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February 16, 2007

The CBOE's Equities Gambit Involves a Twist

Specialists are Part of the Plan

By Nina Mehta

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The CBOE Stock Exchange, in a departure from the current vogue among stock exchanges, is launching in March with a specialist system. The offshoot of the Chicago Board Options Exchange recently appointed six trading houses as "designated primary market makers," or specialists, to provide liquidity to its upcoming equities marketplace.

The move makes the firms the sole liquidity providers receiving the highest transaction fee advantages for the stocks in which they make markets. Each stock and exchange-traded fund is assigned to one DPM and several remote market makers (RMMs). The latter compete for order flow and have fee benefits over market participants.

The adoption of a specialist structure is a sharp contrast to the approaches taken by the newly invigorated regional stock exchanges and, to a large extent, NYSE Arca. These players have all opted for competing market-maker platforms for the trading of New York Stock Exchange, American Stock Exchange and Nasdaq securities. Besides the CBSX, only the New York and American stock exchanges operate specialist systems.

Eric Noll, global head of strategic relationships at Susquehanna Investment Group, points out that in recent years specialist systems have virtually disappeared. "The CBOE Stock Exchange makes the opposite side of that argument-which is that an exchange with dedicated liquidity providers will provide more liquidity than those models without it," he says.

For DPMs, Noll adds, one advantage of a new exchange is that it offers specialist firms the ability to be that single liquidity provider. The NYSE, for example, has already allocated most names to specialists and shut that door.

In creating the role of the DPM, the CBSX took a page from its own book. The position of DPMs on the CBSX, while more limited, is similar to that of DPMs on the CBOE's options marketplace. Both provide liquidity-and the exchange has the carrot and stick to ensure it.

DPM Carrot

In both cases, the DPM role is defined by certain benefits and obligations unavailable to other traders. The benefit on the CBSX is an unusually high rebate for providing liquidity. DPMs will get the same amount per share for providing liquidity that other market participants pay for taking it. "DPMs play an important role in attracting orders to come to us, so we're compensating them for that through rebates," says CBSX president David Harris.

The exchange in general has high rebates for customers posting liquidity and volume-based fees for those taking liquidity from the system.

DPMs will pay the same tiered take fees as other market participants. But their rebates for providing liquidity will be significantly higher. "We'll rebate them what the taker pays," Harris says. "So it's essentially a pass-through."

Under the CBSX's tentative pricing program, takers may pay anywhere from 27 to 30 cents per 100 shares, based on the volume they execute on the CBSX. That amount is what the DPM will receive when it is the contra side of that order.

RMMs, a secondary class of dealer, will get more than the rebate of 25 cents per 100 shares that market participants get under the CBSX's pricing scheme, but less than the pass-through rebate DPMs receive. RMMs will compete for flow with the DPMs and others.

The exchange plans to revise the maker/taker fees just prior to its March launch, to reflect competition in the market.