The old Archipelago Exchange is hoping to replicate its success in equities on a new stage: options.
Last September ArcaEx acquired Pacific Holdings, which includes Pacific Exchange, for $91 million. It announced it would replace the Pacific's newly developed PCX Plus trading system with a "next generation options trading platform" that would utilize some of the order-matching components from ArcaEx's equities platform. The new options platform is due to launch this spring. But past performance is no guarantee of future performance.
"The main question is: Will Arca/New York be the same entrepreneurial firm that Arca was five years ago, or are they going to be the NYSE?" asks Tom Sosnoff, CEO of thinkorswim Group, a retail options trading firm in Chicago.
The firm that started as Archipelago ECN in December 1996 has come a long way. In 2000 it partnered with Pacific Exchange to form ArcaEx, which absorbed the Pacific's equities trading business. ArcaEx went public in 2004. This past March it merged with the 213-year-old New York Stock Exchange and is now part of NYSE Group.
For now, NYSE and NYSE Arca remain separate securities exchanges with different business cultures and platforms. NYSE Arca includes the old Pacific Exchange, which has been renamed Arca Options Exchange, or Arca OX, according to technical documents on NYSE Group's web site.
As of mid-March NYSE Arca had not submitted a proposal with the Securities and Exchange Commission for its new Arca OX trading platform. SEC approval is required before the new system can launch.
NYSE Arca declined to be interviewed for this article because the company is in a quiet period as a result of the merger.
Arca OX has a steep hill to climb. Of the six U.S. options exchanges, the old PCX ranks fifth in market share, with 10 percent of the industry volume.
"The challenge is to get people to take a fresh look at them," says Jeff Shaw, head options trader at Timber Hill, an options market-making firm. Timber Hill, which is part of Greenwich, Conn.-based Interactive Brokers, manages about 360 specialist books on the PCX Plus platform, making it probably the largest specialist firm on NYSE Arca's options exchange.
Arca OX must differentiate itself in an industry that has become increasingly competitive since the upstart, all-electronic International Securities Exchange launched in 2000 and began winning volume. Multiple listings of options took off in August 1999, largely in anticipation of the ISE's entry into the market. The ISE-the first exchange approved by the SEC in more than a quarter-century-built up a market share through anonymous, screen-based trading that now rivals that of Chicago Board Options Exchange, the granddaddy of U.S. options exchanges.
In 2004 Boston Options Exchange launched with a more traditional ECN-like market structure and a controversial price improvement mechanism that enabled market makers to price-improve orders on the exchange's limit order book. This innovation gained ground, prompting the ISE and CBOE to come up with their own electronic price-improvement auction mechanisms.
Playing Catch-Up
The current PCX is an "also-ran," says Jamie Selway, a managing director at institutional agency broker White Cap Trading and a former chief economist at Archipelago.
NYSE Arca doesn't have a lot of natural advantages in the options business. And whatever its plans, it will have to play catch-up with the ISE, CBOE and other exchanges that have been aggressively rolling out automated facilitation mechanisms, automated preferencing, automated block trading and other functionalities aimed at bringing some of the traditional floor-based volume onto the screen.
However, NYSE Arca does have deep pockets and the financial stamina to go after the options market. Richard A. Herr, an analyst at Keefe, Bruyette & Woods (KBW), says the exchange could induce participants to shift some of their liquidity to the new platform through breakpoint discounts for combined equities and options volume. "The pitfall is they'd be pursuing an unprofitable strategy and if liquidity never builds they'd lose money," Herr adds. "It's not a long-term business model."
Anthony J. Saliba, CEO of LiquidPoint, an institutional agency broker, points out that NYSE Arca has a wide network of valauble screen real estate, which could help it attract options volume. "Equities and options are like hand in glove, and the NYSE's exchange members are a captive audience-they're the providers of options order flow," he says. The direct market access system that LiquidPoint uses, built by an affiliate, typically handles more than 15 percent of the daily U.S. options volume.
Veiled Strategy
NYSE Arca has so far revealed little about what the new options market structure will look like. PCX Plus consolidates quotes from participants on the option exchange's San Francisco floor as well as quotes from remote market makers. The PCX's old technology had a reputation for unreliability and low fill rates. Some of its problems waned with the new PCX Plus system, but the exchange hasn't built up much liquidity.
NYSE Arca is eager to make a splash and build volume on Arca OX by designing a winning market structure. Gerry Putnam, ArcaEx's founder and now CEO of NYSE Arca, has not said whether Arca OX will retain the San Francisco floor and create a hybrid model, shift to an all-electronic ECN-like model, or pursue a different strategy to attract order flow its way.
Putnam has long championed the idea of a multi-asset-class exchange that could make strategies involving options and equities simpler, cleaner and cheaper to execute. He has also said, more controversially, that the options exchange intends to trade in penny increments, despite industry resistance. In January ArcaEx execs announced they were in discussions with the SEC about a pilot to quote and trade five exchange-traded funds in penny increments. The current minimum increment for quoting and trading options priced below $3 is 5 cents, while options $3 or higher have a 10-cent minimum increment. The pilot would require SEC approval.
