AND THEN THERE WAS ONE - NYSE, ARCA & PCX

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Unless you have been living under a rock for the last few months, you have undoubtedly heard about the earthshaking merger between ARCA, NYSE and the Pacific Coast Exchange (PCX). Although this merger has caused a great deal of consternation on Wall Street, the shock waves are also being felt in the endless war zone of the Chicago option markets. The delicate balance of power that has existed for the past few years has just been turned on its ear, and the new battle lines may change the way securities are traded in the U.S.

DEVOUR & CONQUER
Although the NYSE’s sudden decision to gobble up ARCA-EX surprised quite a few people in the equities industry, consolidation is not a new trend in the options world. In fact, consolidation has been the order of the day since the dawn of the new millennium. The driving factors for this consolidation have been the incredibly shrinking margins in the industry, along with the resulting increase in risk for liquidity providers. Economies of scale have become increasingly important as firms began to look for ways to lay off risk and lock in profits across a wide array of products. Some of the first players to consolidate were the market makers. Small market making firms and independent options traders were quickly gobbled up by large specialist firms as the cost and risk of maintaining trading operations grew.

The next ones to consolidate were the order flow providers. The market crash in 2000 erased the portfolios of many key clients, while reduced stock prices and volatility levels made options a less attractive alternative to equities. Small brokerages could no longer afford the risks associated with maintaining an options book and were forced to either close up shop or sell out to larger firms with deeper pockets. That just left the exchanges. However, instead of going along with everyone else, they decided to buck the trend. While everyone else in the industry was consolidating, the number of U.S. options exchanges actually increased by 50%.

“Everyone but the exchanges has consolidated,” says Meyer Frucher, Chairman & CEO of the PHLX. “This industry has consolidated below us. These days, you can count on one hand the number of large options specialists. Tragically, there are very few independent market makers left. As a result, all of the major players on the six exchanges are now the same.”

THE DEATH OF THE REGIONALS
As the competition for market share became more ferocious, pressure grew on the regional exchanges like the PHLX and PCX to either close up shop or merge with one of the big dogs. With their floor membership eroding and their daily volume dwindling, the tiny PCX found itself surrounded by larger competitors on all sides. Looking for a life preserver, they reached out to ARCA, which bought a 20% stake in the PCX. They also provided valuable expertise in transitioning from floor trading to electronic trading. In 2005, ARCA finalized their purchase of the PCX by acquired the remaining shares, thereby completing their evolution into ARCA-EX. That purchase transformed the once struggling PCX into a major player in the options industry and set quite a few tongues wagging. When the NYSE gobbled up the combined ARCA-EX, thereby adding their market power to an already formidable competitor, it sent shock waves throughout the entire options industry. How would this new monstrosity affect the competitive balance in the business? Would this one deal open up the floodgates for the remaining equity powerhouses to invade the options markets?

THE MERGER & REGULATION
One potential area of fallout that few people have considered is regulation. The SEC’s spotty record in the options business is a sore spot for many in the industry, myself included. One ongoing complaint is that the SEC takes far too long to approve or reject new proposals and rule modifications. With a massive merger devouring much of their resources, it is possible that many other important decisions could get lost in the shuffle. “At the end of the day, regulation does determine business outcomes. To think that it doesn’t would be a horrific mistake,” says Frucher. “How the heck are we supposed to compete against these two monoliths who are going to absorb all of the intellectual capital in the building. If we do not open up the system for innovation and competition, then I think we are going to be stuck with a duopoly, and that will not be good for the customer.”

WHERE ANGELS FEAR TO TREAD
Despite all of the whispering and rumor mongering, it remains an open question whether the NYSE really intends to dive, guns blazing, into the options pits. Although options volume has been growing steadily over the past five years, these markets are still the place where angels fear to tread. The once profitable bid/ask margins have, for all intents and purposes, vanished. As a result, the risk/reward ratio for the entire industry is rapidly tilting toward the dark side. Many former players have either closed up shop, sold off their options divisions or merged with larger firms that are better equipped to handle the wild P&L swings. Add to those problems the ferocious competition between the exchanges, the ongoing scandals over payment for order flow & backdating, the continuing problems with linkage and the looming specter of penny pricing (with its exponential increase in technology expenses), and you have to wonder what the NYSE sees in the options business.

The short answer is that they might not see it at all, at least not in the way that so many in the industry fear. There is a growing consensus that options were merely the icing on the cake for the NYSE. Their real goal was to gobble up a growing rival and to gain access to the lucrative electronic equity markets. They were also looking to stave off threatening competitive maneuvers by ARCA. “ARCA was threatening to trade pre-opening,” says Bill Brodsky, Chairman & CEO of the Chicago Board Options Exchange (CBOE). “That would have been very hard for a floor-based exchange like NYSE to compete with.”

BLOWBACK
The NYSE/ARCA/PCX merger has already left its imprint on the options markets. With the PCX suddenly elevated to the top of the heap, the long-suffering PHLX found itself in an untenable situation. Out gunned by the other exchanges, they would have to find a strategic partner or face extinction. So, they did just that. Merrill Lynch and Citadel Investment Group promptly purchased equity stakes in the PHLX. This new deal raises even more questions about the future of the options business. Can a partnership between a hedge fund, a brokerage firm and a struggling regional exchange stand up against the combined market power of the NYSE/ARCA/PCX monstrosity? Will a former industry leader like the CBOE be forced to seek their own strategic partners just to survive? Will the electronic juggernaut known as the ISE be able to match the pocketbooks of their newly enhanced competitors? Stay tuned to find out…  

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