CBOE uneasy at entry of Box
By Jeremy Grant in Chicago
Published: August 21 2003 4:29 | Last Updated: August 21 2003 13:50
The Chicago Board Options Exchange, the world's largest options exchange, wants US regulators to review the way US options exchanges operate amid concern over the entry into the market of a new, joint venture exchange planned by the Boston and Montreal stock exchanges.
At the root of the CBOE's desire for a review is its concern that the new options exchange, as planned, calls for a trading arrangement that the CBOE claims would allow brokerages to buy or sell their customers' orders rather than send them to a third party, such as a market maker at an exchange.
The CBOE's unease reflects widespread fears at traditional derivatives exchanges - generally member-owned, open outcry operations - that trades driven by the trading desks at big brokerages could result in the extinction of market makers standing in trading pits.
Some fear that the process, usually referred to as "internalisation", could even spell the end of the still heavily "open outcry" derivatives exchanges in their current form - such as the CBOE and its counterparts in futures, the Chicago Board of Trade and Chicago Mercantile Exchange.
While debate about internalisation is not new, it has gained prominence with the emergence of plans for new futures and options exchanges, some backed by large investment banks.
One of two initiatives to emerge recently comes from the all-electronic, German-Swiss derivatives exchange Eurex, which plans to set up a separate US futures and options operation by early next year. The move is a direct challenge to the CBOT and CME, the two largest US futures exchanges.
The other initiative is Box, a joint venture between the Boston Stock Exchange, Montreal Stock Exchange and Interactive Brokers Group. Four investment banks are also equity investors in the business: UBS, Credit Suisse First Boston, JP Morgan and Citigroup.
Interactive Brokers Group is a privately held company that is the parent company of Interactive Brokers, a brokerage firm based in Greenwich, Connecticut specializing in electronically-listed securities and derivatives products.
Bill Brodsky, CBOE chairman and chief executive, said the way Box appeared to be structured in rules submitted to the Securities and Exchange Commission for approval implied that trades could be "internalised".
"The way we read the Box filing, the whole purpose of Box is internalization. If the SEC were to approve Box as proposed what you've done is to institutionalise internalization," he said in an interview.
Like other traditional derivatives exchanges, the CBOE is opposed to internalisation because it says the process does not allow customers' orders to be exposed to all market participants, so achieving the best price possible.
Although the CBOE in June introduced its first electronic trading system, the bulk of trading on the exchange is still done face to face in trading pits.
There are also objections to "payment for order flow", whereby a brokerage firm is paid by a market making firm to send their customer order flow to that brokerage. "There have been enough issues that have come up recently about conflicts of interest between the big brokerage forms and their customers and to us this is so significant that if the SEC is entertaining this [application] then it ought to be reviewed by the SEC in a macro sense, not an the narrow merits of this [Box] filing," said Mr Brodsky.
"I would like the SEC to have a studied approach to what [effect] internalisation and payment for order flow has had on the options business and before they allow new methods to do this, where major firms bring their order flow and can internalise it and not expose it to the broader options marketplace," he said.
The CBOE is one of five options exchanges in the US, many of which have suffered from declining volumes amid depressed stock markets. The CBOE's trading volume has fallen by 12 per cent this year to 24.7m contracts.
The prospect of the launch of two further options exchanges alarms the CBOE, which this year was overtaken by the International Securities Exchange, the only all-electronic US options exchange, as the largest US equity options exchange. However it is still the largest overall options exchange if index options are included.
CBOE criticism of Box is focused on a mechanism called the Price Improvement Period (PIP) - which Box's customer orders are exposed to the market through a three-second electronic "auction". The CBOE says this period is too short to allow proper "price discovery".
However Ken Leibler, chairman and chief executive of the Boston Stock Exchange, said that before an order is exposed under PIP the broker guarantees the customer a better price than the best bid and offer available in that auction.
He said the three second period was "a trade-off" between allowing trades to be exposed for a certain time and the risk that the broker is taking exposing that trade to the broader market after having guaranteed to the customer a better price than is available through a brief auction.
"When the order goes into the PIP it only goes in after the customer's broker has guaranteed a better price than the auction may produce. The broker is not going to so do for 20-30 seconds because he's exposing himself to market risk. One reason for the period being short is the risk that the guarantor is taking; he's not going to want to do that for too long. I would not call that internalisation, I would call that an open auction," Mr Leibler said in an interview.
Box hopes to launch its exchange by the end of this year. Last week, it submitted to the SEC a revised proposal covering how the exchange will operate, but the revisions were relatively minor and do not appear to address the issue of internalisation.
Mr Leibler said Box acknowledged that was "a new model" in that it would be the only fully electronic options exchange "with a completely transparent [order] book and on top of that conducts price improvement auctions".
Asked whether there is room in the market for any more options exchanges, he said: "We think the [Box] mousetrap is better. The question is not how many markets there are but what kind of markets there are in terms of speed and cost." |
