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Robert Sales
Robert Sales
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Electronic Revolution Pits ISE vs. Floor-Driven Exchanges

The all-electronic International Securities Exchange has taken the U.S.-options industry by storm, offering clients cheap costs and open access. But floor-based markets, such as the CBOE and PCX, are now fighting back with significant technology initiatives.

The all-electronic International Securities Exchange has experienced tremendous growth since its May 2000 debut, forcing its open-outcry-based competitors to usher in a new wave of automation. But the CBOE, AMEX, PCX and PHLX are counterattacking the ISE with their own major technology projects.

"This will probably be a small ripple leading to a larger splash leading to a wave, which, hopefully, will wash over the other exchanges," says Phil DeFeo, describing the potential evolutionary path of the Pacific Exchange's soon-to-be-launched PCX Plus trading system. But what the PCX aspires to attain, the all-electronic International Securities Exchange has already achieved.

In fact, DeFeo, the chairman and chief executive officer of PCX, may as well have been describing the impact that the ISE, launched in May 2000, has had on floor-based, U.S.-options markets - sans the "hopefully" part. Offering customers cheaper costs, faster executions and open access, the ISE started out slowly, grabbing only 2 percent of the overall options market in its first four months of existence. However, from August 2000 to this August, the ISE increased its market share by roughly 22 percent (see chart), leapfrogging the PCX and the Philadelphia Stock Exchange (PHLX) in the process.

Options Markets: Then and Now


1 2 5 4 3
Market Share

40.58% 30.51% 1.97% 11.50% 15.43%

1 2 3 4 5
Market Share

28.60% 24.90% 23.47% 12.29% 10.75%

Source: Options Clearing Corp.

"To some regard, the traditional exchanges maybe took the ISE a little too lightly," says Tony McCormick, vice president of equity options at Charles Schwab's Schwab Capital Markets Group. "But by virtue of them coming in as a new entrant, with a different model that was efficient and transparent and readily accessible, (the ISE) put a lot of pressure on the existing floor-based markets to adapt and become more competitive."

Indeed. The ISE fostered change in many ways, such as by implementing a balanced-fee structure that led to increased volumes and heavy competition for order flow. Ultimately, those factors fueled the elimination of fees charged to investors - or customers of broker/dealers - at all five U.S.-options markets.

Michael Juneman, assistant vice president in charge of floor operations at Timber Hill - a market making firm that makes markets on all five U.S.-options exchanges - says that the ISE deserves most of the credit for the death of customer-transaction charges. "The customer fee being brought to zero was a direct result of competition. If a customer has an opportunity to trade for less at Exchange A than Exchange B, he will go to the cheaper exchange every time," he says.

That said, while acknowledging the success of the ISE, floor-driven U.S.-options markets are not about to back down. Rather, the CBOE, AMEX, PCX and PHLX - responding to the growth of the ISE and recognizing the threat posed by other potential all-electronic entrants - are now fighting back with major technology initiatives of their own (see sidebar: "Future All-Electronic Markets: Boston Options Exchange a Definite, Eurex Investigating," at www.wallstreetandtech.com/story/WST20020927S0001).

Daniel Friel, chief information officer of the ISE, says that the ISE separated itself from the pack by taking the best the existing auction markets had to offer and combining that with technology. "The ISE has a primary market maker that actually acts like a specialist," he says. "So it's kind of an open-outcry market ... except the specialists are all entering their quotes electronically."

Timber Hill's Juneman says that one thing that distinguishes the ISE from its competitors is the fact that it provides all of its market makers with the ability to electronically post bids and offers. The floor-driven markets, he says, must move more towards that model if they expect to gain ground on, or just keep pace with, the ISE.

