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June 30, 2004

The Great Exchange Wars

By Mark Longo

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  • The Great Exchange Wars

Rivals Counterattack As the ISE Blows Away the Competition

Once upon a time, about every major equity and index options product was traded on the Chicago Board Options Exchange (CBOE) floor. Sure, other exchanges, including the AMEX, the Pacific Coast Exchange (PCX) and the Philadelphia Stock Exchange (PHLX) also traded options. But the biggest share of the trading volume took place in the muscular pits of Chicago.

As if to underline all of this, these four exchanges implemented a gentleman's agreement in order to limit competition. In effect, this agreement stated that an equity option could only be listed on one exchange. Microsoft options, for example, traded on the PCX, Intel options on the AMEX and IBM options on the CBOE. It was the best of times in the options world. Everyone had access to their own piece of the options pie.

In 1999, it came to an abrupt end. Under increasing SEC scrutiny, the gentleman's agreement between the major exchanges broke down. And almost overnight, the options industry degenerated into a brutal free-for-all as the exchanges battled each other for volume. Each exchange began listing its competitor's equity options. IBM, which was the CBOE's signature equity option, suddenly began trading on the PCX, AMEX, and PHLX. The CBOE retaliated by listing Microsoft, Dell, Intel and a host of other equity options. The great exchange wars had begun.

The battle between the exchanges was a devastating blow to options traders and options market makers. However, it turned out to be a blessing in disguise for customers. As competition between the exchanges intensified, option markets tightened and transaction fees became practically non-existent. In order to reduce option spreads even further, the exchanges abandoned their archaic 1/16th ticks and replaced them with decimal prices. Equity options markets that had previously been $.25 wide shrunk to $.10 or even $.05.

The CBOE suffered the most from this four-way battle. Since it was the largest options exchange, it lost the greatest percentage of its volume to the competition. Although it was still the dominant equity options exchange, its lead over the PCX, PHLX and AMEX narrowed each year. The competition turned out to be a tonic for the smaller regional exchanges, such as the PCX and PHLX. Prior to the advent of multiple listing, a lack of volume threatened them with extinction. The competitive turf battle that followed gave them a new lease on life. They were able to attract more customers by improving the markets of other exchanges and paying exorbitant per-contract fees to the brokerage houses.

But while the four exchanges battled each other, they failed to notice a fifth combatant entering the landscape. That combatant was the International Securities Exchange (ISE), which was the first electronic options exchange in the U.S. And it went online in May 2000. Its radical new structure threatened the open-outcry trading system that dominated the options marketplace. Rumors about the ISE and its trading capacity were whispered on options trading floors across the country. The looming specter of electronic trading quickly became a cause celebre amongst option traders, many of whom thought it marked the death knell of open-outcry trading.