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November 1, 1998

Stock Options, anyone? The NASD's New Gamble

By John A. Byrne

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Back in June 1985, Richard Ketchum brushed aside criticism of the Securities and Exchange Commission's budding policy for trading options based on Nasdaq stocks.

"Fairness," said Ketchum, the then SEC director of market regulation, "is in the eyes of the beholder. I guess the NASD's view is that what they ended up with wasn't fair."

Certainly, the National Association of Securities Dealers had no doubt about the fairness of the SEC's policy, having lashed out earlier at the agency for allowing U.S. listed exchanges to begin trading options on Nasdaq stocks.

The exchanges were the Chicago Board Options Exchange (CBOE), the New York Stock Exchange, the American Stock Exchange, the Pacific Exchange (PCX), and the Philadelphia Stock Exchange (PHLX).

The NASD was upset because the listed exchanges had full regulatory approval, while Nasdaq's petition to join them trading options on the the Nasdaq 100 index was still pending. The listed exchanges were also approved for trading options on six of the most active Nasdaq issues.

Moreover, the NASD was hot under the collar because the other exchanges had the SEC's blessing to become, in effect, direct competitors.

The NYSE, Nasdaq's arch rival, sent blood-pressure levels soaring even higher among some Nasdaq officials when the Big Board cleared the way for trading in options.

To that end, the Big Board, which vehemently opposed "side-by-side trading," created a physical wall separating the options and stock trading-floor operations. Traders nicknamed it the Rappaport Wall, after Sheldon Rappaport, the SEC regulator involved in the pilot program. (In the late 1970s, the SEC expressed support, but since then never actually permitted side-by-side trading.)

The Big Board's options efforts worried the NASD's high command. If the SEC's approval remained, the NASD told the agency it would press for permission allowing Nasdaq to trade listed options and their underlying stocks. A somewhat bemused SEC called the petititon "highly unusual."

Pilot Program

Except for a brief fling soon afterwards, the foray by the NASD into trading options, based only on Nasdaq-listed companies, simply fizzled out.

"It never got off the ground," said Bernard Madoff, principal at the off-exchange retail-trading giant Bernard L. Madoff Investment Securities, whose firm participated in the pilot program.

"Part of the problem," added Madoff, who back then was director of trading at the New York-based firm, "was that the technology provided to market makers was not adequate for them to trade options efficiently."

The inadequate technology stymied Nasdaq market makers trading contracts on a companion futures product on the Nasdaq 100 index at the CBOE, as a hedge on contracts in the Nasdaq 100 index itself.

The Big Board, too, eventually exited the business, in part because of fears it would diminish the capital available for its core stock trading, and in part because stock and options trading were mixing like oil and water.

"The guys trading equities were sort of like nice boys from Eaton and Harvard, and the options boys were brawlers, like big rough boys from the docks," recalled Chris Keith, a former Big Board official who was the exchange's chief information officer during the pilot program.