ARTICLE on ISE (continued)
Indeed, the fortunes of Adirondack and the ISE are inextricably linked
with each other. In fact, the only capital the ISE has received comes
from Adirondack, which (including KAP's seed money) gave the ISE $35
million and received for its efforts the ISE's 10 primary market maker
seats and 74 of its100 competitive market maker seats. The other 26 are
owned by ISE investor KAP, which has 20 of them, and two executives of
the ISE-President Krell and Gary Katz, senior vice president of
marketing and product development, who own six between them. Those two
individuals joined the ISE after they left the NYSE's fledgling options
operation, which was sold to the CBOE in April of 1997.
The ISE is set up to function as an auction market. Its 10 primary
market makers will provide quotes in options of 60 companies. In
addition,100 competitive market makers each willprovide continuous
quotations in options for ten companies. So-called electronic access
members such as broker dealers will send their orders to those market
makers for execution.
Adirondack and the other current market maker seat holders have to
sell or lease most of the memberships over the next 10 years. But they
won't be selling them on the cheap. Firms interested in a primary market
maker seat must pay Adirondack $15 million, with $1 million up front and
the rest divided over the trades they market through the ISE.
Competitive market makers pay about $1 million that's divided over the
trades they conduct through the ISE. Only the electronic access members
pay an access fee of up to $300,000 to the ISE, depending on the volume
that they will trade. An exra perk: a seat on the brand new options
exchange comes with a put option that gives firms the right to get back
their investment if the ISE turns out to be a dud.
It is the ownership connection between Adirondack and the ISE, which
is unheard of at all other exchanges, that has at led at least one big
options market maker, Arbitrage Holdings' Hajas, to call the situation
anti-competitive. Moreover, he thinks the ISE should sell its seats in
an auction process to the highest bidder the way seat holders on the New
York Stock Exchange conduct the sales of their seats. Instead, he rails,
Adirondack is offering those seats to what he considers a select group
of entities.' In a comment letter to the SEC he writes: "We are aware of
circumstances in which the ISE denied to sell/allocate a membership to
an interested party-where that party offered to purchase the membership
at a price that exceeded the price that the ISE offered the membership
to others." Sources say that some traditional market makers have been
turned down.
Adirondack President Marty Averbuch, who joined the ISE after working
with Porter at E*Trade as vice president of online trading, says that
nobody who has declared an interest in purchasing a seat on the ISE has
been refused. "We are actually in the process of gathering information
and taking questionnaires from people so we can determine who is well
suited to be a market maker," he says. Selection criteria include the
candidate's industry expertise, technological savvy, participation on
exchanges, and the amount of capital available. The mix of firms signing
on as the ISE's market makers will include some "classic market makers
of today, some brokerage firms that want to get into the business, and
some mixtures such as a joint venture between a brokerage firm and
talent from the floor," explains the ISE's Katz. They have to be
approved by the ISE when it has received its own nod of approval as an exchange from the SEC.
To get SEC approval, however, the ISE first has to let its critics
have their say in comment letters to the agency. And once again, its the
ISE/Adirondack connection that has drawn the heat. For example, Sandy
Frucher, chairman and CEO of the Philadelphia Stock Exchange, wonders
"how ISE can effectively oversee a member with whom it has such a close
relationship." Another point of contention has been Porter's dual role
as chairman of the exchange and the leading market maker. CBOE Chairman
Brodsky writes that this "would place all exchange employees who would
ultimately report to Mr. Porter in a very difficult position if they
were expected to oversee and regulate the market maker entity affiliated
with their boss."
For the last two months, the ISE has been working on a response to the
criticism that will be the basis for the SEC's decision to approve it as
an exchange. So far, it doesn't look as if the ISE will make any
substantial changes to the original filing. It has certainly brought on
the big guns to cover itself: The ISE's chief counsel is Michael Simon,
former SEC staffer and outside counsel to the Big Board when he worked
at Milbank, Tweed, Hadley & McCloy, LLP.
Simon argues that the potential conflicts have been sufficiently
addressed by the exchange's strict governing structure. Even though
Adirondack has a large number of seats, its membership voting rights
remain at no more than 20%. And although Porter is the ISE's chairman
for two years, he is not an officer of the exchange. In addition, the
ISE will have a board consisting of 15 directors, including eight
independent directors who are not industry members. If the board needs
to discuss bringing a disciplinary action against Adirondack or any
other member firm, the board representative of that firm can't be part
of that decision, he says.
