Rivals Counterattack As the ISE Blows Away the Competition
Once upon a time, about every major equity and index options product was traded on the Chicago Board Options Exchange (CBOE) floor. Sure, other exchanges, including the AMEX, the Pacific Coast Exchange (PCX) and the Philadelphia Stock Exchange (PHLX) also traded options. But the biggest share of the trading volume took place in the muscular pits of Chicago.
As if to underline all of this, these four exchanges implemented a gentleman's agreement in order to limit competition. In effect, this agreement stated that an equity option could only be listed on one exchange. Microsoft options, for example, traded on the PCX, Intel options on the AMEX and IBM options on the CBOE. It was the best of times in the options world. Everyone had access to their own piece of the options pie.
In 1999, it came to an abrupt end. Under increasing SEC scrutiny, the gentleman's agreement between the major exchanges broke down. And almost overnight, the options industry degenerated into a brutal free-for-all as the exchanges battled each other for volume. Each exchange began listing its competitor's equity options. IBM, which was the CBOE's signature equity option, suddenly began trading on the PCX, AMEX, and PHLX. The CBOE retaliated by listing Microsoft, Dell, Intel and a host of other equity options. The great exchange wars had begun.
The battle between the exchanges was a devastating blow to options traders and options market makers. However, it turned out to be a blessing in disguise for customers. As competition between the exchanges intensified, option markets tightened and transaction fees became practically non-existent. In order to reduce option spreads even further, the exchanges abandoned their archaic 1/16th ticks and replaced them with decimal prices. Equity options markets that had previously been $.25 wide shrunk to $.10 or even $.05.
The CBOE suffered the most from this four-way battle. Since it was the largest options exchange, it lost the greatest percentage of its volume to the competition. Although it was still the dominant equity options exchange, its lead over the PCX, PHLX and AMEX narrowed each year. The competition turned out to be a tonic for the smaller regional exchanges, such as the PCX and PHLX. Prior to the advent of multiple listing, a lack of volume threatened them with extinction. The competitive turf battle that followed gave them a new lease on life. They were able to attract more customers by improving the markets of other exchanges and paying exorbitant per-contract fees to the brokerage houses.
But while the four exchanges battled each other, they failed to notice a fifth combatant entering the landscape. That combatant was the International Securities Exchange (ISE), which was the first electronic options exchange in the U.S. And it went online in May 2000. Its radical new structure threatened the open-outcry trading system that dominated the options marketplace. Rumors about the ISE and its trading capacity were whispered on options trading floors across the country. The looming specter of electronic trading quickly became a cause celebre amongst option traders, many of whom thought it marked the death knell of open-outcry trading.
Their fear is understandable. Ever since the creation of options in the late '70s, they have been the domain of an elite group of traders. In order to join their ranks, you had to master a complex financial instrument, secure a high degree of capitalization and, most importantly, fight your way into the brutal trading pits of Chicago or another major exchange. Most people were unwilling to endure this process. However, the onset of electronic trading threatened this insular trading world. Suddenly, unseen individuals from off the trading floor could make markets and compete with the traders in the pits.
The ISE posed another threat to the other exchanges rapid-fire execution. The speed of an electronic transaction is limited only by the computers and data transmission lines that process the order. Most electronic options trades take only a few seconds to execute. The open-outcry system, however, is far more complex. It requires many more layers of interaction between brokers and market makers to fill an order. Large trades require a broker to physically enter a pit, call out an order, wait for a response from the trading crowd, execute the trade and then report the fill back to his customer. Depending on the size and complexity of the order, this process could take minutes or even hours.
The major exchanges did attempt to reduce transaction times through automation, but these attempts were limited to small customer transactions. The CBOE utilized a program called the Retail Automated Execution System (RAES) to execute some orders electronically. Small customer orders – customers with up to 250 contracts – were automatically executed. The fills were electronically distributed to the accounts of the participating market makers. These measures were helpful, but they could not prevent electronic trading from establishing a foothold in the options world.
While the other exchanges languished, the ISE carved away an ever-increasing percentage of the equity options market. From its humble origins, the ISE has grown to become the largest equity options exchange in the U.S. However, the war is far from over. The other exchanges have responded to the ISE by decreasing their transaction times and expanding their electronic presence. The CBOE has introduced the Hybrid trading system, which combines open-outcry and electronic trading in one platform. The PHLX created the AUTOM system, which allows traders to send limit orders to the specialist book electronically. They have also begun accepting IOC (immediate or cancel orders) electronically. The PCX has rolled out PCX Plus, which allows electronic trading in select equity options. The exchanges have also sought to expand their offerings to equity traders. Single stock futures make up a large component of their new product lines. Like equity options, single stock futures allow traders to use leverage to enhance the returns of their equity portfolios.
The full impact of these changes is still not clear. The success of the ISE seems to prove that electronic trading will remain. As financial marketplaces turn increasingly global, the options battleground will expand and become even more complex. Indeed, foreign exchanges have been eyeing the American markets for some time. EUREX, the world's largest derivatives exchange, has established a significant electronic presence in the U.S. This brave new world may be frightening to the major exchanges, but it is a great time to be an options customer.
