HOW NEW ENTRY IN OPTIONS MARKETS AFFECTED MARKET MAKING AND TRADING COSTS

Patrick de Fontnouvelle, Raymond P. H. Fishe and Jeffrey H. Harris

A significant competition for order flow in options markets occurred in August 1999. Before the competition, the majority of option volume arose from exclusive listings. By the end of September 1999, entry by existing option exchanges had shifted the majority of option volume to multiple-listing status. Both effective and quoted bid–ask spreads decrease significantly after entry with spreads remaining at lower levels 1 year later. A pooled regression analysis shows that new inter-exchange competition reduces option trading costs. This analysis also rejects the view that economies of scale in market making or lower hedging costs contribute significantly to the decrease in spreads.