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January 1, 2007

Tussle Over Index Options

ISE Challenges CBOE's Proprietary Index Offerings in Lawsuit

By Mark Longo

The index war has escalated. For years, the International Securities Exchange (ISE) has been content to take potshots at its main rival, the Chicago Board Options Exchange (CBOE). Its primary bone of contention is the CBOE's dominance of the index options market, particularly the lucrative S&P 500 (SPX) product line. In fact, the ISE hasadopted "Free the SPX" as its unofficial battle cry. However, after sniping at the CBOE through the press and at industry conferences, the ISE suddenly decided to raise the stakes in this long-simmering feud. On November 2, the ISE filed a lawsuit challenging the validity of proprietary index license agreements. Although the suit names Standard & Poor's (a unit of McGraw-Hill) and Dow Jones & Company, the intended target of this action is clearly the CBOE. The announcement of this lawsuit stunned the options industry.

By taking its fight to the courts, the ISE has raised the stakes in this formerly staid dispute and made it more contentious. Although this court case will likely take years to resolve, one development is certain: No matter which side emerges victorious, the outcome will alter the landscape of the options world forever.

On the surface, this may seem like just another ploy for market share. The CBOE controls the lucrative S&P options market and the ISE desperately wants a piece of that pie. However, this case has ramifications well beyond the monthly market-share numbers. By filing this lawsuit, the ISE has highlighted issues that have lurked in the background. At the same time, ISE may have endangered one of the industry's few remaining cash cows-proprietary products.


The CBOE was one of the early options exchanges to realize the potential value of proprietary products. In a moment of foresight, it purchased exclusive licenses to the S&P index family and created its flagship products. Eighteen years later, SPX options are still on top of the index options world and highly profitable. In an industry in which most new products die that is quite a feat.

However, many of the CBOE's rivals believe the SPX would be a greater success, and generate more liquidity and volume for the industry, if it were listed on multiple exchanges. "ISE was founded on the belief that competition among exchanges improves market efficiency and, ultimately, benefits investors," said David Krell, ISE's president and CEO in a statement announcing the suit. "As a result of ISE's leadership, the market has experienced increased liquidity, tighter spreads, and lower customer transaction fees, and we want to deliver those same benefits to investors in the remaining exclusively-listed index options."

This isn't the first time the ISE has come out swinging for market share in the index options markets. The ISE also caused a furor in 2005 when it listed options on the popular SPDR and DIAMOND ETFs without a license. Other exchanges quickly followed the ISE's lead, giving rise to one of the industry's fastest-growing market segments ETF options. McGraw-Hill and Dow Jones promptly sued the ISE, but the case was decided in the ISE's favor. That emboldened the ISE to launch its recent assault on the SPX.