Trading Warrants on SIX Swiss Exchange: A New Model That Benefits Investors

As a result of extensive research and customer consultations, in June 2020, SIX Swiss Exchange moved its Structured Products trading segment from a standard quote driven market to a price validation model (PVM).

The expected benefit of this shift was that investors in leveraged products (warrants) would benefit from a wider selection of tradable instruments and tighter spreads. This is owed to the fact that on venues with price validation, liquidity providers are less exposed to latency arbitrage and can therefore increase their warrants portfolio without increasing their risk exposure.

Now, nearly two years after the introduction of the PVM, we have sufficient data to evaluate the results of the new trading model and to answer the question whether the new PVM has delivered the expected benefits to the targeted retail investors, estimated to be responsible for over 95% of the trades in leveraged products on SIX Swiss Exchange.

PVM-Driven Growth

The portfolio of tradable warrants on SIX Swiss Exchange has grown significantly since the introduction of the PVM in mid-2020 (measured by the number of active product ISINs). This can be observed on Chart 1: Growing Number of Tradable Warrants on SIX Swiss Exchange, which illustrates a step change in the number of active warrants from the beginning of 2021.

Whilst the beginning of this growth trend does not perfectly coincide with the introduction of the PVM, an enhancement of quotation capacity in this trading segment at the end of 2020 fueled this development, as it enabled the liquidity providers and ultimately also the PVM to operate with greater technical efficiency. This led to a 42.4% increase in active warrants in fifteen months (with periodic drops owed to triple witching days). While market factors such as increased market volatility and trading activity have been growth-favorable, the introduction of the PVM appears to be a key factor driving growth in the warrants portfolio.

PVM Impact on Spreads

The PVM was introduced in a way that liquidity providers do not have to actively validate their quotes if they do not wish to do so, and can switch to active validation at any time. Consequently, when comparing the quoting behavior under the PVM with the firm pricing model, we consider the individual switchover dates of liquidity providers.

To analyze spreads before and after the switch to the PVM, we segmented the available price data along two dimensions. First, we divided the warrants into six buckets according to the price at which the warrants trade, then we segmented each bucket into five different volatility ranges of the SMI Volatility Index VSMI (based on the one-month implied volatility of the SMI stocks and is expressed in percentage) to reflect volatility in the underlying markets, and finally, for each cross-section, we derived the relative spread (“spread”) expressed as a percentage of the mean price.

The Chart 2: Relative Spreads by Price and Volatility Bucket displays the results for both periods, pre- and post- PVM, with the background color helping visualize the magnitude of the change in relative spread within a price bucket. Before the introduction of the PVM, the relative spread widens with increasing volatility while shrinking with increasing price.

However, under the PVM – which effectively removes price risk for the liquidity provider – we observed that spreads remain broadly constant across most volatility levels. With respect to whether spreads are tighter under the PVM, the answer is both “yes” and “no”. At low volatility levels, spreads are the same or even wider under the PVM, whereas, at higher volatility levels, spreads have tightened.

These visual results are also confirmed by a regression model in which we express the relative spread with price, volatility and the introduction of the PVM. To do so, we use a panel data regression with a fixed effect to account for security differences on the same dataset. The regression confirms that the price is negatively correlated with the relative spread, whereas VSMI index is positively correlated. Moreover, the model shows that the relative spreads under PVM are tighter than with firm prices when the VSMI index is above 17% (but otherwise wider).

From a conceptual perspective, there is no mechanistic reason for spreads to widen under the PVM in a low volatility environment. While there are several possible market-related explanations, they are not part of this analysis. The most important observation relating to spreads from this analysis is that the PVM has facilitated greater spread consistency across the volatility spectrum, which is an important characteristic given the current climate of uncertainty in global markets.

PVM Impact on Price Slippage

A common question with respect to PVM is how often investors get their orders executed at the displayed prices. In practice, under the PVM, price validations can fail because the displayed price has been adjusted during the price validation phase (N.B. price adjustments can also be positive and result in a price improvement for the investor). When defining a price validation failure in the context of the targeted investor segment (i.e. manually trading investors), an order is likely to be considered failed if it is not executed immediately at the last seen price or within the instructed order limit.

Taking into account human, user interface and network latency, we assume that an execution within three seconds of clicking “Trade” is still likely to be considered a successful transaction, as any shorter delay in the matching process is likely to go unnoticed. Therefore, we propose that only investor-initiated price validations with a trade (or order deletion) after three seconds should be classified as failed. As such, we derive a fail rate that relates the failed investor-initiated price validations to the total number of investor-initiated price validations. Chart 3: Daily Fail Rate of the PVM by Volatility Bucket illustrates this fail rate for the different volatility ranges.

Whilst it is not feasible to compare the above fail rates to those under firm pricing models (because they cannot be quantified), the observed rates are most likely acceptable given that there is no evidence that trading activity on SIX Swiss Exchange has decreased since the introduction of the PVM.

Conclusion: Benefits for Retail Investors Achieved

The charts above indicate that the introduction of the PVM has benefited retail investors in two ways: by fueling growth in the number of tradable warrants and by improving spread consistency across (most of the) volatility spectrum. At the same time, the validation process goes largely unnoticed by manually trading investors and has no negative impact on trading leverage products.

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