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When the Chicago Board Options Exchange launched in 1973, it was the first options exchange, and it enjoyed a relatively uncontested dominance for the next 28 years.

But when the

International Securities Exchange


launched its all-electronic platform in 2000, the CBOE's leadership began to wane in terms of market share, which had been as high as 80% of all option trading volume, and innovation began to wane.

The ISE, by offering tighter markets and faster execution, quickly grabbed some 33% share of all equity option volume and became the exchange of choice for both traders and market-making firms.

The CBOE recognized the challenges it faced quickly enough, but the fixes proved to be a slow and difficult process. It took nearly three years, but the exchange's leaders finally convinced members and seat-holders -- who have a conflict between protecting their turf and the profit margins that came with the old way of trading, and remaining competitive -- to adopt an electronic trading platform.

"We are like the legacy carriers; we are the UAL to the ISE's JetBlue," said William Brodsky, the chairman and CEO of the CBOE. But after a tough couple of years, the exchange seems to have finally implemented the necessary changes to regain its competitive edge and market leadership.

A Bigger Pie

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One of the reasons the CBOE was able to survive is that, unlike the airlines, the options industry has provided exchanges with a growing pie, as total options volume has grown by over 25% for three consecutive years.

In 2003 and 2004, the CBOE's volume growth, while still in healthy double digits, lagged the overall industry. But in 2005, the CBOE recorded a 30% increase in trading volume, slightly besting the industry's 27% growth. This compares with equity volume, which increased by just 5% in 2005.

The CBOE's long time ace-in-the hole has been its near-monopolistic control of the listed options of some of the most popular index products, particularly the

S&P 500

(SPX) and S&P 100 (OEX) indices.

The SPX remains one of the few single-listed products, and attempts by the ISE and other exchanges to offer competitive broad market index products such as the ISE 100 Index (IXX) have failed to unseat SPX as the product of choice for institutional investors.

Also, the tremendous growth in ETFs and index products, such as the

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, has driven a parallel explosion in option volume, and the CBOE has managed to secure a solid volume in these multiple-listed products -- CBOE trades 38% of SPY option and 32% of QQQQ option volume. All told, volume on index products jumped 41% in 2005.

Open Outcry Lives

The most important change the CBOE has made was implementing a hybrid trading platform that retains open outcry but also offers electronic execution and the ability to be a remote market-maker. The CBOE is one of the few exchanges on which market-making firms such as SLK, Susquehanna and Timberhill have maintained a floor presence. SLK has closed its floor operations on the American and Philadelphia exchanges in recent years, and Susquehanna and Timberhill closed floor operations on the American exchange.

But the numbers show that live brokers have not yet outlived their usefulness. While the CBOE now executes more than 92% of its orders electronically, nearly 45% of its volume is still done through open outcry. This indicates that large complex orders generated by institutions are still being shopped around and have a better chance of being executed through a live broker.

The fact that just 8% of the orders account for 45% of trading volume shows that these large orders are vital to the exchange's success, and it explains why Brodsky says its important for the CBOE to "remain the last place in which open outcry exists."

Another indicator of the value of a physical presence is the price that a seat, or the right to trade, fetches. The most recent sale price was $870,000 in December, soaring from a low of $270,000 in 2004. The cost to lease a seat, which until last year had been calculated using recent sale prices but is now based on supply and demand and is therefore is a better measure of the value being placed on the right to trade on the floor, has been trending higher.

Gaining Independence

The exchange has clearly turned its ship around, and its future looks bright. Its plans to demutualize, which would be the first step toward a possible initial public offering, help explain the fact that seat prices are increasing faster than lease prices. The ownership of a seat would give one the right to own shares in the for-profit entity.

With the IPOs of other exchanges such as the

Chicago Mercantile Exchange

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Chicago Board of Trade


and the International Securities Exchange enjoying tremendous success, the CBOE seats might have a speculative premium built in as investors look to cash in on an IPO.

But that all brings into focus the CBOE's next huge obstacle: The members of the Chicago Board of Trade, which was basically the parent of the CBOE, still hold exercise rights to trade on the CBOE. With BOT members looking for ways to monetize their membership interest, the CBOE has been left in the awkward position of not being able to accurately calculate the number of shares that will be rewarded to each membership stake. Brodsky, the CBOE's CEO, says that when the BOT's lockup period expires and members are free to sell shares of the stock they received in the IPO, this will bring some clarity.


Board of Trade members need to retain full ownership; once they sell even one share, they forfeit the exercise right," he says.

Still, Brodsky acknowledges the "situation is extremely complicated and may not be resolved in 2006," but he has promised to look into doing everything that is reasonable and in the best interests of the membership, including an offer to buy out the exercise right, to expedite the process of demutualization. The CBOE has made great strides in the last year, and this last step toward securing a successful future is worth monitoring.

As originally published, this story contained an error. Please see

Corrections and Clarifications.

Steven Smith writes regularly for In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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