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September 28, 2006

The Coming Shakeout in the Options Market

By Nina Mehta

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Every year like clockwork, the heads of the U.S. options exchanges predict a bout of industry consolidation. There has been public and not-so-public flirting in recent years, but no pair of options exchanges has actually made it to the altar. Indeed, seven years after the exchanges began competing directly with one another in 1999, the number of exchanges has risen from four to six. That trend may be at an end. Broader changes now taking place could shake up the status quo-and potentially make the longstanding prediction for industry consolidation come true.

Two major developments are prompting practitioners and observers alike to predict a restructuring of the industry. First, the Securities and Exchange Commission is herding the exchanges toward a pilot in which some options on stocks and exchange-traded funds will be quoted in pennies, rather than the current nickel and dime increments.

It's Mutual

That move could obliterate market makers' spreads in the quote-driven options business and force exchanges to compete more aggressively.

Second is demutualization. Of the six marketplaces, only two-the Chicago Board Options Exchange (CBOE) and the American Stock Exchange-are still owned by their members. And both are in the process of changing that. As exchanges shift to shareholder-owned, for-profit companies, they fuel competition in an already aggressive options market.

As exchanges then become publicly traded companies, as is the International Securities Exchange (ISE), or take on new investors, they gain a pile of cash that can be used to win new business through technology enhancements and fee reductions-or by buying another exchange.

"The options industry is fragmented," says Richard Repetto, an analyst at Sandler O'Neill & Partners. "Penny quotes will lead to stiffer price competition among exchanges." That will eventually result in consolidation among exchanges, as happened among execution venues in equities over the last half-dozen years, he says.

The penny pilot, scheduled to begin on January 29, is expected to dramatically increase options volume as well as options message traffic. It is also likely to narrow dealer spreads, which could end the practice of exchanges paying for order flow. That would force the markets to compete even harder for order flow.

As penny quoting is extended to more options classes beyond the initial pilot, spreads will shrink, reducing the profits of market makers, says Diego Perfumo, an analyst at consulting firm Efficient Frontiers. And since intermediaries are necessary in the options market to create liquidity, exchanges will have to attract order flow to their venues based on tight spreads.

That means they will have to redouble their efforts to attract liquidity. According to Perfumo, exchanges will have to share their profits with market makers. They can do this by reducing their cost of trading and through order-matching rules that enable market makers to participate in marketable orders if they're at the national best bid or offer.

Bring It On!

One exchange raring for increased competition is the ISE. Chief operating officer Gary Katz notes that the current level of "hyper-competition" between exchanges will only benefit the industry and spur growth. He adds that his exchange's trading platform is fast, scalable and ready for penny quoting. The exchange recently released a new, more sophisticated front end with a redesigned trade blotter for institutional investors.