The idea of creating a dark pool in options has not been easy because options trades are not permitted to occur off-exchange. But a recent deal between the Chicago Board Options Exchange and 3-D Markets, a block-crossing network, suggests that exchanges and liquidity pools can cooperate on crossing institutional orders based on benchmark prices.

Nearly two weeks ago, the CBOE signed an exclusive licensing agreement with 3D Markets Inc, a block options crossing network in New Hope, Penn., to offer GWAP benchmark priced trades to institutions.

Without going into the underlying math, GWAP — which stands for gamma weighted average price — is a proprietary formula that 3-D developed that allows for the creation of a VWAP in options.

“The GWAP is intended to allow an institution to buy or sell a substantial number of contracts at the GWAP price, which reflects had they been able to purchase that for a VWAP number,” says Ed Provost. The

The GWAP will be calculated based on what the stock did that day. “It is based on part of the VWAP of the stock. You have to have that calculated in order to come up with the price,” says Provost. An institution would put a buy or sell order in at the opening and that number would be matched with someone who wanted to take the other side, presumably a liquidity provider (market maker).

GWAP is the brainchild of 3-D Markets, which develops software and networks as solutions to help institutions add liquidity to existing options markets. “We’re providing the technology, the pricing mechanism and the system that brings the two parties together. That’s where the Archangel platform comes in,” says Jeromee Johnson, president of 3-D Markets.

Under the current market structure in options, 3-D Markets can’t execute these trades in its dark pool ArchAngel. All options trades must be executed on an exchange. To get around this obstacle, 3-D Market’s Archangel Benchmark Cross will operate as a facility of the exchange. The CBOE will provide the regulatory framework, and the regulatory oversight, explains Johnson.

“We think the partnership with the CBOE and the magnitude of that represents certain validation for that and who we are and what we’re doing,” says Johnson. “It’s really reflective of their interest in the institutional markets,” he says.

Because options are not as liquid as stocks and trade in multiple places (seven exchanges) it’s difficult to calculate the VWAP as a fair and secure price. “That’s why we came up with an alternative,” says Johnson.

The new partnership is significant because it’s targeted at institutions that are trading thousands of contracts – as many as 250,000 – to execute at a fair price with anonymity and without market impact.
And these are not hedge funds doing high frequency trades. “The institution is probably a long-term holder of options, when they bought 50,000 options reflective of what the stock did that day,” says Provost.

Many of these large options trades are being done over-the-counter options trades with broker dealers. CBOE would like to bring those OTC trades to the exchange. With the concerns over the demise of Bear Stearns and concerns over counterparty risk, one of the benefits of the GWAP benchmark process is the access to the triple-A rated Options Clearing Corp., which eliminates any meaningful counterparty risk, says Provost.

However, this is not like a dark pool where institutions can enter their own orders through an electronic trading system. In this case, buy-side firms would have to go through a CBOE member, such as Merrill Lynch, Goldman Sachs, Susquehanna, or Group One, to name a few. Or, they can go through 3-D Markets, which have a broker dealer license and access to CBOE. “A random institution could not come to 3-D Markets unless they could trade on the exchange or through 3-D Markets,” says Johnson.

In this age of direct-market access trading and the buy-side gaining more control over its order flow, it seems like the institutions should have direct access to the GWAP cross. Perhaps that will come eventually. First, CBOE and 3-D Markets plan to focus on obtaining the regulatory approvals before they can announce a formal testing and rollout schedule. SEC approval is required to post these benchmark-priced trades.