.

KEYWORDS

block trading, energy options markets, execution costs

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INTRODUCTION

When the Dodd Frank swap rules were introduced in October 2012, energy traders, who had been trading swaps for

decades, diverted their order flow to the futures market (Philips, 2013). This switch was facilitated by both the

Intercontinental Exchange and the Chicago Mercantile Exchange (CME), as they introduced new futures contracts

similar to existing swaps and reduced the minimum block threshold for many futures and options. The reduction of the

minimum block threshold became effective on October 15, 2012, in an attempt to retain the order flow associated with

the execution of exchange for related positions (EFRPs),

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a type of privately negotiated transactions also affected by the

new swap rules.

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However, while the reduction in block sizes has been associated with the so‐called futurization

phenomenon, what might been missed in the popular press is that the fact that block trading might also have had an

impact on the energy options market structure, as market participants with relatively small order sizes gained access to

block trading.

The reduction in the block trade threshold was intended to preserve market participants’ability to engage in

noncompetitive, privately negotiated transactions. Block trades, which are likewise privately negotiated transactions

executed away from the public auction market, are subject to minimum transaction size requirements and have been

traditionally used by market participants to execute large orders for which the centralized (“downstairs”) market

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might

Published 2019. This article is a U.S. Government work and is in the public domain in the USA.

J Futures Markets. 2019;39:985–1007. wileyonlinelibrary.com/journal/fut

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The data that support the findings of this study have been provided by the U.S. Commodity Futures Trading Commission (CFTC). The data are not

publicly available due to privacy restrictions. The research presented in this paper was co‐authored by Dr. Eleni Gousgounis, Associate Professor at

the University of Scranton and a consultant with the Office of the Chief Economist of CFTC and Dr. Sayee Srinivasan, Deputty Director, Risk

Surveillance, Division of Clearing & Risk, CFTC. This research was produced in each authors' official capacity. The analyses and conclusions

expressed in this paper are those of the author(s) and do not necessarily reflect the views of other Commission staff, the Office of the Chief Economist,

or the Commission.

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EFRPs refer to privately negotiated transactions, executed over the counter, which consist of two positions: a transaction in the organized exchange and a corresponding related overthe counter

(OTC) position, that is, cash, OTC swap, and OTC derivative. These are exchange transactions for bona fide business.

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The OTC leg of the transaction would subject market participants to CFTC swap regulation, while transitory EFRPs are prohibited based on rule 538.

be unable to provide sufficient liquidity without commanding a significant liquidity premium. Similar to EFRPs, block

orders are routed to the “upstairs market,”

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an off‐exchange network of broker/dealers and large institutional investors,

who negotiate transactions privately primarily over the phone. Table 1 presents the reduction in the block sizes for

major CME energy contracts. Noticeably, the minimum permissible block trade threshold for WTI crude oil options

dropped from a thousand to a hundred contracts. This dramatic reduction could potentially allow market participants

to divert order flow from the floor and/or the electronic order book to the upstairs market, potentially raising concerns

over reduced market transparency and liquidity. To wit, Hranaiova, Haigh, and Overdahl (2004) report that many

market participants a decade ago viewed block trades as order flow diverted from the floor. On the contrary, advocates

of block trading argue that such trading does not necessarily take business away from the centralized market, but

instead can increase liquidity as participants entering the market using block trades might subsequently trade in the

centralized market to either hedge or offset their positions.

The objective of the present paper is to assess how the reduction in the minimum threshold for block trades may

have affected liquidity and overall market quality. We focus on WTI options contracts, for which the minimum block

order threshold was reduced from a thousand to a hundred contracts. Block trading in WTI crude oil options, which

was very limited before October 2012, increased substantially thereafter, currently representing about 30% of the total

volume. The increase in block trading volume could reflect solely the transition of EFRPs to blocks. However, it is also

possible that the lower minimum block thresholds have attracted additional order flow to the upstairs market; such

order flow might have otherwise never reached the market, but it might also represent trades that would otherwise have

been directed in the electronic market and/or the pit. In this context, we explore the characteristics of orders executed

as blocks. We investigate whether block trading is more popular for relatively less liquid orders, such as option trading

strategies,

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and if so, whether block trading allows market participants to achieve lower execution costs compared to

those offered in the electronic market and the pit. Interestingly, the execution difficulty associated with the complexity

of option trading strategies is also commonly considered the primary reason for the relatively slow transition of options

trading from the pit to the electronic market, which supports the claims on the importance of human intermediation in

reducing search costs and raises concerns over the potential migration of order flow from the floor to the less

transparent block trading.

We find that block orders differ from EFRPs in that they have a higher information content (although still low) and

in that block trading is more popular with option trading strategies, compared to outrights. While the block outright

volume appears to subside over time, the proportion of option trading strategies trading as blocks increases right after

the rule change remains stable close to 30%. At the same time, pit orders, which are predominantly option trading

strategies, gradually decline from about 30% to about 10% towards the end of our sample. We also find that block and pit

orders share similar characteristics and face higher execution costs than electronic orders. Block orders face the highest

effective half spread, which can be attributed to high search and negotiation costs, as the information content of those

orders is lower than the orders executed at the pit and the electronic platform. However, these orders benefit from block

TABLE 1 The reduction in block trade thresholds in energy contracts

Contract Commodity code Old block threshold New block threshold

Light Sweet Crude Oil futures CL 100 contracts 50 contracts

Light Sweet Crude Oil options LO 1,000 contracts 100 contracts

Brent Crude Oil Last Day Financial Futures BZ 100 contracts 25 contracts

Henry Hub Natural Gas futures NG 100 contracts 50 contracts

Henry Hub Natural Gas options ON 1,600 contracts 100 contracts

New York Harbor ULSD Heating Oil futures HO 50 contracts 25 contracts

RBOB Gasoline futures RB 50 contracts 25 contracts

Henry Hub Natural Gas Look‐Alike options LN 550 contracts 15 contracts

Note: It describes the reduction in the minimum threshold for block trades in the energy market, which was introduced in October 2012. It shows the old and

the revised block minimum threshold for eight prominent energy contracts trading at NYMEX.

Source: CME Group (2012).

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The “downstairs”market refers to trading in the centralized market which includes the electronic order book and the pit (floor trading), which was active in the time frame examined.

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The “upstairs”market refers to all trades negotiated off‐exchange and in the case of energy futures it includes EFRPs and block trades.

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Option trading strategies (often called spread trades) refer to the simultaneous trade on more than one options contracts.

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GOUSGOUNIS AND SRINIVASAN