Rise of the Machines - Part One
When the clock struck midnight on December 31 1999, it marked the beginning of a new era in the options industry. The open outcry system that had dominated the markets for nearly three decades was about to be usurped. At the same time, the long period of peaceful coexistence between the exchanges was coming to an abrupt halt. The new millennium would be marked by relentless technological evolution and unbridled warfare between the exchanges. What prompted this epic upheaval in the option markets? Was it an all-out assault by foreign competitors or a far-reaching government investigation? Actually, it was none of the above. Instead, it merely the launch of small electronic competitor called the International Securities Exchange (ISE).
THE GOOD OLD DAYS
Rumors about the ISE had been swirling through the trading pits for years. By the late ë90s, it had become a favorite bogeyman of open outcry traders. However, market makers were not the only ones on edge as the ISEís launch date loomed. With a new competitor threatening to steal their market share, the exchanges began looking for ways to protect themselves. Their trading volume had to be safeguarded at all costs, even if it meant violating the peace treaty that had held the industry together for decades.
Until 1999, the four option exchanges operated under the terms of the much maligned, and officially denied, ìgentlemanís agreement.î This agreement essentially prohibited exchanges from trading each otherís products. When the SEC finally ordered a halt to the practice, the Philadelphia Stock Exchange (PHLX), AMEX, Pacific Exchange (PCX) and Chicago Board Options Exchange (CBOE), were suddenly free to invade each otherís territory. The days of playing by the old rules were over. In the new millennium, it was going to be every man for himself.
While the options world was being rocked by change, the futures world was in the grips of a technological revolution. However, it wasnít a new electronic competitor that wreaked havoc on the industry. Instead, it was the rise of a new electronic product. ìDefinitely, the E-mini S&P contract is the one that started the online trading revolution in the futures businessî says Danny OíNeil, Principal of online futures brokerage Xpresstrade. ìThis product has become very popular with our customers precisely because it is so liquid and so transparent.ì The CME actually began trading electronic futures contracts in 1992 through its Globex platform. However, it wasnít until the launch of the E-mini contract in 1997 that the platform, and the futures industry, had its first bona fide electronic success.
TOO BIG FOR YOUR BRITCHES
In order to understand the importance of the E-mini contract, you have to understand the nature of the liquidity in the S&P 500 futures pit. The S&P 500 future is a popular tool for traders and for portfolio managers looking to speculate on the broad market. It is also a pivotal hedge for a wide variety of derivatives instruments including SPX options and the S&P options. Unfortunately, while this product was popular, it was also too large and too expensive. The high cost of the contract put it beyond the means of all but the richest customers, dramatically limiting its appeal to the growing retail sector. At the same time, the size of the contract prohibited its use as a hedge for small or mid-size trades, making it the exclusive domain of large institutional traders.
As a result, customers demanded a smaller and cheaper product that was easier to execute. Thus, the E-Mini contract was born, and the futures world would never be the same. ìIf you look at the options markets, once the ISE went online, it brought in a whole new batch of users. The same can be said about the E-mini futures contract back in 1997,î says Rick Redding, Managing Director of Products and Services for the CME. ìThe E-mini S&P really woke the world up to the prospects and potential of electronic trading. The regular S&P future is a very big product for the average person and even the average institution. So, we took the liquidity out of the institutional market and put it into a marketplace that was both institutional and upper-end retail. At the same time, we married our electronic platform with our open outcry platform.î
SAVIOR OR TERMINATOR?
Depending on your point of view, May 26 2000 is either the beginning of an options Renaissance or a day that will live in infamy. On that day, the countless rumors and endless speculation finally came to an end. On that day, the ISE finally came online. When their first contract was launched into the electronic ether, even their die-hard opponents realized that a sea change had taken place in the industry. The genie was out of the bottle. There could be no going back. ìWe really believe that the ISE, along with multiple listing and the resulting increase in competition, are what has driven this industry to the heights that it has currently reached,î says Bruce Goldberg, Senior Vice President of the ISE. ìPrior to that point, these products traded as monopolies. The spreads were wide, the fees to customers were extremely high and there was very little institutional participation. Now you have immediate execution, tight spreads and no customer fees. Electronic trading is what transformed this marketplace from an inefficient to an efficient market.î
Continued in Part Two...
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