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October 19, 2006

When Options Meet Equities: Competition ramps up with the ISE & CBOE's equities foray

By Mark Longo

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  • When Options Meet Equities: Competition ramps up with the ISE & CBOE's equities foray

The tremendous growth in the options markets is a source of endless fascination for market observers. With volume growing at a record-breaking pace month after month, one would expect the options exchanges to be scrambling to meet this surging demand with new products. But the exchanges aren't focusing development efforts solely on the options market.

Instead, they've turned to a completely new instrument for their expansion opportunities-equities.

Options exchanges moving beyond their core market is not a new phenomenon. Over the years, the exchanges have also made inroads into the futures markets. However, the exchanges' futures products pale compared to the scope of their new equity offerings.

Equities Flavor

Four of the six major options exchanges are already either part of or affiliated with a stock exchange. These are the BOX, PHLX, AMEX and the former PCX-now known as NYSE Arca Options. For them, a renewed focus on equities is hardly surprising. These four exchanges and their affiliates have already spent millions revamping their equity trading systems to offer their customers increased functionality.

However, the two largest options exchanges, the ISE and CBOE, are now jumping into the equities fray. In an attempt to negate their competitors' advantages, these industry giants have decided to launch their own equity exchanges.

While the strategies of the ISE and CBOE might seem similar at first glance, their individual approaches to equities are quite different. The CBOE Stock Exchange is designed to complement its existing Hybrid Trading System, which combines open-outcry execution with electronic trading. So the CBOE plans to establish Designated Primary Market-Makers (DPMs) on its trading floor to facilitate equity order flow.

This combination of open-outcry and electronic execution may not seem like a unique contribution to the equity world. After all, the NYSE has offered some hybrid functionality since early this year. But the apparent similarity between the two models has not discouraged CBOE officials. With the NYSE and other equity exchanges focused on improving their electronic functionality, the CBOE sees room for an exchange that combines ECN with a DPM network to facilitate institutional order flow.

"We are the original hybrid exchange, and we have seen from the options marketplace that this model can be very valuable," says Ed Provost, executive vice president of business development for the CBOE. "The NYSE's hybrid system is very complex, and will be both a fast and a slow market. That means there are times you can trade through them and times you cannot. The CBOE Stock Exchange, on the other hand, will always be a fast and protected market that is very much like an ECN with its price/time priority. We will be 100 percent electronic, with the ability for brokers to negotiate with the DPM when they are seeking liquidity beyond what is displayed in the marketplace." Several NYSE specialist firms have signed on and invested in the new exchange.

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