Today, the ability to electronically post two-sided markets is reserved for the specialists at the AMEX, PHLX, CBOE and PCX. But Juneman says that whereas each of these floor-based markets has a single specialist driving a two-sided market per option, the ISE has the equivalent of 10 specialists posting bids and offers for each issue listed on its exchange. "When an order comes in (to a floor-based market) and push comes to shove and the market makers don't like it, they look the other way," he says. "The (specialists) are then left there holding the bag, so oftentimes their size doesn't compete with the size the ISE can put out - because the ISE allows 10 (primary) market makers to post a bid and offer for (each option) it trades."

The PCX, in response to requests made by firms like Timber Hill, has developed an electronic-trading system dubbed PCX Plus - an application that will not only allow ordinary market makers on the floor to enter two-sided markets but will also enable market makers in remote locations to post bids and offers. The rules for PCX Plus were submitted to the Securities and Exchange Commission in June, and the PCX hopes to receive the green light to launch the system before the end of January 2003.

In the past, says an exchange spokesman, only PCX specialists - known as Lead Market Makers (LMMs) - were authorized to electronically enter two-sided quotes. But, after PCX Plus goes live, any PCX market maker will have the power to electronically enter bids and offers from any remote location. Moreover, via PCX Plus, both LMMs and competing market makers will have the ability to enter two-sided markets for options traded in any pit across the exchange's floor. In other words, if you are standing in one crowd but want to electronically post a bid and an offer for a contract traded in a pit on the other side of the floor, you will be able to do just that.

"Our objective was to maximize the potential profitability of all our constituents on the floor ... . So a market maker in one pit (will be able to) make markets in another pit," says PCX's DeFeo. This added functionality, he says, should enhance the price discovery and liquidity on the floor by lifting restrictions on what options a market maker in a certain crowd can and cannot trade.

But the remote posting capability of PCX Plus may be the one functional enhancement that could separate PCX from other floor-based-options exchanges. Market makers that own or lease at least one seat at the PCX will be able to use PCX Plus to electronically enter bids and offers from any location across the world.

The exchange spokesman says that the PCX expects to attract substantial off-floor liquidity through PCX Plus - including order flow routed by specialists based on the floors of other exchanges. The PCX will attempt to reel in remote market makers by offering a range of incentives, including low-cost entry. A market maker that chooses to enter bids and offers remotely, says the spokesman, will be able to trade eight PCX issues for the cost of one seat on the exchange - $20,000. Moreover, he says, remote market makers will also have more freedom to pick and choose the options they want to trade than their floor-based counterparts. "If you're a competing market maker on the floor of the exchange, you have a primary assignment. You've got one crowd, and you're expected to trade 75 percent of your volume in that one crowd ... But if you are making markets remotely, you (will be able to) trade any issue you want, and it will cost you a lot less money," says the spokesman.

Still, despite the incentives that the exchange is tying to its remote option, DeFeo does not think that PCX Plus will ultimately replace PCX's floor. People will continue to use the floor, he says, to reap benefits from its price discovery and liquidity - but it will not be the only venue for trading.

William Brodsky, chairman and chief executive officer of the CBOE, says that floor-based markets were automating their environments long before the rise of the ISE. However, he concedes that the all-electronic market has effected change and enhanced the competitive landscape. "There is no question that the ISE had made an impact ... . I think competition is very good - it gets our juices going. And a lot of the things that we've done reflect how the ISE has changed the (market) model," says Brodsky.

The development of a new trading system is one of the ways in which the CBOE is answering the ISE. Like the PCX, the CBOE is building an application that will give floor-based market makers the ability to electronically post bids and offers. But, in contrast to the PCX, the largest U.S.-options market currently has no plans to allow either its specialists or market makers to enter two-sided markets remotely.

Today, explains the CBOE's Brodsky, only a designated primary market maker (DPM) - the exchange's equivalent of a specialist - can electronically post bids and offers for CBOE options. But following the debut of the exchange's so-called Hybrid Trading System - which is expected to go live in early 2003 - all of the exchange's market makers will be able to electronically input two-sided quotes.

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