By all the usual measures, these are the best of times for the Chicago Board Options Exchange.
Trading volume is soaring, and membership seat prices have rebounded after a disturbing tumble last year. Exchange members are making good money as the bull market rolls on.
Yet beneath the surface, unrest is lurking. The exchange is divided over pressing matters of strategy. And the threat of new competition is pushing the CBOE toward a sweeping makeover that would gore some sacred cows.
“We’re at a time of great change,” said CBOE Chairman William Brodsky. “There are people who have reason to object to it.”
On one side, progressives want to spend a fortune rolling out a screen-based system that ultimately could replace the traditional, open-outcry trading floor–a sensitive issue at every U.S. exchange today.
They also want to alter the way the CBOE handles its core business, abandoning its trademark crowds of independent marketmakers in favor of a New York-style specialist system.
They are pressing for cutbacks in staff and services at the exchange, too, heaping costs onto floor traders while reducing fees for customers and the brokerage firms that represent them. It’s either that, they say, or the firms will direct their orders elsewhere as competition intensifies.
On the other side, some conservative members see in the proposals a misguided over-reaction that would rob the place of its soul. The same competitive threats that have pushed progressives to the edge of panic seem but phantoms to those advocating a go-slow approach.
“They’re moving too fast,” said Lawrence Blum, an originator of the CBOE who owns three memberships. “This is a wonderful thing we developed, and we don’t want to see it lost.”
Further, the CBOE’s decision last month to scrap a planned merger with the Pacific Stock Exchange–the centerpiece of its business strategy last year–has some questioning the effectiveness of exchange leadership.
“We might be lacking a little bit of vision, and a little bit of courage,” said Paul Liang, whose Chicago-based investment firm owns 11 CBOE memberships and 44 at the Pacific.
The debate comes amid a federal antitrust investigation of options-industry trading practices, which could spur competition from rival exchanges for some of the CBOE’s top products.
And it comes as New York’s International Securities Exchange prepares to launch an era of screen-based competition next year in the business of trading options–financial instruments that allow their holders to buy or sell stocks or stock indexes at a certain price within a certain period.
The ISE alone is a chilling prospect for the 1,000-plus options traders who earn a fine living by making markets the old-fashioned way. “I have meetings all week with guys who are panic-stricken because of ISE,” said Tony Saliba, a CBOE veteran who consults on screen-trading issues.
Indeed, the CBOE is warming up for a once-unthinkable embrace of the so-called black box.
With the ISE bearing down, CBOE leaders are being pressed to make a risky bet: If they decide the ISE and other screen-based competitors represent only a modest threat, they might get away with merely upgrading software at a cost of less than $20 million.
But if they decide they must design and deploy a screen-trading network complete with thousands of terminals as soon as possible, the cost skyrockets closer to $60 million.
The decision needs to be made soon, because completing and deploying the system would take at least a year. That’s too long a delay if the ISE were to catch on and wrest market share from a floor-bound CBOE.
“If we need to deploy in the summer of next year, we have to make commitments by the summer of this year,” said Chuck Henry, the longtime CBOE president, who oversees the technology project. “It’s a dilemma. Very bright people come down on both sides of this issue.”
A similar dilemma faces the exchange on the more obscure but equally divisive issue of designated primary marketmakers, or DPMs. They agree to maintain orderly trading in a given option in return for a guaranteed share of the action.
Introduced a decade ago to shepherd new options, DPMs have expanded as the bull market boosted their stocks. They now control about half of CBOE equity trading volume.
The other half of CBOE volume comes from options traded by traditional marketmaker crowds, which the exchange once touted as a fairer system, because every player competes for customer orders.
These days, the old ways need to change, CBOE brass suggest, because brokerage firms won’t pay the fees that support the marketmaker system. Also, the firms want greater accountability, preferring to appeal to a DPM in case of trouble, rather than a group of independents.
The proposal goes to the heart of CBOE philosophy and tradition, and it could set off a feeding frenzy as traders and firms vie for the rights to premier options such as those on International Business Machines Corp. stock.
Some members are aghast at the prospect: “We’re going to give 35 guys the right to make all the money?” Blum asked rhetorically. “It’s putting more and more into fewer hands.”
Vice Chairman Tom Bond says the DPM conversion would do nothing of the sort. And he disagrees with Blum and others who say the plan would reduce demand for exchange membership seats.
DPMs and marketmakers co-exist nicely, he said. “We hope this system will make the exchange grow.”
CBOE members are expected to vote on the DPM plan in April, and Bond conceded, “It won’t be unanimous.” But Blum is more emphatic: “It will never pass.”
The same pressure for cost-cutting that is pushing the CBOE to consider changing its trading methods also has led to a sharp cut in fees for most customer orders, effective March 1.
To make up for the $20 million reduction in annual revenues expected from those cuts, the exchange is raising fees for its traders, a move that could engender ill will.
It’s also planning to slice a chunk off its budget. Marketing and education programs may shift to the Chicago-based Options Clearing Corp., where the entire industry would share the cost, CBOE officials say. Layoffs too, are likely.
And the changes won’t stop there. The CBOE wants to improve its methods for handling large orders from Wall Street firms. That’s a direct reaction to the ISE, which has promised a cheaper and more efficient approach to those big trades.
“We are resolute that we will do what’s important for the future,” Brodsky said. “The future’s very bright.”
Even with the strategic picture clouded by uncertainty, Brodsky’s optimism may not be misplaced. The CBOE has succeeded in remaking itself once before.
After the Crash of 1987 killed off much of its retail business, the exchange went on a new-product blitz that continues to this day. Diversification and automation have attracted a broader customer mix more heavily weighted toward professional traders than in the past.
Yet even in the depths of its post-crash depression, the CBOE never tried to wrest away established options from rival U.S. exchanges.
Now, the Justice Department wants to know why.
Since a 1989 rule change, the exchanges have competed on most new listings. But they have maintained that making markets in options that each trades exclusively would be too expensive and unproductive. Others say more competition would benefit investors.
Antitrust investigators have petitioned the exchanges and a handful of traders for information, a possible prelude to civil litigation. Liang, for one, said he recently spent some two hours explaining option-listing practices to the feds–and found their questions remarkably unthreatening.
Still, “if the government’s not just off on a frolic or a lark, (the exchanges) have got something to worry about,” said Paul Slater, of Chicago’s Sperling, Slater & Spitz, an antitrust specialist.
Alger “Duke” Chapman, who headed the CBOE through most of the period under scrutiny, insists that he and other industry officials always were scrupulous to avoid any antitrust conflicts. But he conceded that responding to investigators could weigh down the exchange. “You’ve got to take those things seriously. It’s so damn time-consuming.”
His successor, Brodsky, agreed. The investigation will take four to six months to resolve, he estimated. “They’re still asking for a tremendous amount of material.”
Meantime, the CBOE’s other big issues loom.
Asked if his honeymoon is over now that he’s celebrating his second anniversary as leader of the exchange, Brodsky laughed wearily and said: “I don’t think I had one.”
