"The Amex Is Facing Fresh Questions on Handling of Option Orders" was the bold headline in a Wall Street Journal column yesterday regarding the Securities and Exchange Commission's ongoing probe of the American Stock Exchange. While the alleged violations are three years old, their nature -- involving preferential treatment by specialists -- makes them more timely than ever, given the current regulatory environment. And making matters worse was the exchange's "deliberate attempt to conceal the deficiencies," according to the SEC report.
The last thing needed by options markets, which have continually battled perceptions that retail investors are not treated fairly, is a confirmation of those suspicions. "The situation at the Amex is certainly a black eye, but I don't think it is representative of the efforts and actual practices of the options industry to protect customer interests," said Ned Bennett, CEO of OptionXpress, an online brokerage firm.
To be sure, the Amex's acute problems -- its recent drop in value resulted in GTRC Golder Rauner agreeing to buy the exchange for just $110 million (while its CEO was making $22 million this year) -- have brought its long-term viability into question. But the current environment has put all exchanges in the spotlight, focusing mainly on self-regulatory issues and fair-market practices.
New York Stock Exchange
plans to maintain its current self-regulatory structure, options exchanges are moving toward separating trading operations and oversight. This is being done through the process of demutualization, which "essentially separates ownership interest of trading rights, such as seat-holders and member firms, from equity interests in the company or exchange itself," said David Krell, president and CEO of the International Securities Exchange.
The ISE, which was created and launched in May 2000, shifted to this structure two years ago "to more efficiently meet the needs of and adopt to the marketplace and broaden our product line," stated Krell. The system makes it easier to raise capital because ownership and investment isn't limited to trading members.
This line of thinking is being endorsed by the Pacific Exchange. "There are several advantages to structural separation: It definitely allows for a faster, more efficient decision-making process, it improves oversight by creating a greater separation, and it allows you to unlock some valuation," said Dale Carlson, vice president of corporate affairs for the exchange.
The PCX, which demutualized its equity operations in 2000, will have its members vote in December regarding the options portion of the business. Carlson also noted that the PCX has already revamped its corporate governance to require at least 50% of the board to have no affiliation with the exchange or its membership. In addition, it has created an entirely independent oversight committee.
The Boston Stock Exchange, when it eventually launches, will begin life with a complete structural separation of equity investors and trading-right holders, although critics contend there is an inherent conflict of interest due to similar participation rights between the investors and market-making firms. The five initial equity investors are
Credit Suisse First Boston
Salomon Smith Barney
J.P. Morgan Chase
. These names will undoubtedly have a major presence in the exchange's trading and market-making.
But OptionXpress' Bennett believes self-regulation will work. "Given the current environment, it's in their own interest to keep their noses clean and operate under the auspices of an independent board."
For now, the Chicago Board of Options Exchange has no plans for demutualization. But it should be noted that unlike the case of the CBOE (and of course, the NYSE, for that matter), the value of a seat on the Pacific Exchange has dropped substantially over the past few years, leaving little concern that opening up the investor base would dilute the value of current owners' holdings. The newer exchanges have the advantage of having established themselves with a clean slate, and need not worry about protecting vested interests.
That's not to say the CBOE doesn't diligently enforce rules and regulations. "The CBOE has an excellent track record of putting customer interest ahead of the membership," said Bennett. Under its own volition, the CBOE recently divulged executive compensation packages (its chairman was paid a relatively sane $1.25 million for fiscal 2003), showing the exchange is aware that it must respond to public scrutiny. At the same time, this balancing act comes at some cost, as the exchange is sometimes slow in adopting new technologies or opening its markets.
In my next column I'll look at how electronic trading has transformed the industry and forces the various exchanges to simultaneously compete and cooperate.
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