Steve,You've recently written about the Philadelphia Stock Exchange (PHLX) demutualizing. Can you explain what that means in terms of the industry and its effect, if any, on trading? -- J.B.
Nomenclature aside, the
Philadelphia Stock Exchange is basically an options exchange, as nearly 80% of its volume now comes in the form of option contract execution. The exchange was established in 1790, making it the first licensed securities exchange in the U.S. But just as its heyday as a leading stock exchange has long since passed, its stature in the options industry has also declined.
As of October, its market share of the U.S. option market was just 11.85%, tying for a distant third with the crumbling
American Stock Exchange among the five currently operational exchanges. With about a 31% market share of equity options, the surging all-electronic
International Securities Exchange has displaced the
Chicago Board Options Exchange, which has about a 26% equity option market share, to become the new leader less than three years after its launch.
Keeping Up With the Joneses
Demutualization basically changes an exchange from a nonprofit organization owned by members to a for-profit business owned by shareholders. The process separates ownership interest of trading rights, such as seat-holders and member firms, from equity interests in the company or exchange itself.
Separating trading rights, such as seat-holders and member firms, from equity interests in the company or exchange itself, is one of the first steps in simultaneously eliminating entrenched conflicts of interests, says David Krell, president and CEO of the International Securities Exchange. Aside from creating a structure that helps separate operational and trading issues from oversight and regulation, demutualization provides more latitude and opportunity for growth.
The PHLX's decision to demutualize is simply a continuation of an already established trend. The Pacific Exchange was the first to demutualize its equity operations in 2000, and in two weeks, its members will vote on demutualizing the options portion of the business.
"I expect the vote will have an overwhelming majority to move forward with the process we started three years ago," says Dale Carlson, vice president of corporate communications at the Pacific Exchange.
The ISE demutualized itself in May 2002, less than two years after its inception. "The structure of the original launch was basically bound by the then-current regulations surrounding exchanges," says Steven Sears, project director for the ISE.
The quickly changing landscape has allowed the
Boston Stock Exchange to begin life with a complete structural separation of equity investors and trading-right holders. The Boston exchange is expected to launch in the first quarter of 2004.
To state the obvious, if an exchange does not do what is necessary to make itself an attractive and viable place to do business, the right to trade there will hold little value. So, given its diminished market share and declining seat value, it should come as no surprise that PHLX's members voted 307 to 71 in favor of the change. The PHLX expects to get approval from the
Securities and Exchange Commission
in the first quarter of 2004.
Of course, the next possible step for these exchanges, which none will willingly discuss, is that demutualization is a necessary precursor to creating a public trading company. Given the success of the
Chicago Mercantile Exchange
, whose share price has more than doubled since its December 2002 initial public offering, other exchanges must be salivating at the notion of raising capital and offering members liquid means for monetizing their seat holdings.
"Separating ownership rights from trading rights represents the modernization of the way exchanges do business," said Meyer "Sandy" Frucher, CEO of the PHLX, in a statement released after the vote.
The upshot of this upheaval will be significant. First, exchanges will have improved oversight, as having to answer shareholders and operating in the public domain will require more transparency. In addition, migration will continue into electronic and remote trading as exchanges look to boost efficiency and profit to satisfy shareholders, resulting in tighter spreads, faster execution and more efficient and accessible markets. All in all, it's a good thing for investors.
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