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December 6, 2006

Amex Mends Ways on Busted Options Trades

By Nina Mehta

The American Stock Exchange has done an about-face in the last four months when it comes to busted options trades. The once heavily criticized exchange has not broken an options trade within the national best bid and offer due to system errors since July.

"Trade busts"-the nullification of trades after they occur-have been a source of friction and anger for Amex customers in recent years. In July the exchange with arguably the most egregious reputation on that front ended the practice.

"We don't believe investors who send Amex orders should take any risk in our systems," says Neal Wolkoff, Amex's chairman and CEO. "If an order is within the NBBO, we won't break that trade on the basis of a system error."

Instead, the exchange is shouldering the cost of settling disputes involving system errors.

System errors result from problems or glitches in an exchange's computer and communication systems. For example, a system error could lead to a market maker's quote freezing or a delay in the price of an underlying stock updating a market maker's options quote. Until recently, an Amex market maker could then ask the exchange to nullify the resulting trades.

Trades that are broken pose a potential problem for investors because executions they thought were certain are subsequently nullified. That affects their perception of the quality of an exchange's market. Amex set aside a kitty of $3 million to settle claims involving system errors. From mid-July through September, the total paid to market makers to settle claims was less than $75,000, Wolkoff says.

The new policy reflects greater confidence in Amex's technology platforms. In early summer, Amex migrated its ANTE options trading platform to a Linux operating system, increasing the platform's stability. ANTE also got a software upgrade, which increased its reliability and provided new functionality.

For market participants, the July change was a long time coming. Amex's critics have been harsh in their assessments of the exchange's technology.

As recently as last November, Citadel Derivatives Group sent the Securities and Exchange Commission a scathing letter in response to an Amex rule filing, charging the exchange with giving its own market makers unfair advantages through its trade adjustment and cancellation procedures.

Citadel wrote: "Amex's rules and practices regarding busting trades during the existence of an alleged verifiable disruption or malfunction' in its computer or communication systems that occur force the rest of the market to bear the costs of the Amex's defective computer systems. These rules and practices also enable Amex market makers to profit by using the shield of alleged systems errors as a sword, letting them pick and choose what trades to honor."

Wolkoff didn't agree with most of Citadel's lengthy letter. But in the end Citadel and others won Amex's ear. "The system is getting better," Wolkoff says.

"Our attitude is, Let's not make our issues somebody else's issues,'" he adds.

Citadel, for its part, recently signed on to be one of three remote options market makers on the Amex, along with Timber Hill/Interactive Brokers and SLK-Hull Derivatives.