February 28, 2005

Advanced Trading Spring 2005With options trading volume growing faster than equities volume, Archipelago says it will acquire PCX Holdings, parent company of the Pacific Exchange and Pacific Equities, in a move to offer options trading side by side with stock trading on its all-electronic platform.

Gerald Putnam, chairman and CEO of Archipelago, said there were synergies between the two markets as well as potential for cost savings during a briefing for analysts and media.

The deal, which is pending approval from the SEC, will diversify Archipelago's revenue stream into a fast-growing market, by allowing Archipelago's equity customers to use the same platform for options trading.

"It's going to infuse blood into the Pacific," says Damon Kovelsky, an analyst with Framingham, Mass.-based Financial Insights, who notes that the exchange had fallen behind some of the other options exchanges in recent years. He predicts that this may be a harbinger of more exchange consolidation in the U.S., where exchanges are likely to diversify into more asset classes, such as derivatives.

In addition to purchasing the options business, Archipelago also will acquire the self-regulatory organization (SRO) of the PCX and its 20 percent ownership interest in the Options Clearing Corp.

"This is the natural evolution of the Arca-PCX relationship," says Kovelsky. In 2000, Archipelago took over the Pacific's equity-trading business, which previously had two floors in San Francisco and Los Angeles. PCX kept the options business, while stock trading moved to Archipelago's screens. As part of Archipelago's conversion from an electronic communications network (ECN) to an exchange, PCX then became its regulator.

According to Archipelago's Putnam, one of the reasons for combining with PCX was a push by its customer base - especially where there is an overlap in stock and options trading, because it would be cheaper to consolidate the activity via Archipelago's infrastructure.

But first, Archipelago needs to integrate its electronic platform with PCX-Plus, PCX's new electronic options trading platform. PCX currently operates a hybrid options-trading model with a floor in San Francisco and the new PCX-Plus trading system. It's been transitioning from a floor-based options market to an electronic model since 2003.

Financial Insights' Kovelsky says he expects the integration to take about a year.

PCX has been losing market share to the all-electronic International Securities Exchange over the past 18 months, analysts said during the briefing, noting that Archipelago is acquiring one of the smaller players; PCX ranks fifth among the six options exchanges. Its market share for December averaged 12.3 percent, which was a high for last year, said Philip DeFeo, chairman and CEO of PCX and the Pacific Exchange at the briefing.

PCX plans to migrate to an all-electronic platform by 2006, said DeFeo, adding that the need for a floor would fade by the end of 2005. "There's enormous costs involved in running a floor as well as the legacy systems that support that process," he said.

Analysts, however, pressed Archipelago and PCX to explain how they were going to save costs and from where the growth in revenues was going to come . Archipelago officials said the acquisition would not add to revenues until 2006. Putnam said that close integration between the two systems would come by late 2006.

"With some technological innovations, I think they're going to be able to grow the Pacific's options business [but] it's not going to be easy," Kovelsky adds.