Alohal,
Thanks. There are so many excellent contributors to the thread now that it is a pleasure to take part in the debate. Anyway, here's a good article on the impending ISE:
9/20/99 Inv. Dealers' Dig. (Pg. Unavail. Online)
1999 WL 19514220
Investment Dealers Digest
Copyright 1999 Securities Data Publishing
Monday, September 20, 1999
Shaking Things Up-Again Having revolutionized stocks, E*trade's founder takes
on the options world
Dave Lindorff
Three years ago, William Porter, founder of online trading pioneer
E*Trade Group Inc., was a man on a mission as he headed for Washington,
D.C., to meet with Richard Lindsey, then the ambitious director of
market regulation at the Securities and Exchange Commission. In the fir
st of what turned into more than 20 meetings with SEC officials, Porter
set forth a revolutionary idea to shake up the cozy world of options
trading: an online options exchange to replace the antiquated floor
broker system.
As it turned out, Porter and his colleagues at E*Trade weren't the
only ones irked by the options exchanges' exorbitant costs and fat
margins. They found a sympathetic ear in Lindsey, whose agency for years
had been trying to figure out a way to bring more competition to the
industry, but to little avail.
Now, as Porter's latest brainchild, the International Securities
Exchange, or ISE, awaits for the final approvals from the SEC, it is
already preparing to trade 600 of the most popular options by March of
2000. If all goes as planned, the ISE will become the first national
securities exchange to receive that atus since the Chicago Board of
Options Exchange (CBOE), its largest competitor, began trading more than
25 years ago. By signing up with the ISE, Wallstreet firms will be able
to buy options with a click of the mouse.
Porter seems determined to shake up the world of options the same way
he helped transform the brokerage industry through the creation of
E*Trade. "For the country it's the right thing to do," says the
soft-spoken Porter. "The rest of the world is ahead of us. On the
futures side, Eurex [the German electronic exchange] is moving into this
country big time. They are beating our futures exchanges and that's nonsense. We should be beating theirs. But instead we have these
floor-based systems. They have to go."
On the surface, it looks as if the mathematician with a penchant
forstart-ups couldn't have chosen a better time to turn the mysterious,
highly technical options industry upside down. The nation's four options
exchanges --the CBOE, the American Stock Exchange, the Pacific Exchange
and the Philadelphia Stock Exchange- are under attack from the
Department of Justice, which is investigating whether they engaged in
noncompetitive listing practices under a so-called gentleman's
agreement.' Class action lawyers have jumped on the bandwagon, alleging
the exchanges charged customers too much because of such practices.
But while its creators claim that the ISE will bring needed
competition to the industry, they are meeting with strong opposition.
Critics-mainly competitors-argue that the ISE's own business model is
flawed, with conflicts of interest that could create a new cartel with
problems of its own. If nothing else, it's clear from the ferocity of
the criticism hurled against the ISE by the exchanges that it could deal
them a serious blow. William Brodsky, chairman and chief executive
officer of the CBOE, insists that the ISE isn't fit to become a
full-blown national securities exchange because of conflicts of interest
in its governance structure and restrictions on competition. Peter
Hajas, CEO of Arbitrage Holdings LLC, a leading options market maker,
castigates it a "broker cartel" that will exclude some from access to
its new club.
Most of the big Wall Street firms, in the driver's seat in this new
environment, have been reluctant to endorse the new system. But
electronic brokers and others have expressed hope that the system will
increase the speed and accuracy in which their orders are executed, not
to mention cutting costs. Supporters of the system include Lehman
Brothers, an ISE investor, and Deutsche Bank. Ralph Reynolds, managing
director at Deutsche Banc.Alex Brown believes that the firm could save
"up to 77% of [its options] costs annually, assuming that all business
were transferred to the ISE."
The existing exchanges, meanwhile are responding to the threat with a
variety of tactics, from cutting costs, updating their electronic
systems and finally, after the ISE's arrival forced the issue, listing
options of other exchanges. Market makers, also under attack, are trying
to come up with new ways of fending off the challenges as well. All that makes the ISE's founders feel a big smug. "We have created some positive
values even though we did not trade a single option," says David Krell,
president and chief executive officer of the ISE. "We are the best thing
that happened to this business."
Porter's Plan
Since his initial October 1996 meeting with Lindsey, the 70-year-old
Porter has been quietly working to make sure the ISE succeeds-an
undertaking that many consider much more ambitious even than E*Trade.
Porter, who celebrated his birthday the day of the press conference last
November in New York where he unveiled his ambitious options exchange
for the first time, is determined to emerge as the winner.
