In Wednesday's column I looked at the structure and regulation of the options industry. Today I'll focus on product listings and trade execution issues.
The two events that have had the biggest impact on options trading are dual listings (allowing one contract to trade at multiple exchanges) and electronic trading. Even though they came from different directions -- the former a child of government regulation and the latter from free-market competition -- both are technology-driven and have gained in popularity because of their efficiency and fairness. While this has led to more transparent, tighter markets and lower costs, it also presents new challenges for the exchanges and members.
former SEC Chairman Arthur Levitt mandated dual listing of contracts, that created competition, but it did not foster communication," said OptionXpress CEO Ned Bennett. While in theory customers would receive more competitive bid/ask spreads, exchanges were not required -- nor did they have much incentive -- to match each other's quotes.
Part of the problem was the practice of payment for order flow. This essentially amounted to either a kickback process to entice firms to direct business toward a particular exchange, or "rebates" to member firms that offered discounts to garner business. Whatever the label, the practice had been viewed as a necessary evil: As quickly as one exchange succumbed to the perception that the practice was anticompetitive and created conflicts of interest, another would reinstitute it to gain market share, forcing other exchanges to find ways to entice order flow back.
This practice will always be present in one form or another, whether it's specialists claiming they need incentive to carry risk, market-makers wanting subsidies for providing liquidity, or institutions looking for volume discounts.
Take My Price, Please
While brokerage firms should have always been looking to provide the best prices, the onerous burden of comparing markets often fell on the customers' shoulders. But now the process of scanning for the best bid/offer has been greatly simplified.
"Customers are now far more sophisticated and demanding than in the past. And technology and rules actually make it a lot easier for them to smart-route orders than it is for broker/dealers," said Tony Saliba, principal and founder of both First Trader Analytical Solutions, which provides the CBOE and Amex with front-end workstations, and LiquidPoint, which offers an electronic broker/dealer trading platforms to brokerage firms.
This shift in power -- and what threatens the floor broker/market-maker and specialist system livelihood -- stems from electronic linkage of options listings. This ties all five options exchanges together, creating real-time price dissemination, which leads to more transparent, competitive and liquid markets. Since it was rolled out with just five issues last January, the link now encompasses more than 80% of listed options. The linkage system is managed and overseen by the independent Options Clearing Corp.
"This has been a boon for active options traders but is still a cumbersome and expensive process of adaptation for the exchanges and broker/dealers with legacy systems," said Saliba.
In addition to the reduced costs and efficiencies provided by electronic trading, it also has improved regulatory control. "Electronic trading systems do not allow for trading violations to go through undetected. The process, especially when removing the specialist system as we and the International Securities Exchange have done, simply does not have trade-through problems or specialists not honoring market quotes," said Dale Carlson, vice president of corporate communications the Pacific Exchange.
His opinion is born from the fact that electronic trading leaves an indelible time and price stamp on all orders, creating a traceable audit trail. The number of customer complaints against ISE and PCX, according to Carlson, is almost an infinitesimal fraction of those against specialist-based exchanges such as the Amex and CBOE.
Another reason for the ISE's success in quickly becoming the market-share leader is the recent trend of firms eliminating floor operations. "Being able to make markets remotely greatly reduces the overhead for both the exchanges and it member firms," said Carlson, explaining one of the reasons for the Pacific Exchange's decision to shutter its Los Angeles floor exchange and migrate toward the Archipelago electronic trading platform.
My Enemy's Enemy Is My Friend
While this sharing and cooperation are a necessary evolution of the trading business, the exchanges still view each other as competitors. This has led to some very unholy and migratory alliances as exchanges balance their desire to gain market share with the need to protect their franchises.
As the CBOE is no longer the industry goliath, other exchanges have begun slinging rocks with greater frequency. In an attempt to remove its last pillar of strength -- the exclusive trading rights for options-based index products such as the
-- the ISE has sent a letter to the Securities and Exchange Commission, claiming that the exclusive licensing agreement amounts to a monopoly in violation of dual listing rules and constitutes anticompetitive practices.
The CBOE counters that index products differ from equity options in that "millions of dollars have been spent in both development, marketing and acquiring the license ... and are therefore protected under intellectual property and contract law," according a letter the CBOE submitted to the SEC.
The Pacific Exchange, which endorsed the ISE's letter, sent one of its own requesting a moratorium on any new exclusives, including the impending launch by the CBOE of trading in options and futures based on its volatility index (VIX). The Pacific Exchange, as Carlson points out, is not "looking for a free ride, and
we have offered to pay a nonexclusive trading fee. This is what's best for the customer and business over the long term. When the Amex made similar non-exclusive arrangements involving the QQQs, it led to a threefold increase in volume and much more liquid markets."
New Kid on the BOX
Other battle lines are being drawn over the launch of the Boston Options Exchange (BOX), which is currently awaiting approval from the SEC but which hopes to open by the fourth quarter, according to Janice Foley, vice president of corporate communications. Foley notes that the SEC is currently reviewing more than 220 comment letters, of which just 13 are negative. "I don't think it would be a stretch to surmise that those 13 come from competing exchanges," she said.
The major criticism of the BOX's structure is that its Price Improvement Period, or PIP, will promote internalization, i.e., a firm receiving an order can "cross" it on its own books without displaying it on the open market. But Foley explained that "PIP requires at least three firms to bid and allows for a three-second window for price improvement." The BOX won't have any specialist per se, but it will have a layered system of primary market-makers, member firms and those with direct access to the electronic system.
Some think this is tantamount to creating a private auction. "The BOX limits competition, fosters internalization ... and will greatly degrade the auction process," reads one portion of the ISE's comment letter. This is slightly more combative than the diplomatic "we welcome all competition" party line that ISE Director of Special Projects Steven Spears offered a few months ago.
The PCX's Dale Carlson is much more straightforward. "The BOX's
PIP is a feeble attempt to construct a private auction and keep markets hidden," he said. "Three seconds and three bids does not a market make."
But LiquidPoints' Saliba defends the newcomer. "I think some of this criticism comes from self-preservation and some from a simply lack of understanding," he said. "What people need to realize is that in three seconds we can receive 33 price improvements from over 100 sources." Saliba points out that orders can be placed with a maximum bid or offer that will continually improve on current prices. "The process will ultimately lead to tighter bid/ask and better executions," he concluded.
Despite these turf wars, the customer can only benefit from the increased scrutiny and advances in technology.
Steven Smith writes regularly for TheStreet.com. 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 invites you to send your feedback to