Tussle Over Index Options

ISE Challenges CBOE's Proprietary Index Offerings in Lawsuit

The index war has escalated. For years, the International Securities Exchange (ISE) has been content to take potshots at its main rival, the Chicago Board Options Exchange (CBOE). Its primary bone of contention is the CBOE’s dominance of the index options market, particularly the lucrative S&P 500 (SPX) product line. In fact, the ISE hasadopted “Free the SPX” as its unofficial battle cry. However, after sniping at the CBOE through the press and at industry conferences, the ISE suddenly decided to raise the stakes in this long-simmering feud. On November 2, the ISE filed a lawsuit challenging the validity of proprietary index license agreements. Although the suit names Standard & Poor’s (a unit of McGraw-Hill) and Dow Jones & Company, the intended target of this action is clearly the CBOE. The announcement of this lawsuit stunned the options industry.

By taking its fight to the courts, the ISE has raised the stakes in this formerly staid dispute and made it more contentious. Although this court case will likely take years to resolve, one development is certain: No matter which side emerges victorious, the outcome will alter the landscape of the options world forever.

On the surface, this may seem like just another ploy for market share. The CBOE controls the lucrative S&P options market and the ISE desperately wants a piece of that pie. However, this case has ramifications well beyond the monthly market-share numbers. By filing this lawsuit, the ISE has highlighted issues that have lurked in the background. At the same time, ISE may have endangered one of the industry’s few remaining cash cows-proprietary products.


The CBOE was one of the early options exchanges to realize the potential value of proprietary products. In a moment of foresight, it purchased exclusive licenses to the S&P index family and created its flagship products. Eighteen years later, SPX options are still on top of the index options world and highly profitable. In an industry in which most new products die that is quite a feat.

However, many of the CBOE’s rivals believe the SPX would be a greater success, and generate more liquidity and volume for the industry, if it were listed on multiple exchanges. “ISE was founded on the belief that competition among exchanges improves market efficiency and, ultimately, benefits investors,” said David Krell, ISE’s president and CEO in a statement announcing the suit. “As a result of ISE’s leadership, the market has experienced increased liquidity, tighter spreads, and lower customer transaction fees, and we want to deliver those same benefits to investors in the remaining exclusively-listed index options.”

This isn’t the first time the ISE has come out swinging for market share in the index options markets. The ISE also caused a furor in 2005 when it listed options on the popular SPDR and DIAMOND ETFs without a license. Other exchanges quickly followed the ISE’s lead, giving rise to one of the industry’s fastest-growing market segments ETF options. McGraw-Hill and Dow Jones promptly sued the ISE, but the case was decided in the ISE’s favor. That emboldened the ISE to launch its recent assault on the SPX.

Under most circumstances, the mere possibility of opening up the SPX pit to outside exchanges would be a cause for celebration among the competing exchanges. However, despite their widespread desire to trade the SPX, few industry participants are willing to endorse a side in this lawsuit. “We’re just going to sit back and let the titans fight it out on this one,” said Scott Morris, CEO of the Boston Options Exchange (BOX). “I actually think that both sides are acting rationally.

After all, it’s hard to differentiate yourself in this environment, and the SPX is a way for the CBOE to do that. If I were them, I’d try to hold on to this advantage for as long as possible. On the other hand, it’s undeniable that the multiple listing of SPX would result in tighter spreads and lower fees for the customer, while also providing greater liquidity for the industry as a whole.”

Far from rallying other exchanges to its cause, the ISE’s lawsuit has caused the other exchanges to step back and analyze the situation.

Instead of cheering for an open SPX market, many of the options marts execs are nervous. There is a widespread concern that an ISE victory would leave its own proprietary products vulnerable to legal action. “To tell you the truth, I don’t know what we would do if the ISE wins this particular lawsuit,” said Kelly Naughton, strategic director for Russell Investment Group. “It would definitely create doubt about whether or not someone could come after our own products in a similar manner.”

The First Shot

The ISE fired the first shot with its lawsuit but, with a premier product on the line, the CBOE has decided to fight back with its own lawsuit. It joined McGraw-Hill and Dow Jones & Company in a countersuit against the ISE. They assert the ISE’s intention to list S&P and DOW options products violates the CBOE’s licensing agreements.

Although the ISE’s aggression has served it well in the past, its attack on the SPX may backfire. The current situation allows the CBOE to portray itself as both a victim and the defender of innovation in the options industry. At the same time, the ISE’s apparent lack of respect for intellectual property has angered others who have structured their businesses around proprietary products. The CBOE played up this dichotomy in a recent letter to its members:

“The CBOE’s ongoing willingness to assume the risk of introducing new products outpaces that of any other options exchange. Some of our competitors would like to share the fruits of our labor without having to shoulder any cost or risk. No matter how this strategy is cloaked, it is free riding and is ultimately anti-competitive. The desire on the part of a competitor to have a stake only in our more popular, market-tested winners is equally understandable, but the practice of cherry-picking, like free riding, is ultimately a disincentive to those who would truly innovate.”

Although this legal battle is still in the early stages, it has already spilled over into other aspects of the marketplace. On December 6, the ISE raised the stakes by filing yet another lawsuit. This time, its target extends beyond the SPX to the core of the CBOE’s marketplace. This latest suit contends that the CBOE’s Hybrid trading system infringes on the ISE’s patents for automated exchange trading. While the CBOE has yet to file a countersuit, the exchange promised to “defend itself vigorously against this meritless claim.”

See You in Court

The most disturbing part of this disagreement is that it was allowed to escalate into a lawsuit in the first place. When a judge is deciding the fate of the marketplace, instead of the twin engines of innovation and competition, it is a failure of oversight. Unfortunately, the rest of us now pay the price for this failure.

The sad truth is that, no matter who wins this index war, the industry as a whole will wind up losing.

If the CBOE triumphs, then the industry’s leading index product will remain locked away in the near future, minimizing growth and stifling competition in the marketplace. However, if the ISE wins, then it will create a strong disincentive for innovation in the options world. Neither is good.

The views in this column are those of the author and do not reflect the opinions of Traders Magazine. The author welcomes comments and questions. He can be reached at Mark.Longo@sourcemedia.com.