Every year like clockwork, the heads of the U.S. options exchanges predict a bout of industry consolidation. There has been public and not-so-public flirting in recent years, but no pair of options exchanges has actually made it to the altar. Indeed, seven years after the exchanges began competing directly with one another in 1999, the number of exchanges has risen from four to six. That trend may be at an end. Broader changes now taking place could shake up the status quo-and potentially make the longstanding prediction for industry consolidation come true.
Two major developments are prompting practitioners and observers alike to predict a restructuring of the industry. First, the Securities and Exchange Commission is herding the exchanges toward a pilot in which some options on stocks and exchange-traded funds will be quoted in pennies, rather than the current nickel and dime increments.
It's Mutual
That move could obliterate market makers' spreads in the quote-driven options business and force exchanges to compete more aggressively.
Second is demutualization. Of the six marketplaces, only two-the Chicago Board Options Exchange (CBOE) and the American Stock Exchange-are still owned by their members. And both are in the process of changing that. As exchanges shift to shareholder-owned, for-profit companies, they fuel competition in an already aggressive options market.
As exchanges then become publicly traded companies, as is the International Securities Exchange (ISE), or take on new investors, they gain a pile of cash that can be used to win new business through technology enhancements and fee reductions-or by buying another exchange.
"The options industry is fragmented," says Richard Repetto, an analyst at Sandler O'Neill & Partners. "Penny quotes will lead to stiffer price competition among exchanges." That will eventually result in consolidation among exchanges, as happened among execution venues in equities over the last half-dozen years, he says.
The penny pilot, scheduled to begin on January 29, is expected to dramatically increase options volume as well as options message traffic. It is also likely to narrow dealer spreads, which could end the practice of exchanges paying for order flow. That would force the markets to compete even harder for order flow.
As penny quoting is extended to more options classes beyond the initial pilot, spreads will shrink, reducing the profits of market makers, says Diego Perfumo, an analyst at consulting firm Efficient Frontiers. And since intermediaries are necessary in the options market to create liquidity, exchanges will have to attract order flow to their venues based on tight spreads.
That means they will have to redouble their efforts to attract liquidity. According to Perfumo, exchanges will have to share their profits with market makers. They can do this by reducing their cost of trading and through order-matching rules that enable market makers to participate in marketable orders if they're at the national best bid or offer.
Bring It On!
One exchange raring for increased competition is the ISE. Chief operating officer Gary Katz notes that the current level of "hyper-competition" between exchanges will only benefit the industry and spur growth. He adds that his exchange's trading platform is fast, scalable and ready for penny quoting. The exchange recently released a new, more sophisticated front end with a redesigned trade blotter for institutional investors.
In Perfumo's view, the ISE is in the lead position as the industry's most efficient venue and lowest-cost provider. However, its main threat now comes from the NYSE Group.
NYSE Arca Options last month rolled out a newly developed electronic trading platform, called OX, and plans to shift over all options classes from the old PCX Plus platform by the end of November. The platform is based on the same technology behind the Archipelago electronic platform for equities. Arca bought the Pacific Exchange, which traded options and equities, before it merged with the New York Stock Exchange.
NYSE Threat
There are two reasons behind the NYSE threat, according to Perfumo. First, NYSE can afford to buy another exchange-and the CBOE is preparing to go public. And second, NYSE has a scalable trading platform, which allows for consolidation. Without a scalable electronic platform, consolidation makes little sense.
"Clearly, New York wants to increase its market share and may have to buy an exchange and merge it with the P-Coast," says Meyer ("Sandy") Frucher, chairman of the Philadelphia Stock Exchange. "If Nasdaq wants to get into the game, they will have to buy somebody as well."
Repetto calls NYSE Arca Options a "new competitor with deep funding." Its recent aggressive fee reductions for market makers are a sign of its ambition.
The analyst also sees the CBOE gaining strength as it follows through on its promise to demutualize.
In the first half of this year, the ISE was the largest exchange by equity options volume, with 32.3 percent of the market, followed by the CBOE at 28.5 percent. Next in line were Philly with 13.5 percent, Amex with 10.2 percent, NYSE Arca Options with 10 percent and Boston Options Exchange with 5.5 percent.
Over the same period, CBOE maintained its historical lock on index equity options volume as a result of its exclusive and proprietary listings. Its 85 percent market share in that business makes it the largest overall options exchange.
Perfumo says the NYSE is likely to battle the CBOE to grab market share. That means the ISE can't stand pat. "The ISE may have to think about consolidating volume by buying the CBOE," he says. "That would preempt the NYSE and reduce New York's chance of getting a big part of this market."
Like NYSE Arca Options, the electronic BOX also has a scalable platform. But, Perfumo notes, it doesn't have enough money to buy an exchange or enough volume to make itself a target. Amex would be a better acquisition gambit for an exchange on the prowl, he says, but that exchange has lost a lot of its matched volume in recent years, although it still has a large brokered business. Matched volume is the main catalyst for liquidity, since it attracts order flow.
The Electronic Club
The ISE and BOX are currently the only two all-electronic exchanges. The other four-CBOE, PHLX, Amex and NYSE Arca Options-support both electronic and floor-based trading. But all have funneled huge amounts of IT resources and money into their electronic platforms.
"The driver behind all the competition between exchanges and the increase in customer flow is the ability to do business with tremendous velocity," says Neal Wolkoff, Amex's chairman and CEO.
Amex is upgrading ANTE, its options trading platform, and has a new FIX front end geared to institutional investors. The exchange intends to be "open, accessible and fast" to catch a bigger portion of the industry's growing institutional electronic business, according to Wolkoff.
Exchanges are also pursuing new investors as they upgrade or overhaul their technology. Philly has a new technology platform and last year got a slate of six strategic investors, including some of the largest Wall Street brokers and market-making firms. In July those investors doubled their investments and now own almost 90 percent of the exchange.
Giving those brokers a stake in the exchange increased PHLX's market share. "We brought in strategic partners, some of whom had never looked at us as seriously as we'd hoped," says PHLX's Frucher. "Doing so enabled us to have them look at us more seriously and get more order flow."
BOX Conversion
The BOX has seven equity partners, including many of the same firms that invested in the PHLX. This summer BOX converted from its original NSC trading platform, provided by ATOS-Euronext, to SOLA, a trading platform developed by the Montreal Exchange, one of the firms that founded BOX. The new platform is designed to be faster and more scalable for a market likely to see volumes explode as penny quotes become a reality, says Ken Leibler, the exchange's chairman.
In Leibler's view, cost will be king as soon as exchanges compete without the benefit of payment for order flow programs. "We outsource our regulatory and IT systems and have minimum ongoing exchange costs," he says. "We're low-cost and ready to be in a world that's highly competitive and cost-sensitive, which hasn't really happened yet."
But it will. And with a penny pilot slated for January, the exchanges are readying themselves for the expected heightened battle for order flow.
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