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January 30, 2008

Exchanges to SEC: Penny Pilot is Bad for Business

By Peter Chapman

Three of the options industry's six exchanges are calling on the Securities and Exchange Commission to halt the progress of the ongoing penny pilot.

The International Securities Exchange, the Chicago Board Options Exchange and the American Stock Exchange, which collectively handle two-thirds of industry volume, maintain that the pilot is damaging the industry and should be restructured.

"ISE remains very concerned about the dramatic decrease in available liquidity and the impact this contraction is having on institutional participation in the options market," the exchange informed the SEC in a report.

In its second report on the impact of the penny pilot, the Amex also expressed concern about a decrease in available size driving money managers to the over-the-counter marketplace. Amex warned that "expanding the pilot beyond the 35 securities that currently comprise the pilot would be premature."

All six options exchanges were required to submit analyses of Phase II of the pilot-the five-month period between May and September-to the SEC by late last year. Of the six, only the Boston Options Exchange (BOX) had not submitted a report as Traders Magazine was going to press.

The pilot began in January 2007 with 13 options and was expanded to 35 classes in September. Another 28 are scheduled to be added this year.

While BOX and NYSE Arca are generally bullish on quoting options in smaller increments, the Amex, CBOE and ISE are not. The Philadelphia Stock Exchange is mum on its position.

The results of the second round of impact studies differ little from those of the first series, released last spring. Spreads have narrowed in the penny names. Size has declined. Volume has declined in all but the two largest options-the ETFs QQQQ and IWM. Message traffic has increased.

The three exchanges expressing negative views on the pilot all laud the shrinkage of spreads but maintain the changes in the other three factors have the potential to destroy what has been a booming business.

They recommend further analysis over a longer time period and suggest some options might need to be removed from the pilot. The ISE, for its part, recommends the less liquid options such as that on Whole Foods Market be removed.

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