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August 31, 2004

Hedging Bets for the Bear: Remote Access, PIP, Fees Reductions and Microhedge

By Mark Longo

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  • Hedging Bets for the Bear: Remote Access, PIP, Fees Reductions and Microhedge

A brass knuckles battle over options business has started in the last few months.

Trading options is a messy, tough game, yet increasingly officials of various exchanges think that they can turn a profit on this dicey, competitive business.

"We expect competition to intensify," said an official of one of the options exchanges in a recent filing with the regulators. That's because, with a potential bear market on the horizon, equity index options could become an increasingly important way of hedging portfolio risk.

This changing market is prime territory for some vendors. For instance, SunGard, which operates the BRASS trading system for equity market makers, is enhancing its Microhedge product for customers who trade both equities and options.

This theoretical hedging system, born in the trading pits of Chicago, is still used by many options market makers to analyze their positions. The program has one advantage over similar programs: It allows users to disseminate theoretical values, a crucial function for market making on the major options exchanges. What it means is that more exchanges now are looking more closely at options.

Up until recently, the International Securities Exchange (ISE) and the Chicago Board of Options (CBOE) have been among the leaders in this specialized area. The ISE is in the process of going public. It would be the second derivatives exchange to go public. The other is the CME, which trades a sophisticated class of derivatives. By the way, the CME's shares had recently quadrupled in value since it went public. That has drawn the attention of many would be competitors.

Recently, CBOE decided that it would allow seven specialist firms to make markets remotely. This decentralized its manual floor, bringing in electronic trading. This was a keep-up-with-the Jones move. That's because the ISE model was all-electronic as well as owned by some of the heavy hitters of the trading industry - Morgan Stanley, Bear Stearns, Deutsche Bank and Goldman Sachs, among others.

Earlier this year, the Boston Options Exchange (BOX) also jumped into the options war, offering its own fully automated method that attempts to make in-roads in the ISE and CBOE markets.

But the BOX has had some rough going. It has yet to make a serious dent in the options marketplace. The BOX accounted for only 1.8 percent of the total options volume in June.

Still, almost two percent isn't hopeless for a new exchange, but that doesn't put it in the big leagues with the CBOE and the ISE. The ISE has had its share of problems. It had only one percent market share in its first year. But a year later its market share jumped to eight percent. And, by the first half of this year, ISE's market share was some 29 percent.

The ISE hasn't been able to turn the profits of some of its bigger competitors. For example, in the first quarter, ISE earned a rather measly net income of $8.4 million. The CME, in that same period, earned some $46 million. The ISE hasn't been able to lock up some of the unique deals of its competitors.