Nasdaq Wants More of the Options Pie

The flavor changed with penny pricing, and Nasdaq aims to control the recipe.
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The NasdaqI:IXIC last week made good on its claim to get involved in options business and officially joined the Option Clearing Corp., creating the seventh option exchange. Before we get to how this seems to fly in the face of industry consolidation, let's do a little Reader's Digest-style recap of how this came about.

Way back in early 2006, when the

Nasdaq

announced it would be entering the option business,

I described it as a nonevent

; the Nasdaq was just trying to play catch-up and it would be years before anything happened.

Nasdaq Thrives on Market's Mayhem

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But less than year later I changed my tune

and I was pounding the table

for the Nasdaq to drive down I-95 and buy the Philadelphia Exchange (PHLX), which had recently made transition from open-outcry-floor-based trading to an electronic platform, and its market share of options volume jumped from 8% to 14% for the period ending in 2007.

My reasoning then was that the PHLX was coming cheap, it would cost some $650 million compared to Nasdaq's failed $13 billion bid for the London Stock Exchange. That rejection might have been the best thing that ever happened to the Nasdaq, as the LSE does not offer derivative products such as options or commodity futures. The PHLX has some great propriety products such as the

Oil Services HOLDRs

(OIH) - Get Report

ETF and the

Semiconductor Index

(SOX) and in a world of multiple listings in which options are a commodity product, having exclusivity is a key to maintaining or gaining market share.

Aside from the much lower price -- even as some claim that the Nasdaq paid nearly double the $350 million that analysts had pegged as its value -- it was buying into a high-growth business. Equity volume has been growing at about 11% a year over the past five years. Option volume has enjoyed 35% annual growth over the past five years.

I give the Nasdaq credit for both its patience and being flexibility in the way it expands its platform. When it initially announced in 2006 it would be entering the options arena, it made it clear that it was waiting for options to begin trading in penny increments. This was crucially important, as the Nasdaq was one of the few exchanges that already had the bandwidth to accommodate the geometric expansion that would accompany such a move. When its courtship of the LSE was rebuffed, it went and acquired the OMX, which does offer derivative products.

There are about 8,000 publicly traded stocks that have a simple bid/ask price. Three are about 4,000 stocks that have listed options; those options have anywhere from six strike prices and up to 10 expiration periods. To stream live quotes for 60 or more options on a single stock requires incredible bandwidth that some exchanges and many brokerage firms were not prepared to handle.

Well, now that penny pricing in options has moved from pilot program to industry fact, Nasdaq is well positioned to achieve its goal of grabbing 20% market share within its first year of entering the market.

As Ron Ianieri, president of Options University, who has been engaged as a consultant by the Nasdaq to build business and educate customers, reminded me, the PHLX is owned by six of the big bulge bracket investment banks -- including

Goldman Sachs

(GS) - Get Report

and

Lehman

(LEH)

-- which are the main liquidity providers for trading volume.

Because major traders on the exchange also have an equity stake, it is not a stretch to assume that when the Nasdaq paid double the supposed valuation -- and what's a extra $300 million on Wall Street -- that it was done with a handshake deal that those six firms would maintain if not increase their order flow to the PHLX and will be receptive to using the Nasdaq's platform for trading options.

This may just be conjecture on my part, and there is nothing nefarious about using various means to gain market share. For years, exchanges openly engaged in payment for order flow, and brokerage firms paid "soft dollars" to mutual funds in which they paid for research in exchange for reduced trading commissions. There has been a crackdown on some of these more obvious conflicts of interest that might keep customers from receiving the best price of having their orders truly made available to the open market. But as brokers and investment banks have come to own equity stakes in various exchanges, there has been a trend that these liquidity providers would look to internalize trading activity and cross as many transactions as they can on platforms in which they have an interest.

Given the Nasdaq's brand, the big and broad market it tapped into to buy the PHLX and its international footprint, I remain bullish on Nasdaq shares. Look for the Nasdaq to buy the Boston Option Exchange soon, which would bring its market share up to around 20% in short order.

Suddenly, getting to 25% and challenging market leaders such as the International Securities Exchange and the Chicago Board of Option Exchange - each of which have about a 32% market share -- doesn't seem that far out of reach.

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 appreciates your feedback;

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