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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.

""What we're doing is allowing our floor-based market makers to electronically post (quotes) ... . But the requirement is, if you're going to quote in a particular option, you have to have someone in the crowd who is representing those quotes,"" says Brodsky. Since the CBOE has ""around 1,000"" regular market makers, he says, exchange participants should be able to see a lot more quotes - and have access to more size - after the hybrid system is launched.

But the CBOE chose not to emulate the remote component of the PCX Plus system for a couple of different reasons. Firstly, says Brodsky, the CBOE did not want to devalue the cost of a seat on the exchange. And secondly, the exchange believes that it will have more than enough floor-based market-maker support. ""If the (PCX) had (enough floor-based) market makers, they'd probably do the same thing we are. But they don't have that many people to begin with, so they're trying to find, obviously, other ways to get people involved,"" Brodsky explains.

Enabling electronic entry for market makers will actually be the third major component of the CBOE's hybrid project. In May of this year, the exchange rolled out a dynamic quoting system that allows investors to see real-time prices and size for all CBOE options series. Subsequently, in July, the exchange released Large Order Utility (LOU) - a point-and-click trading application designed to provide customers with the power to instantaneously execute large-size orders. LOU, in addition to providing automatic executions, also has the ability to price-improve orders by exposing them to the liquidity on the floor, says Brodsky.

Timber Hill's Juneman says that his firm is looking forward to the third phase of the CBOE's hybrid project, but gives LOU mixed reviews. LOU, he says, does provide the ""point-and-click"" access the CBOE was previously lacking, but is not the best system for executing large-size orders.

The PHLX and the AMEX, like their open-outcry rivals, are adding automation to their open-outcry environments. The PHLX has filed a proposal with the SEC to launch a new trading system that will, for the first time, empower its market makers to electronically change a bid or offer posted by a specialist.

William Morgan, the PHLX's chief information officer, says he is not certain when the SEC will rule on the exchange's proposal. But he says that after the new system is implemented, a market maker will be able to ""electronically change a PHLX quote"" via a handheld PC.

The ISE, Morgan says, has, in the past, held an advantage over floor-based markets by providing a more ""level playing field"" to all of its participants. Specifically, he says, the all-electronic market gained an edge not only by making its data transparent and accessible but also by allowing all of its market makers to electronically enter two-sided quotes. But the PHLX, he says, will soon offer the same type of openness that has propelled the ISE. ""Market makers used to have to verbally request a market be changed by a specialist. Now that, of course, has changed because we're going to give the market maker the ability to change a quote directly,"" says Morgan.

That said, however, the PHLX currently has no intention of offering its new system to remote market makers. Interestingly, the exchange has already built a remote-competing-specialist system for its equities floor - but extending that application to the options floor, at this date, seems unlikely. Morgan declines to comment, but a source at the PHLX says the exchange would run the risk of angering its existing specialists if it extended electronic-posting privileges to market makers operating away from the floor. ""That would change the (options) allocation process ... (and) that's a very sticky subject,"" the source says.

The AMEX, meanwhile, is developing a new options-trading system that will completely replace its incumbent platform. ""We've created an electronic auction that will be a part of our marketplace,"" says Michael T. Bickford, senior vice president in charge of options at the AMEX. ""Rather than yelling out bids and offers with their voices ... a market maker or specialist who is inputting a price into an auction will do so electronically."" While declining to specify the third-party-technology vendor that is building the new system, Bickford says the electronic platform should go live by the second or third quarter of next year.

The system, he says, is flexible, and could potentially accommodate remote specialists - but the AMEX has no plans to offer it outside of its floor at this time. Still, while insisting that the AMEX remains a ""big believer"" in the traditional floor-auction marketplace, Bickford says the system has been designed with an eye on the automation trend.

""We understand that bricks and mortar may some day become a thing of the past, so we've built (our options system) with the flexibility ... (to) ultimately take it off of our trading floor - if need be,"" he says.

While conceding that the ISE has taken some business away from the AMEX during the last couple of years, Bickford says that the all-electronic upstart has also taken market share away from the CBOE. Indeed, while AMEX's overall slice of the options pie has narrowed, it has actually inched closer to the CBOE since May 2000.

Despite the fact that all of the floor-based markets are in the midst of significant technology upgrades, consolidation is a real possibility in that group of exchanges. ""We're in a business that demands scale and efficiency and to the extent that you can achieve that, or you have too many exchanges delivering that, you have some that will combine or some that will (become extinct),"" says the PCX' DeFeo. ""We've been around for 122 years, and I expect that we will be around in the next 100 years, but not if we don't change as the markets change.""

A source at a large options market-making firm also sees exchange consolidation on the horizon. ""We already do a lot of business with the ISE ... . So I would have a hard time believing, two or three years from now, that there is still going to be six (options) exchanges,"" this source says.

Schwab's McCormick, on the other hand, thinks there will be a mix of electronic expansion and floor-based consolidation. The existing open-outcry markets will not try to merge with one another, he says, but will seek out alliances with electronic entrants. "" I think the (floor-based exchanges) might try to partner and become the vehicle for electronic entry guys ... . I could see Eurex, maybe, forming (a union) with the Pacific or something like that,"" says McCormick.

When the ISE looks to the future, says Friel, it does not ""discount"" floor-based markets - but is cognizant of the fact that it will have to fight a ""multi-front war"" against electronic models similar to its own. But will the next wave of electronic-options markets try to mimic the ISE, or attempt to offer clients something innovative and unique?

It's difficult to give a definitive answer to that question, because the Boston Options Exchange - an all-electronic market that has yet to get off the ground - has provided precious few details about its market model. But McCormick says that since a new entrant must differentiate itself, it's a good bet that at least one future electronic-options market will try to adopt an ECN-type model. Such a model, he says, would represent a significant departure from the traditional options market - which requires market makers to maintain two-sided quotes and sizable liquidity. ""Will the SEC allow someone to open an environment where there is no requirement to put up a two-way market with any size? I don't know,"" says McCormick. ""But a (new entrant) may (attempt to) look more like a central-limit-order book, with price and time priority built into it.""

ISE Senior Vice President of Business Development Bruce Goldberg says that, to be successful, every new entrant - whether floor-based or electronic - must figure out what added value it brings to the customer. ""Is a new exchange going to provide greater liquidity, better quality markets or faster execution? Those are the questions that every new entrant has to ask itself,"" he says.

Meanwhile, the AMEX's Bickford predicts that the only new exchange entrants in the industry will be of the electronic variety. Since there are now four floor-based markets and one electronic exchange, he says, there are more opportunities for new electronic entrants to differentiate themselves. ""If you're a new competitor looking to come into the marketplace, you've got to look for where your opportunity is,"" he says. ""The electronic (options) marketplace is less staked out ... (and), from a cost basis, it's definitely easier and more cost efficient for new entrants to put together an electronic exchange.""

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