"Penny quoting and trading will be a seismic change to the options market," says White Cap's Selway. "Putnam will do pennies everywhere it makes sense to do pennies-and that makes them a compelling, disruptive force on the landscape."
In recent years the SEC has explored the idea of penny increments in options but has acknowledged some of the inherent difficulties. Unlike in equities, penny increments in option quotes would lead to a massive surge of message traffic. OPRA, the Options Price Reporting Authority, which consolidates last sale and quote data for the U.S. options industry, already represents about two-thirds of total options and equities message traffic, according to the Financial Information Forum, an industry group that focuses on data issues.
Spreads
There's also fear that narrower increments would reduce displayed liquidity, as occurred in equities. Another concern is that the resulting reduction in spreads could make the business of market making harder to sustain, thereby impacting liquidity.
On the plus side, say order-sending firms, smaller increments would improve pricing for customers. Narrower spreads would also probably eliminate or reduce payment for order flow, which took off after exchanges began multiple-listing options in 1999. The SEC has said it would welcome a reduction in the level of payment for options order flow.
"It's hard to say how the market moves in a penny world," says Shaw from Timber Hill. "But even if OPRA can handle the traffic, quote vendors can't right now."
Sosnoff from thinkorswim Group says he's eager to see penny increments for his customers but that the increased messaging traffic is a real barrier. "We're not talking about institutional traders with 2 gigs of RAM and a server under their desk," he says. "We're talking about people on their home computer who may be looking at an options stream and at the same time trying to write an email."
Pennies
Still, pennies are on the horizon. LiquidPoint's Saliba says he expects to see penny increments in some of the more active options contracts by the end of the year. But the veteran advocate of electronic trading adds that floors remain a vital part of the options industry. Arca OX, he suggests, might want to think carefully before scrapping the current San Francisco floor.
KBW analyst Herr adds that moving to a fully electronic exchange and shutting the floor also entails another kind of "handoff risk." If the current floor liquidity disappears, Arca OX would have to build up its market share from an even weaker position than the one it currently has.
However, an ECN-like structure with penny increments for some of the most actively traded options could build on NYSE Arca's success in equities. "There are plenty of exchanges out there today to help market makers make money," says White Cap's Selway. "A truly differentiated options exchange wouldn't have special rules for market makers."
Whatever its ultimate market structure, Arca OX is counting on a variety of benefits from enabling cross-asset-class trading. In an increasingly competitive environment of for-profit exchanges thinking about consolidation, exchanges are reluctant to simply stick to their own knitting. Trading multiple asset classes diversifies an exchange's revenue stream. Exchanges that leverage their existing technology and trading platform can benefit from the potential increase in volume at a relatively low cost.
Last October at a Futures Industry Association panel on the options industry, William Brodsky, CBOE's chairman and CEO, suggested an even simpler reason for the then-proposed NYSE/Arca merger. The logic for the deal, he said, was less that customers needed a common platform to trade equities and options than the fact that the options business was growing at a faster clip than equities.
Indeed, the supermarket notion of bringing together options and equities on one platform isn't necessarily matched by demand. Interactive Brokers, Bloomberg and other institutional agency brokerages offer sophisticated front-ends that already support buy-writes and other multi-leg trades.
"The idea of one-stop shopping for equities and options may be convenient, but at the end of the day customers want the best price and the quickest execution of the different pieces," says Steve Sanders, managing direct at Interactive Brokers. "If [Arca OX] happens to have a combo product at the best price and quickest execution, we'd be happy to go there, but otherwise we'll just break up a trade and give it to different exchanges."
Timber Hill's Shaw says that combination order books have been growing in recent years and could gain ground as the options industry continues to expand. "But unfortunately [Arca Ox] will be one of the last exchanges to do that," he says. "Automating that will only get them to where some of the other exchanges already are."
Buy-Writes
ISE has offered buy-writes since 2004, with the equity leg of the trade executed by NYFIX Millennium. The ISE doesn't publicly break down its volume for strategy-based products such as spreads, buy-writes and delta-neutral trades, but market participants speculate that they could account for 7 percent to 15 percent of the exchange's monthly volume. "That business has been increasing nicely," says ISE's chief marketing officer Bruce Goldberg.
Nasdaq is preparing to offer smart routing of options orders to options exchanges by late spring. BOX also has plans to introduce buy-writes with the Boston Stock Exchange.
LiquidPoint's Saliba sees strong industry potential for combined equity-options products. And in his view there's still room for improved efficiency in executing multiple legs " at a lower cost and on a single, guaranteed-fill platform."
Arca OX Data Feeds
Arca OX is building two proprietary market data feeds-a top-of-book feed and depth-of-book feed that will include the top five price levels in its consolidated book.
The exchange will continue to send top-of-book data to OPRA, but the prop feeds will enable speed-conscious black-box traders, market-making firms and other subscribers to get data quicker by eliminating the hop to OPRA's data center.
Both feeds will be offered only in FIX FAST (FIX Adapted for STreaming), a new protocol from the FIX Protocol Ltd. that compacts messages with no loss in latency. That will reduce the bandwidth requirements even as message traffic increases. The industry group's compaction protocol was tested last fall on the ArcaBook equities feed as well as feeds from other exchanges across different asset classes.
