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April 1, 2011

ISE Wins Clean Cross Battle

By Peter Chapman

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In this market, communication is done through instant messaging and price discovery is done on analytics programs such as on SunGard's Valdi Options Solutions-formerly MicroHedge. This approach is said to rankle the SEC, which prefers exchange-based price discovery. Vol traders include large firms as well as lesser-known player such as HAP Capital and First New York Securities.

Top IDBs include WallachBeth, Linkbrokers, Tradition Financial Services, Tullett Prebon, GFI Securities and BGC Financial.

The ISE spent nearly two years trying to win SEC approval for its clean cross, against strong opposition from other exchanges and market makers. It claimed it needed the order type to compete effectively against floor-based exchanges.

The ISE's detractors argued that order exposure was a hallmark of the options industry and that the QCC was in violation of that tenet.

For its part, the ISE argued there was little competition on exchange floors because electronic trading and penny increments have taken many traders off the floors in recent years. Also, exchange rules do not permit their off-board members to participate in floor trades. So, in practice, exposure on floors is nonexistent, the ISE asserted, and its QCC does not represent radical change.

SEC data belies that argument. A study undertaken by the regulator last year showed that about three-quarters of all trades of more than 500 contracts at the Chicago Board Options Exchange were broken up. Another 71 percent of all large trades at the Nasdaq PHLX were broken up.

IDBs whom Traders Magazine spoke with confirmed that the risk of breakup on exchange floors was very real. They welcome the new QCC order. "This is not just good news for IDBs," said one senior IDB official. "It's good news for the wholesale markets. It's good news for the market makers. It's good news for anybody who depends on the delta neutral options-versus-stock package. QCC is all about putting together a delta neutral package and not having it get broken up."

A common complaint is that floor traders will often step in at the last minute and break up a trade. NYSE Arca tried to end that practice last year when it proposed a requirement that its floor traders make a "final bid" early in the process. That proposal was derialed by complaints from market makers.

Some believe the new rule will hasten the demise of the exchange floor. "There are some big players that want to create a live and tied exchange," said Mike Menslage, a vice president at trade processor Rickard & Winans, and a former CBOE specialist. "The ISE has its regular exchange where you can point and click and buy options at the national best bid and offer. But an institution could have this separate exchange, where it can see the same quotes but they are tied to stock."

That transparency could cause the market for delta neutral trades to explode, Menslage said. "You would be able to access the option and the stock right on the screen," he said. "The concept of trading volatility as an asset class can be done electronically."

To do so, the ISE would need to build out functionality found at the OneChicago single-stock futures exchange, traders say. With the exchange's BETS system, traders can simultaneously input both the futures portion and the stock portion of a combined trade. The futures trade goes to OneChicago's matching engine. The stock trade is reported to the Nasdaq trade reporting facility.

The ISE is considering something similar, a spokesperson said.


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