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Viewpoint – The rise of retail in derivatives markets

As the makeup of trades and market participants changes, operations must keep pace

3 March 2021

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One of the biggest trends in financial markets in 2020 was the rise of retail participation, particularly in the US equity markets. Brokerages reported a massive increase in the number of new accounts and the amount of assets being invested through their platforms. And social media lit up with posts from active traders talking about their trading strategies.

A significant portion of this activity spilled over into the US equity options market. According to UBS, retail trading now accounts for 42% of total equity options volumes, up from 30% at the beginning of 2019. The US equity options markets set an all-time record last year for number of contracts traded, making that jump in market share even more impressive.

This surge of activity is creating exciting new business opportunities for exchanges, brokers, market makers and many other companies in the derivatives industry. But it also raises some serious issues.

Are first-time investors taking on too much risk? Do they fully understand the contracts they are trading? Is this increase in retail participation permanent, or just a short-term fad?

As someone who has witnessed the growth and evolution of financial markets for more than two decades, I know firsthand that markets move in cycles. For every bull market that brings in new participants, there will be a bear market that drives them away. But I also believe structural forces are creating a long-term uptrend that will support continued retail participation in derivatives markets for years to come.

First, the cost of trading has fallen very close to zero, thanks to the adoption of zero-commission trading and intense pressure on bid-ask spreads. It's a basic law of economics: people will tend to use more of something when the price goes down.

Second, innovation has made trading far more convenient. In fact, trading stocks and options is now as easy as using your smart phone. There are clear risks that come with that, but there's no denying that technology has granted wider access to derivatives markets.

Just as importantly, this is not just a US phenomenon. Brazil, China, India and Korea also have huge numbers of retail traders, and many of the top contracts on the derivatives exchanges in these countries benefit from heavy inflows from individuals. In fact, the derivatives exchanges in those countries have grown so rapidly they now rank among the largest in the world — thanks in large part to retail trading.

FIA is a strong believer in the power of markets, and the importance of making them accessible. However, if this retail revolution is indeed here to stay, then our industry needs to make some changes.

Many firms in our industry are focused primarily on institutional customers, and their organizations are not always well suited for the demands of serving large numbers of customers making large numbers of very small trades. This is one reason why FIA has made operational efficiency a top priority. As trade sizes get smaller and the number of transactions goes ever higher, our industry needs to automate and standardize as much as possible.

Adopting standards and automating the processing of trades is important not only to help firms seize the new opportunities created by the rise of retail, but also to ensure that these markets remain resilient. As we saw during the pandemic-related volatility of 2020, a complex system without standardization and predictability can create real challenges for our industry in times of stress.

Industry standards are an essential building block for automation, and associations like FIA are well positioned to lead the way. When trading volumes surge, the back office teams at every firm must have the ability to scale up their work so that transactions can continue flowing through the markets.

Looking outward, there's also a big opportunity for FIA and its members to play a key role in educating a new generation of market participants about both the risks and rewards of trading derivatives. The guiding principles should be responsible innovation and thoughtful participation in our markets. Reducing unnecessary barriers to market access is important, but that doesn't mean there should be no barriers at all.

Trading isn't a game, even if it feels that way sometimes, and FIA see it as our obligation to encourage responsible behavior — by retail investors, as in many other areas. In a well-regulated market, the risks are clearly disclosed and well understood, and exchanges and intermediaries are subject to high standards for customer protection and market integrity. These principles should be at the forefront of all our work as we welcome new traders to these markets.

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