Quiet and reticent , Porter seems nonchalant about his fierce drive to
create the ISE. " I am doing it because it's a challenge. Why do you
climb a mountain? Because it's there," he says. "I am rich as hell. I
don't have to do a thing. It's a challenge. It's fun." What he neglects
to mention is that the ISE has an unusual business structure that will
reward him greatly if the upstart turns into a success.
Porter's assault on the options industry has a logical progression.
Trading for his own account led him into the financial world in 1982,
when he created Trade Plus, the first software program for online-stock
trading. Once he had the system in place, large brokerage houses like
Fidelity Brokerage, Charles Schwab Corp. and Quick & Reilly Inc. signed
on. Out of that came E*Trade Securities, which Porter started as a
discount brokerage firm in 1991.
After hiring Christos Cotsakos, the flamboyant and better known
chairman of E*Trade, in March of 1996, Porter began to spend more time
to look for ways to make E*Trade's back office operations more
efficient. One area he focused on was the arcane world of options
trading. Porter soon discovered that replacing the old system-sending an
options order to a broker on the floor of one of the nation's options
exchanges and paying a hefty commission-with a computerized version of
the process would save E*Trade a bundle.
"We were spending $10 or $12 more to execute an option for our
customers than we were when we were going to the third market for
stocks," recalls Porter. At first it seemed like an easy task to cut
those costs. "My original proposal was: I'll put together a computer and it'll do the whole thing."' says Porter. "It would just be one
organization that would own the whole thing and provide an exchange for
the whole world."
That's similar to what E*Trade had done before, sending its retail
stock orders to Roundtable Partners LLC, a consortium of almost thirty
discount brokers and electronic trading firms that was set up in 1995.
Roundtable was a wholesale operation that paid for the orders flow from
discount brokers and executed them. "When I first heard about it, I said
go and put all the money I could into it,"' he says. Last year,
Roundtable went public under the name of Knight/Trimark Group Inc. and
has quickly grown into the largest market maker in Nasdaq stocks.
Why not set up a consortium for trading options that mirrored the
Roundtable set-up in stocks? There was certainly ample demand. Given the
rise in the stock market over the past three years, the volume of equity
options has ballooned during the same time period, as investors seek to
either speculate that the market will go higher or, alternately, hedge
against a market downturn. Equity option premiums sold between January
and August of 1999 reached $150 billion, more than triple the $39
billion for the same time three years ago, just before Porter's initial
trip to the SEC.
In today's market, retail orders for stock options make up almost 80%
of all equity options orders. Among the firms sending lots of retail
order flow to the exchanges is E*Trade. Even though it is not among the
top 10 options order flow providers-those include Salomon Smith Barney
and Charles Schwab-adding its options order flow with that of other
discount brokers in a consortium would quickly make them a force in the
options world, and bring initial order flow to the ISE.
But unlike the stock business, where electronic communication networks
are matching an increasing part of all orders, the options industry has
a barrier to entry: All options contracts must be cleared by the Options
Clearing Corporation, a Chicago based company that is owned by the four
options exchanges. It issues the options contracts and guarantees that
the obligations of both parties to a contract are fulfilled.
And there's the rub: Porter's system had to become a national stock
exchange in order to execute trades.The price tag, too, was hefty: a
cool $1 million to become one of OCC's shareholders. Nonetheless, Porter
pressed forward with his idea to set up an electronic options exchange and stepped down from his position as chairman of E*Trade in January of
this year to focus on it full time. (He still keeps a board seat and
remains one of E*Trade's major shareholders.) Now the inventor with 14
patents to his name-ranging from low light level television to infra red
horizon sensors that are used on satellites circling the earth-finds
himself in the center of the storm that is sweeping through the cozy
world of the nation's options exchanges.
The ties that bind
As if becoming an exchange wasn't a difficult enough challenge, the
SEC demanded that the new exchange be run by a diverse group of members
and owners. How much that has occurred, however, is a matter of
interpretation.
When the ISE filed its application with the SEC last February, one of
the most remakable revelations was the unusual, and close, financial
arangement with what will be one of its leading market makers, called
Adirondack Trading Partners LLC. In the first place, Porter will be the
chairman of both groups for two years. Moreover, it turns out that one
of Adirondack's biggest investors is a firm largely controlled by Porter
and E*Trade: KAP Group, which put up $6 million in original seed money
for the ISE., and owns over a third, or 500,000 of Adirondack's 1.39
million shares. The rest is owned by a consortium of discount brokers
that include Ameritrade Holding Corp., Scottsdale Securities Inc.,
Herzog Heine Geduld, and Knight-Trimark.
(Continued Next Post) |
