CBOE’s Plans to Trade the SPX on C2 Hit a Snag

The Securities and Exchange Commission has postponed its decision to approve a Chicago Board Options Exchange plan to trade options on the S&P 500 Index on its new C2 platform.

The regulator had originally planned to rule by Friday, but has put off the deadline until June 6 to allow more time to consider possible problems with the product. The SEC published its decision on its website last week.

CBOE launched its all-electronic C2 exchange last year. The introduction of trading in SPX contracts on C2 is eagerly awaited by many in the industry who see it as a more efficient trading mechanism compared to the manual nature of SPX trading today in the pits of CBOE.

Still, during the comment period for CBOE’s proposal, two firms questioned the merits of the proposal on various grounds, including concerns that the new product would introduce unwanted volatility in the underlying securities of the S&P 500 Index.

The CBOE is asking the SEC for permission to settle C2’s SPX trades in the afternoon, rather than in the morning, as occurs in SPX trades on the CBOE’s flagship exchange. Both the International Securities Exchange and Blue Capital Group, an index options market maker, told the SEC that an afternoon settlement might be a step back to the days of the controversial "triple witching hours."

In the 1980s, options and futures on stocks and indices all settled on the same four Fridays per year, causing severe disruptions in stock trading as New York Stock Exchange specialists scrambled to cope with a deluge of orders at the close. The settlement periods were known as "triple witching hours" because options on three types of instruments–individual stocks, indices and futures–all settled at the same time.

The chaos and resultant media attention forced the industry to move largely to morning settlement, although some products are still settled in the afternoon. That includes options traded on the S&P 100 Index as well as trades done in the over-the-counter market.

"The regulatory powers must carefully and perhaps painfully revisit the history of PM-settled listed index derivatives, and the birth of AM-settlement," Randall Mayne, an executive with Blue Capital told the SEC in a letter.

The ISE is also concerned. "The proposed PM-settled options risk undermining the operation of fair and orderly markets," ISE exec Michael Simon told the SEC in a letter.

Not so, said CBOE. The exchange operator told the SEC that the conditions that produced the triple witch no longer exist. Stock trading is now widely dispersed across many exchanges and alternative trading systems and some exchanges use electronic crosses to efficiently close out their days.

Besides the volatility issue, the ISE also questioned the CBOE’s motives for incorporating an afternoon settlement. Because the C2 SPX settles in the afternoon it will be a slightly different product than the existing SPX, which settles in the morning. Therefore, trading in the new SPX will not impinge on trading of the old SPX. In other words, C2 will not have to prevent trade-throughs of orders in the SPX on the CBOE.

The lack of competition between CBOE and C2 in SPX will preserve the monopoly the CBOE has in trading the contract in its pits, ISE charged. CBOE can "continue to trade S&P 500 options on the floor without having to accommodate the more narrow quotes that are likely to exist on C2’s electronic market," Simon told the SEC. He called the six-and-a-half hour settlement difference between the two SPX contracts a "sham."

The CBOE does have a legal monopoly in trading the SPX, but preserving that exclusivity with a different settlement time wasn’t the rationale for the afternoon settlement, according to one exec there. CBOE executive vice chairman Ed Tilly told Traders Magazine that the SPX’s afternoon settlement would appeal to money managers who do similar PM-settled trades in the over-the-counter market.

The CBOE and other options exchanges are engaged in a long-term battle to wrest market share from OTC dealers.