The Options World is Mad for Equities!
The tremendous growth in the options markets is a source of endless fascination for market observers. With volume growing at a record-breaking pace month after month, one would expect the options exchanges to be scrambling to meet this surging demand with new options products. But the exchanges arenít focusing their development efforts solely on the options markets. Instead, theyíve turned to a completely new instrument for their expansion opportunitiesóequities.
THE GOOD OLD DAYS
Options exchanges moving beyond their core market is not a new phenomenon. Over the years, the exchanges have also made inroads into the futures markets. However, the exchangesí futures products pale when compared to the scope of their new equity offerings.
Four of the six major options exchanges are already either part or affiliated with a stock exchange. These are the BOX, PHLX, AMEX and the former PCXónow known as NYSE Arca Options. For them, a renewed focus on equities is hardly surprising. These four exchanges and their affiliates have already spent millions revamping their equity trading systems to offer increased functionality to their customers.
However, the two largest options exchanges, the ISE and CBOE, are now jumping into the equities fray as well. In an attempt to negate the advantages of their competitors, these industry giants have decided to launch their own equity exchanges.
HYBRID VS. ELECTRONIC
While the strategy of the ISE and CBOE might seem similar at first glance, their approach to equities is actually quite different. The CBOE Stock Exchange is designed to complement its existing Hybrid Trading System, which combines open outcry execution with electronic trading. As a result, the CBOE plans to establish Designated Primary Market-Makers (DPMs) on its trading floor to facilitate equity order flow.
This combination of open-outcry and electronic execution may not seem like a unique contribution to the equity world. After all, the NYSE has offered limited Hybrid functionality since early 2006. The apparent similarity between the two models, however, has not discouraged the CBOE. With the NYSE and other equity exchanges focused on improving their electronic functionality, the CBOE sees room for an exchange that combines ECN functionality with a DPM network to facilitate institutional order flow.
ìWe are the original Hybrid exchange, and we have seen from the options marketplace that this model can be very valuable,î says Ed Provost, Executive Vice President of Business Development for the CBOE. ìThe NYSEís Hybrid system is very complex. As a component of its design, the NYSE will be both a fast and a slow market. That means there are times that you can trade through them and times that you cannot. The CBOE Stock Exchange, on the other hand, will always be a fast and protected market that is very much like an ECN with its price/time priority. We will be 100 percent electronic with the ability for brokers to negotiate with the DPM when they are seeking liquidity beyond what is displayed in the marketplace.î
As the CBOE works to expand its Hyrbid model, the ISE has opted for a much more streamlined approach. The CBOE plans to offer 2,500 listings at launch in February 2007. Conversely, the ISE Stock Exchange launched with just 10 stocks on September 8. They plan to add more products over the few months, culminating in a full complement of listed stocks, Nasdaq stocks and ETFs when their displayed market goes live in the fourth quarter. The centerpiece of the ISE Stock Exchangeís rollout is a proprietary technology called Midpoint Match. As its name implies, this anonymous matching system executes orders at the midpoint price of the NBBO. In many ways, it is similar to the price improvement model that has been so successful in the options markets ìThe unique design of MidPoint Match fills a need in the marketplace for continuous price improvement, and we are confident that investors will benefit not only from the trading flexibility offered by MidPoint Match, but also from the advantages delivered by its exchange-based structure,î said ISE President & CEO David Krell.
For those outside the options world, this focus on the equity markets may seem curious. After all, options are the product du jour in the financial markets. Every major firm on Wall Street is scrambling to capture a piece of the expanding options pie. With so much growth in these markets, why would an options exchange break into a market with comparatively stagnant growth rates, razor-thin margins and countless competitors? Is this merely an attempt to facilitate the hedging activities of their options customers? After all, most options customers also trade equities. Offering access to both products on a single system would therefore theoretically make it much easier to execute hedges and other combined positions.
Such a development would have been revolutionary five years ago. However, trading technology has now progressed to the point that it is commonplace to trade both instruments on a single platform. Most professional options traders already execute options and equities orders from a single screen. Even online options brokerages that cater to retail customers offer similar functionality. As a result, the benefit of listing equities and options on a single trading system has become marginal at best for most exchange customers.
If the benefits to their customers are minimal, then why are the largest options exchanges branching out into new territory? The primary answer is Reg NMS. The changes being implemented through Reg NMS are fundamentally altering the competitive landscape of the equities industry. Primary equity markets like the NYSE used to be able to hide behind the dual barriers of the trade-through rule and inaccessibility, but that is no longer the case. With competing markets finally able to trade through the slow primary markets, a whole new playing field has opened up for smaller competitors as well as new competitors like the ISE and CBOE.
However, the changes to Reg NMS are not the only driving force behind these new stock exchanges. To find the other motivating factor one needs to look no further than the juggernaut of NYSE Arca, which includes the former PCX. When that merger was announced last year, it sent shockwaves through the options markets. Ever since the announcement, the options industry has been waiting anxiously to see what the combined exchange has planned. The launches of the new equity exchanges by the CBOE and ISE are widely viewed as preemptive attempts to position themselves against this powerful rival. ìFew exchanges will be able to continue operating without offering an assortment of products that are traded by the public today,î says the CBOEís Provost. ìWeíve always been driven by a product diversification strategy, so offering equities is a logical extension for us. We feel that we have the technology and the resources to bring the equities market to life, much as we have in the options markets.î
Although many options exchanges have shifted their focus toward the equities markets, they are not the only ones looking for greener pastures. Nasdaq announced their plans to launch an options market the day before the ISE Stock Exchange began trading. Despite concerns that the options market is already hopelessly fragmented, Nasdaq believes that thereís room at the table for one more player. Nasdaq plans to join the fray in the third quarter of 2007.
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