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May 16, 2007

Nasdaq Flirts with the Philadelphia Stock Exchange

By Sarah Rudolph

For an ambitious exchange like Nasdaq, acquiring an existing options market would give it a running start in its competition with the now-global New York Stock Exchange. So it's no surprise Nasdaq is wooing the Philadelphia Stock Exchange, which has 13 percent of the options market.

"Philadelphia would be Nasdaq's best option," said an industry source, who added that the PHLX's price tag could be about $300 million. "Philly has ETF and currency options. And going after the International Securities Exchange or the Chicago Board Options Exchange would mean paying $3 billion to $4 billion."

Building an options exchange from scratch is a tall order. Nasdaq for some time has planned to launch an options exchange in the fourth quarter of this year. Nasdaq has plenty of cash on hand after a failed bid to acquire the London Stock Exchange.

Nasdaq's publicly stated goal of gaining 20 percent of the options market would be much easier with the PHLX, the options industry's third-largest exchange, than without it. "Unless you can convince people you have something unique-faster execution, lower cost-it's hard to gain market share," said Randy Frederick, director of derivatives at Charles Schwab. "If Nasdaq doesn't acquire the Philadelphia exchange, it will have to compete with it. So it makes more sense to buy."

If Nasdaq acquires Philly, it may alter the options exchange's dealer pro rata model. "Because Nasdaq doesn't have an options exchange yet, my guess is they would merge the Philly's model with their ideology of how they want to see market structure shaped," said Ed Boyle, vice president of equity derivatives at TD Securities. "Right now it appears they are trying to replicate the equity market structure in the options market."

Nasdaq's current plans leave little room for specialists. Nasdaq has said it would operate a "fully automated, price-time priority market with an opportunity for price improvement." However, Philadelphia's current specialist system has helped it increase its options share.

Six major dealers own 90 percent of the Philly-Citadel Derivatives Group, Citigroup, Credit Suisse, Merrill Lynch, Morgan Stanley and UBS. "These dealers have a high incentive to send order flow there," said Tony Saliba, president and CEO of LiquidPoint. "If you change that model, the dealers may discontinue the efforts that have helped Philly gain market share."

Whether Nasdaq buys the PHLX could hinge upon the outcome of a lawsuit that is seeking to have the Philly's ownership revert back to former PHLX members.