Talk about dog-eat-dog. The U.S. options industry seems headed for a vicious round of fee cuts and price improvement rebates as the exchanges wrestle each other for order flow. This comes as the options exchanges, responding to savage competition, are opening the doors to public ownership. The upstart electronic Boston Options Exchange (BOX) – which only accounts for about three percent
of total U.S. equity options volume – is in the middle of this fracas. Its radical price improvement process – PIP – has forced others to look more closely at their models. One fear is that the trading volume on BOX could rise significantly as more firms learn about and try the PIP.
The CBOE, for one, is worried. "You have to be crazy to ignore things that are going on in the industry even if you don't philosophically agree with them," said Bill Brodsky, Chairman and CEO of the Chicago Board Options Exchange, at a recent industry conference in Chicago. "We are not going to sit by and just allow one aspect of the business to happen without having a response. Our thought is that there are inherent flaws in the PIP process and we would rather improve on it rather than just copy it."
The war between the options exchanges is about more than deep discounting. Technological advances have changed the dynamics of trading. Another johnny-come-lately, the electronic International Securities Exchange, clearly had the wind at its back when it launched itself. Now the BOX has forced a bout of industry introspection. For some, the route to success is demutualization. Here is a fancy word that describes an exchange's transition from a limited membership organization to a shareholder-based corporation.
The Philadelphia Stock Exchange, a floor-based options exchange, recently demutualized. Meyer "Sandy" Frucher, Chairman and CEO of the Philly mart, says demutualization is no surprise. "It is an intermediate step toward a certain amount of repositioning," Frucher told the Chicago conference. "You need to position yourself so that you have currency with which you can strike strategic alliances."
Frucher added that exchanges would eventually become one-stop shops. "You're going to have to move more toward the European model, the Eurex, Euronext model, which has equities, options, futures and a technology company all under the same roof," he said.
With the BOX joining the fray earlier this year, the options marketplace is crowded. Kenneth Leibler, Chairman of the BOX, used the conference session to simultaneously pitch and then shrewdly downplay his exchange's PIP. "PIP represents 10-15 percent of our overall volume, certainly a minority of total trading volume in the BOX market," he said. "Average price improvement has been over $2 a contract. It is not penny pricing but actually forty percent [two cents] of the nickel spread is returned to the customer in the form of price improvement."
Still, one executive is skeptical. Michael Bickford, senior vice president of the American Stock Exchange, told the conference: "Ken talks about two cents out of nickels, but I'm willing to bet that a lot of that is two cents out of dimes."
The BOX has some wondering if the competition has gone too far. After all, with razor-thin profit margins and transaction costs at an historic low, do we really need six options exchanges? The various options executives gathered in Chicago answered with a resounding no. In fact, the only thing that seems to unite most of the warring exchanges is criticism of the BOX and the PIP. The representatives of the Amex, CBOE and PHLX dismissed the PIP though they all vowed to somehow emulate it. Frucher said the BOX has put more pressure on the strapped business models of the exchanges. "There is no question that the BOX coming into the space causes us to reassess our financial and fee structures," he said. "There is no question that the BOX is accelerating internalization models on every exchange."
The BOX threatens the other exchanges in numerous ways. First, the lure of price improvement draws order flow away from competing exchanges. Second, the PIP offers price improvement in one-cent increments while competing exchanges still quote prices in nickel and dime increments. This paves the way for an inevitable switch toward penny pricing, a move that the exchanges are dreading because of the exorbitant costs of upgrading technology, trading experts say. Although the panel was uniformly against the PIP, the constant sniping must have been music to Leibler's ears. "I'm always interested in these discussions. The PIP is a small percentage of our business. I'm actually pleased that most of the competition is obsessed with it," he said.
The exchanges are in a tight corner. They are struggling to find new sources of revenue as old ones dry up. Whenever possible, they produce the killer weapons – proprietary products. The CBOE has been successful. With their exclusive licenses on S&P index options, along with new proprietary products like futures on the VIX, the CBOE has been able to withstand a severe erosion of its equity options business. Indeed, the importance of proprietary products has led to a delicate balancing act among the competitors. "We all genuflect to the god of competition, while in the back room we are all desperately trying to find proprietary products," Frucher said. Bickford of the AMEX, also acknowledged that proprietary products are the Holy Grail of the options industry. "What frequently drives the engine of the exchange and allows you to do many of the innovative things and pay for the technology is the ability to have proprietary products," Bickford said. "Unless there is something driving the engine, it becomes real hard to get things accomplished." So the future of the options business is uncertain. Some are asking: Who let the dogs out?
Wider Spreads at the BOX
The Boston Options Exchange (BOX) has requested permission from the Securities and Exchange Commission to widen its option quote spread from 25 cents to $1, to $5. However, the practical effect of the filing would be negligible. That's because competition has squeezed the wiggle room out of the option bid/ask spreads. BOX noted that requiring market makers to quote prices that are "unnecessarily narrow" is potentially risky if the markets move quickly. The SEC regulates the width of option markets incrementally based on price. As option prices go up, the markets get wider. The BOX is merely asking the SEC to waive those market width regulations.
Electronic options markets like the BOX have not experienced the extreme market conditions of the late 1990's. This has prompted some traders to speculate that a severe market crash would wreak havoc with electronic exchanges. When the market goes into a tailspin, options exchanges enter into what are known as "fast market conditions." This term signifies that the market environment is too dangerous to make standard width markets, a condition in which market makers are permitted to increase the width of their markets. The BOX filing is meant to apply in these "fast market conditions." The BOX's option markets aren't going to jump from $.25 wide to $5 wide overnight. But, if the SEC waives its restrictions, the BOX could theoretically make markets as wide as it liked. It is possible the BOX is simply figuring it doesn't want to wait until a market crash to seek permission to widen markets. Indeed, the BOX filing has many thinking it is preparing for a catastrophe. -Mark Longo
Mark Longo is an options trader and a former member of the Chicago Board Options Exchange.