This brings up another thorny issue that needs to be addressed:
surveillance. The ISE wants to monitor its trading activity through a
proprietary automated surveillance system that it is currently setting
up. But it's planning to outsource other regulatory functions-like
overseeing branch offices and checking firm's sales representatives-to
another marketplace that's better equipped to perform such functions as
overseeing branch offices and checking the sales practices of brokers.
It's currently in negotiations with the New York Stock Exchange and the
National Association of Securities Dealers, but so far a decision has not been reached.
One problem is that the ISE is trailblazing its way through the
difficult process of becoming an exchange--a process set up by
regulators to bring competition into the staid world of traditional
exchanges. But not even regulators are always too sure what all the
criteria are an applicant has to fulfill in order to gain its approval.
"There isn't a tremendous amount of guidance to go on," says an attorney
who deals with those matters on a regular basis." You take a step in the
minefield very slowly and figure out whether you blow up or not."
That includes considering how close a system must be to being finished
before it can receive approval. "It's a tough question," says the
attorney. "How far along do they have to be in terms of being able to
turn on the switch before they can be approved as an exchange?" Speeding
up the approval process is crucial because the ISE can't join any of
industry groups -like the Options Clearing Corporation-or trade a single
option until it's an exchange. In the meantime, its competitors are
breathing down its neck.
Wall Street wants more
Two months ago the ISE moved into a building just a few blocks away
from the Big Board, where its 50 employees are feverishly preparing for
a launch date of March 2000. But just as it gears up, some key Wall
Street firms are getting disenchanted with its prospects. And those are
exactly the players the ISE wants. "The ISE doesn't need market makers,"
says an options pro at a Wall Street firm."It needs order flow from
companies like [Salomon] Smith Barney, Morgan Stanley, Merrill Lynch,
Goldman and Schwab. But the question that these firms are asking is
whether they should be doing this through a consortium like the ISE, or
one of the others, or should they just do it ourselves."
As the fight for order flow between marketplaces is turning fierce,
the role that brokerage firms play in the new environment is becoming
more powerful. Some of them are demanding that exchanges allow them to
act as agents on both sides of their customers' trades. This threatens
the role of market makers and specialists who have long lived a
protected life within exchange walls. Now they are beginning to pursue
Wall Street. firms with promises of rebates and cheaper prices, putting
the ISE in the awkward position of trying to attract firms that have
suddenly found themselves in the driver's seat and are sought after by all the exchanges.
As a result some firms are slow to sign on to the ISE. "We haven't
decided yet," says the head of options when asked whether his firm will
join the ISE. "A lot of people are now realizing that the options
business is changing dramatically in the next twelve months and nobody
wants to be left out. Everybody is figuring out a way for their own
survival and the firms with the order flow can choose from all the
different opportunities."
Indeed, some Wall Street firms are even considering a market of their
own where they can execute both sides of their customers' trades without
the use of middlemen. It's not clear which firms are leading the effort
and so far no filing with the SEC has been made. But the marketplace
couldn't come soon enough for some traders who privately talk about the
practice, which would increase their profits by avoiding paying market
makers to execute trades.
The ISE's rules, on the other hand, don't allow firms to cross their
entire customer orders but will have market makers who execute the
trades. For example, a firm that wants to cross a customer order must
first expose it on the ISE's computer screen to all market participants
for a period of two minutes. If none of them offers a better price
during that time, it can trade the order itself. But traders say that's
an eternity in a world where the price of an option can change within
seconds.
Katz says the practice would put the ISE's auction system in jeopardy
because market makers would lose their shirt if firms were allowed to
pick all of the good orders first. But Porter looks at it differently. "
My original idea was exactly what those people are talking about. If the
SEC allows them to do it, then we will do exactly the same thing," he
says. However, observers think that regulators won't approve such
practices easily, given the inherent conflict of interest that occurs
when a principal also acts as the agent.
Such changes are scary to market makers and specialists, who face
becoming dinousaurs if they don't adapt quickly to the new environment.
Thus, to keep the Wall Street firms happy, they have begun to offer
rebates for directing firms' order flow to them. The practice began a
few years ago in Nasdaq stocks and has helped Roundtable and other third
market firms to build up substantial businesses. Now the biggest options market makers-among them Susquehanna Financial Group Inc., The Hull
Group (which was recently purchased by Goldman, Sachs & Co.), and The
Timber Hill Group-are offering what some refer to as kickbacks in
various forms to their customers. The going rate: About $.75 for each
bid and offer per options contract, which typically consists of 100
shares of stock. If the contract traded at a spread of an eighth, the
rebate would cost market makers as much as $1.50 out of a $12.50 spread.
