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February 1, 2005

ArcaEx's Ride on the Options Side

By Mark Longo

The explosion in the options business has attracted the attention of one of the biggest electronic trading players on Wall Street. Back in January, Archipelago, operator of ArcaEx, the upstart electronic stock exchange, purchased the Pacific Exchange (PCX). "I think the combination of Arca and the PCX will be very powerful," says Dale Carlson, a spokesman for the Pacific Exchange. "Their electronic equity platform and our PCX Plus platform are most compatible. That will allow traders to execute electronic equity and options orders at a single exchange." If the deal clears regulatory and PCX shareholder approval, it could radically alter the balance of power in the equity and options markets. One market player warns that Arca could become an eight-hundred pound gorilla.

"Arca has a twenty-plus market share in Nasdaq trading and they're one of the biggest electronic trading players," says Kevin Connellan, director of equity trading for Northern Trust in Chicago. "Anytime someone with that much market power enters a fragmented market segment like the options business, they have to be watched." Nevertheless, the purchase has its supporters. "This is a sign that the options industry is coming into maturity," says Ed Boyle, vice president of equity derivatives at TD Securities. "It was a fairly inefficient and immature market coming into the 90s. The volume got ahead of the technology, slowing natural maturity. This kept markets fairly wide. Now maturity has finally caught up with the industry, bringing tremendous efficiency."

The idea of ARCA jumping into the options game has led to speculation that other equity powerhouses will follow suit. Nasdaq briefly become a player in the options business when NASD acquired the American Stock Exchange. Although it eventually sold it back to its members, there is the possibility that the Nasdaq - or indeed, the NYSE, which has talked about promoting derivatives trading - could follow Arca. One analyst says exchanges will certainly look, but that doesn't mean they'll act. "The other exchanges will evaluate the deal," says Rich Repetto, an analyst who covers electronic trading firms for Sandler O'Neil & Partners. "But, before anyone else jumps the gun, it's going to take someone with market power like Arca to prove that it can work." Repetto says several trading heavyweights have thrown in the towel. "In contrast to Arca, Knight Trading Group recently sold their options business," says Repetto, who follows Knight. "They obviously felt that the margins in the options markets were not significant enough to warrant the risk."