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August 6, 2009

Against the Tide

Options Exchanges Strive to Capture Blocks from OTC Market

By Peter Chapman

In March, the Chicago Board Options Exchange asked the Securities and Exchange Commission to permit CBOE members to hedge an options position before actually taking on the position. The practice, known as "anticipatory hedging" or pre-hedging, has long been barred on the nation's options exchanges due to concerns about front-running. Traders can hedge their options positions with stocks or other instruments after taking them on, but not before.

Ed Tilly, CBOE

The CBOE argued that increased volatility and decreased liquidity due to penny trading combined with exchange exposure rules make it necessary to allow brokers to pre-hedge. If they can't pre-hedge, they won't bring their crosses to the exchange. They will trade them over the counter.

That's the rub and that's the main reason why the CBOE is trying to win an exception to its anticipatory hedging rule. More and more trading is being done away from the exchanges and in the over-the-counter market. The exchanges are trying to win back the blocks.

"The exchanges need to eliminate all of the obstacles that make the OTC market more attractive than the listed market," says Ed Tilly, a CBOE executive vice chairman. "The difference between the two should only come down to the SEC's exposure requirement."

The exposure requirement means traders who wish to cross a paired order on an exchange must open up trading to all members. That's a hurdle too high for many traders as exposure leads to break-ups, which impair the economics of the trade.

The exchanges have little choice but to remove obstacles if they want to continue to service block orders. Trading in penny increments, introduced in a pilot two years ago, has decimated size on the screen, driving money managers and their brokers to the OTC market to source liquidity. An expansion of the pilot that would likely drive more trades OTC is in the offing.

The over-the-counter market is a bilateral trading environment where brokers commit capital to facilitate their customers' orders. Both parties to the transaction clear and settle their trades themselves without the involvement of the Options Clearing Corp., the central clearing organization owned by the exchanges. The market is controlled by a handful of large brokers including Goldman Sachs, Morgan Stanley and Citi.

Robert Newhouse, Ballista Securities