The practice is controversial because the payback goes into the
pockets of the firms, not their customers. This raises the question
whether the firms that receive the rebate could become more concerned
with the payment than with best execution of their customers' trades.
Although the SEC does not have a rule in place that forbids the
practice, Porter says that the regulator does not want the ISE or
Adirondack to give order flow rebates to their customers. Simon adds
that ISE rules don't guarantee that a dealer who paid for a trade will
be able to trade it. But Porter also says that other market makers
joining the ISE can engage in the practice if they want to do so.
The exchange woes
The listing war over options that was unleashed when the ISE arrived
has thrown a spotlight on the industry's self serving rules that have
dragged the options markets into court. Unlike the rule at the stock
exchanges, market makers in the options markets do not have to fill
orders from broker dealers at the best price. Nor is there an electronic
linkage between the exchanges to send orders to another exchange if it
offered an even better bid or offer.
Instead, obscure rules keep the exchanges from competing with each
other. For example, while options market makers are not allowed to fill
an order at a price worse than that quoted at another exchange, the
competing exchange doesn't have to offer them that price.
When most options were listed on only one exchange, that rule hardly
mattered. But with multiple-listing, it has become a major problem.
Because there is no linkage, exchanges cannot electronically send an
order to another market with the better price. Sometimes market makers
use the telephone to contact their competitor to get the better price
for their own account before filling the customer's order. But under
current rules market makers don't have to deal with competitors, only
their customers. And because they want a relationship with the dealer who sent the order, not the competing market maker, they can decide not
to deal with the competing firm. All this is perfectly legal, but it
means the customer, who has no idea that all of this is going on, may
not get the best price for his order, especially if the market moves as
negotiations are taking place.
Ironically, the ISE, which advocated multiple-listing, is following in
the footsteps of its competitors and adopting some of those arcane
rules. Simon calls them "abominable" but essentially argues that the ISE
cannot be the only market that walks to a different beat. At the same
time, the ISE says it will break tradition by being the first exchange
to show the size, or volume, of all orders at their best bid and offers.
still, under current rules its market makers won't have to honor their
best bids and offers when they deal with broker dealers as a principal,
only when the broker dealers are acting as agents for their customers.
Regulators are starting to look at the practice. "The SEC is going to
force the issue of what happens to the order when it gets to the
exchange," says a trading pro at a big Wall Street firm."The options
markets have evolved to a point now where they must be forced to honor
any order from any person that comes to their floor. And what that means
is an intermarket firm quote rule for options which just doesn't exist
today."
But before the SEC attacks that problem, it wants to solve another
issue that is hanging over the options industry: a potential capacity
overload. The industry's computer systems that broadcast price
quotations to investors during times of heavy quote traffic are having
trouble handling all the business. And many argue that the problem will
get worse with the ISE's quote volume, in addition to quote increases
from multiple listed options and decimalization. "The ISE says they'll
do 16,000 messages per second," says an options pro. "The peak message
last month was 1,600. There are no systems in the world that can handle
that kind of stuff." But Katz says that's the number of messages in its
own system. The volume that's broadcast through outside systems is much
smaller: 600 messages per second.
It's clear from all the changes afoot in the world options that the
uncertainty of the fast changing business climate that has spurred the
enormous increase in options volume is finally reaching the floors of
the options exchanges. One of the main drivers behind the dramatic
changes is no doubt the ISE. But whether it will emerge as one of the
winners in the new environment remains to be seen.
Certainly the exchanges' determination to reform themselves before
their new competitor is up and running makes it uncertain what incentive
firms have left to hook up with something so new and different. " I
don't think the ISE is gonna make it," says a doomsayer who trades
options at one of the big Wall Street firm,"because I think the other
options exchanges are going to respond in a way that makes the ISE
obsolete before it ever gets started."
It's not clear whether his pessimism is just a way to get a better
deal from the ISE. But it's also true that greed can easily turn to fear
on Wall Street. Says an options pro: "If all of a sudden six to eight
slots [on the ISE] were taken, with one or two to go, people would be
rushing to say Geeze, I better get in there."' Even that wouldn't
guarantee success. Mitchell Thaw, director of listed options trader for
Schroder & Co., is a proponent of the ISE. But, as he puts it," I don't
care who does my business as long as I get the right price for my
customers." That sounds good, but in order to achieve that goal all
market participants, including the ISE, still have a long way to go. |
