With a Snap, the Pacific Exchange-CBOE Merger Breaks Off

The collapsed deal may be attibuted more to old-fashioned greenbacks than regulators.
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Justice, schmustice.

That's what traders in both Chicago and San Francisco are saying in the wake of Thursday's cancellation of the merger that would have combined the

Chicago Board Options Exchange

, the nation's biggest options exchange, with the

Pacific Exchange

, the third biggest.

Terse statements from both sides attributed the deal's collapse to increasing interest by the

U.S. Department of Justice

, but traders say many other points of contention were based in old-fashioned greenbacks.

"It came as a shock, and we need to hear more before we can really say what happened.

The deal seemed it was in the 11th hour and ready to go," says one Pacific Exchange trader.

A CBOE spokeswoman says the Justice Department's second request for information, which came Dec. 23, would have delayed the merger process into the summer, disrupting the CBOE's timeline for upgrading its screen technology. The P-Coast spokesman declined to comment until the exchange's board of governors had time to review the situation. A Justice Department spokeswoman says regulators are aware that the deal has been broken off but declined further comment.

"The CBOE board backed off because of Justice in part but also because the landscape had changed so much since the agreement was reached," says Jon Najarian, who heads

Mercury Trading

, an options trading firm with operations in Chicago, Philadelphia and San Francisco. "Once the

electronic options exchange

International Securities Exchange

was launched, the deal should have been called off."

The November launch of the ISE heightened the need for the nation's four options exchanges to ratchet up their technology to develop screen-based systems that would compete with the new automated options exchange. Because of that one development, and the expectation that other electronic challengers will emerge, the exchanges rushed to get together.

And while the federal government -- primarily the

Securities and Exchange Commission

-- has been a proponent of multiple listing of all options contracts, exchanges such as the Pacific have made a living off of exclusive listings such as

Microsoft

(MSFT) - Get Report

,

Compaq

(CPQ)

and

Sun Microsystems

(SUNW) - Get Report

. Yet the cost of technology has spiraled so high that the exchange felt it needed to partner with a larger entity in order get to the cutting edge.

This morning, for instance, the Pacific quote system had been behind the actual trading, creating essentially a fast market where posted prices couldn't be trusted until 9 a.m. PST, PCX traders say. In addition, the exchange halted the development of a handheld trader's computer when the CBOE deal was announced and now will have to jump-start those and other technology efforts.

The P-Coast must quickly examine other alternatives and may end up back at the bargaining table with the CBOE, but now at a tremendous disadvantage, some traders say. In addition, the talks between the

Nasdaq-Amex

and the

Philadelphia Stock Exchange

may be put under pressure by the unraveling of this deal. Nasdaq-Amex declined to comment.

The CBOE and P-Coast had engaged in some rancorous negotiations en route to hammering out a merger agreement in early November. But the final straw came when Justice made a second request for information -- usually a sign it is taking a long look at a merger -- which some people at CBOE took as an indication that the deal was doomed, according to Paul Liang, an influential options seat owner and head of

PBL Partners

.

One request that regulators made was for any correspondence or conversation concerning any merger of CBOE and any other exchange going back to 1993, he says, adding that such a request was impossible to answer. "Nobody understood what they really wanted," Liang says.

But other financial issues weighed heavy on the talks. The issue of multiple listings and awarding sole listings to the exchange with the highest market share had been at the forefront, but more recently member fees had been at the core of disagreements.

CBOE members were concerned that despite their seats being worth about $530,000 and a Pacific seat trading for just over $350,000, members from both exchanges would have equal votes. In addition, the deal stipulated that the $1,000 monthly fee paid by P-Coast traders would be reduced to the CBOE level of $500.

The emergence of the ISE meant that CBOE would be moving aggressively to cut customer fees -- some estimates placed the cuts at 30% of their current levels -- and to place more of the onus on members. On Wednesday, traders say, the CBOE lowered rates to 20 cents from 45 cents per trade on the ones that come through the electronic order book. The P-Coast, meanwhile, most likely couldn't have made the same adjustment.

Another trader notes that the merger was contentious from the start, beginning when the CBOE seemed reluctant to pay for a new Pacific trading floor. He believes that almost killed the deal a few months ago. In order to save the deal then, the exchanges agreed to postpone plans for the new floor.

But some traders were skeptical then, saying that they suspected that once the merger was finalized, CBOE would want to scrap all plans for a new floor and move the trading to Chicago since CBOE was already expected to move some of the most active options to Chicago.

That idea was lent more credence in December, when the Pacific returned all the money it collected from members that was to go toward building a new floor. A Pacific spokesman confirmed that all the money was returned -- an amount of roughly $4.4 million dollars, raised over eight months, at $1,000 per seat from the 552 seats, he said.

In the end, it came down to a matter of priorities, explains Liang, the seat holder. "If we had to spend the manpower to address the Justice Department, it would take away from our business," he says. Now, the two exchanges will go forward "like we never talked," he says.

Staff reporters Gregg Wirth and Medora Lee contributed to this story.