`Point-and-click' system grabs business from traditional pits
Exchanges consider their options
By Robert Manor
Tribune staff reporter
Published October 18, 2002
An upstart electronic exchange has seized a big piece of the nation's trading volume in stock options, with much of the gain coming at the expense of the Chicago Board Options Exchange.
The International Securities Exchange began operating in May 2000, the first new nationally registered exchange to open since 1973. The ISE started out dead last among the country's five options exchanges.
Last month, it held 23 percent of the trading volume in stock options, with no sign of slowing down, compared with 2 percent two years earlier. During the same period, the CBOE's share of trading volume sagged from 39 percent to 27 percent.
The ISE is now the third-largest options exchange in the country, barely trailing the American Stock Exchange, which has about 26 percent of the options market; within striking distance of the CBOE; and well ahead of the Philadelphia and Pacific exchanges, which have nearly 12 percent each.
How did a roomful of computers in lower Manhattan grab so much business from the trading pits in Chicago?
"We identified a need of customers for greater efficiency and lower costs," said David Krell, chief executive of the ISE. He estimates that in its brief existence ISE has saved investors and brokers about $1 billion in lowered trading costs and improved prices.
Stock options give their owner the right, but not the obligation, to buy or sell the underlying security at a fixed price by a certain date. Each contract represents the rights to 100 shares. Until the ISE, the bid and ask prices for options contracts were set exclusively by market makers in open outcry at the trading pits of a physical exchange.
It was a cozy arrangement for the exchanges.
Until the Securities and Exchange Commission pressured them in the late 1990s, each exchange held a monopoly in the equity options it offered. And it was easy for market makers to set a wide and lucrative spread between the price they would pay for an option and the price they would sell it for."Two market makers on the floor of a traditional exchange typically will have the same quote because they are standing right next to each other," Krell said.
The ISE is entirely electronic and its market makers compete with one another. Investors can sometimes buy options through the ISE at a better price than at other exchanges.
"They very often have higher bids and lower offers," said Jerry Kopf, a principal with Benjamin and Jerold Discount Brokerage of Chicago.
As an example, Kopf looked at the price of an IBM option bid at $1.80 and offered at $1.95 at the ISE. The difference between the two prices, called the spread, represents a profit of 15 cents per share, or $15 per contract for the market maker.
The same options were offered at $1.80 bid and $2 asked at the CBOE and the Philadelphia exchange, and at $1.65 bid and $1.95 asked at the American exchange. The respective spreads of 20 and 30 cents represent significantly greater profits for market makers at the expense of the investor.
Someone buying five contracts at the CBOE and Philadelphia exchange would have paid $25 more than at the ISE. Someone who sold five contracts at the American Stock Exchange would have gotten $75 less than at the ISE.
The ISE says that because it takes the highest bid and the lowest offer from its market makers, it offers a narrower spread and better prices about 90 percent of the time.
Kopf said the ISE offers another advantage.
"It's very fast," he said. "They have a quicker execution because of their point-and-click system."
Speed isn't just a convenience. Options fluctuate in price constantly and an investor can watch opportunity disappear quickly.
And because brokerages and market makers need no trader on the floor of a physical exchange, the ISE has cut costs of trading.
One person with a computer screen can do the work of dozens of people in a pit.
The CBOE knows a threat when it sees one, and isn't backing down.
The exchange has its own electronic trading platform, CBOEdirect, which it is expanding, even as it maintains that open outcry has a viable future.
"What ISE is offering is point and click, and we are going to offer that," said William Brodsky, CEO of the CBOE. "This is our No. 1 priority."
Brodsky envisions trading in the pits going on while other investors trade electronically. The Chicago Mercantile Exchange has already moved in that direction, and says the two systems complement each other.
Brodsky agrees that the ISE has brought more competition to the exchanges, has reduced the spreads and has taken some business from the CBOE.
He also noted that the ISE is buying orders, something the CBOE does not do. Payment for order flow is a controversial practice in the securities industry. Market makers pay money, typically a dollar or so per contract, to brokerages in exchange for their trades.
The ISE levies a fee of 65 cents for each contract traded through its system. The exchange says the money goes to market makers, who, at their discretion, can use it to pay for order flow.
The practice is entirely legal. But regulators worry that brokerages will send their order to the highest bidder, not to the exchange offering the best price.
"People say this is a repugnant practice," Brodsky said.
The CBOE paid for order flow for a time, but no longer does so. The exchange has even asked the SEC to ban payment for order flow.
The ISE's competition is also affecting the price of a seat on the CBOE.
In 1997, the lowest price paid for a seat was $555,000. That has dropped every year since, and the last seat sold fetched just $160,000 in September.
A membership in the ISE, meanwhile, has been stable at about $1.5 million.
Some industry observers say the CBOE isn't doomed, but it is going to change, and rapidly. Investors will benefit as a result.
"The ISE is formidable competition and the other exchanges are all paying attention," said Robert Hamada, a professor of finance at the University of Chicago Graduate School of Business. "More competition has to be better for the consumer."
It is noteworthy that its name is the International Securities Exchange and doesn't include the word "option." That could mean headaches in the future for other open outcry exchanges, like the New York Stock Exchange.
Does the ISE want to trade stocks or futures or bonds someday?
"We have not yet branched out to any other securities," said Krell. "But that is certainly a goal for us in the future." |
