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August 31, 2001

New World Options

By Michael Simon

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Old-timers may remember these days in the stock- trading world: no national best bid and offer; no efficient way to reach between markets; and markets that were crossed.'

Amazingly this description still covers stock option trading today. More amazingly, this is actually a vast improvement over the options market that existed about two years ago.

Back then, most options were traded on just one exchange, leaving investors subject to both the price available on that exchange and the vast differences in technology that exchanges had to offer.

While investors could see the price of an exchange's bid and offer in each options series, the options tape' - the Options Price Reporting Authority, or OPRA - did not show the size of quotes.

With customer trading fees dwarfing market maker fees, customers subsidized market makers through both high fees and non-competitive spreads.

When the International Securities Exchange announced in November 1998 that it would begin trading in early 2000, the effect was dramatic. It spurred rapid change.

First, the Chicago Board Options Exchange opened the door to multiple trading in the summer of 1999. By the end of that summer, the American, Pacific and Philadelphia Exchanges had all followed. Competition reduced spreads and drove exchange fees for customer orders to zero.

When the ISE opened in May 2000, it provided its members with quotes and displayed size and an efficient all-electronic trading platform. Within months, customer fees fell well below zero. Each of the five exchanges received Securities and Exchange Commission approval to institute formal payment for order flow programs. Finally, this January, OPRA began carrying quotation sizes for all five exchanges.

Having entered the equities equivalent of the 1970's, the options exchanges now are designing efficient intermarket facilities. Actually, this took some prodding from the SEC, which issued an order requiring the exchanges to submit a plan for linking the markets by January of 2000. The ISE, CBOE and Amex jointly submitted a plan in which exchange members continue to choose the market to which their orders are sent.

Once an exchange receives an order, specialists and market makers that choose not to trade at the inside national market could use the linkage to send the order away. In contrast, the Phlx and PCX each submitted different versions of a plan based on strict price/time priority, where a central switch' automatically would route an order to the market that was first in time at the inside price.

Last year the SEC approved the ISE/CBOE/Amex plan. The SEC simultaneously adopted a trade-through disclosure rule,' requiring broker dealers to disclose trade-throughs to their customers, but exempting from the rule orders sent to linked markets.

With the SEC having rejected strict price/time priority, (and facing the burdens of the trade-through disclosure rule), the Phlx and PCX joined the approved linkage. The exchanges then hired the Options Clearing Corporation to build the linkage. The implementation is scheduled for 2002.