FAILURE ISN’T AN OPTION FOR NEW EXCHANGE: ISE CAPADES CHANGE TRADING PATTERNS WELL BEFORE MART OPENS

When David Krell was writing a market newsletter for a now-defunct brokerage in New York and the Chicago Board Options Exchange sprang to life in 1973, he didn’t know a put from a call.

Now, he does. And, more important for the options industry, the Chicago Board Options Exchange knows all about him.

“I like to do new things,” says the 53-year-old president of the new International Securities Exchange whose career has included a stint as the options board’s marketing chief.

The new exchange – designed to make a profit – won’t open until at least March 24 and, even then, won’t have a trading floor but will offer an electronic auction market.

What’s more, the Securities and Exchange Commission has yet to approve what would be the first all-electronic options exchange.

Even so, the new board already has transformed the business.

With existing competitors, Chicago has slashed fees, reorganized trading operations and expanded the number of issues that are listed on more than one exchange – responding, the options exchange and its members concede, to the new threat.

The result has been a significant step toward improving the flow of pricing information in a market where the industry’s four exchanges historically haven’t communicated such data to one another.

More efficient markets, narrower spreads and resulting higher volume are what the industry is counting on.

“You are looking at a day, with or without the ISE, that John Q. Public can trade up to 50 contracts of a U.S.-listed option, and they’re going to get automatic best execution and not have to worry about where it’s trading,” predicts Thomas A. Ascher, a former vice-chairman of the options exchange.

Yet the new electronic exchange is hardly a sure thing. With $91 million in start-up capital, it is well-financed under the guidance of chairman William Porter, founder of online brokerage E*Trade Group Inc.

But the new exchange’s plan has drawn fire from the CBOE, among other critics. They raise questions about potential conflicts of interest and about how its novel for-profit status would square with the industry’s custom of self-regulation.

Chicago exchange CEO William J. Brodsky has lobbied the SEC and urged members of his exchange to battle the challenger.

“What would you do if you were in my chair?” he asks them. “Guys, this is real.”

That resolve points to an underlying danger for the floorless exchange: Amid competitive counterforces unleashed by its plan, it could suddenly find its business model outmoded.

For example, the options boards long had an understanding not to list items already quoted on other exchanges. They were wary of moving onto others’ turf for fear of being invaded themselves.

With the new exchange’s ultimate intent to list 600 of the most actively traded options – covering 90% of the CBOE’s volume – that understanding fell apart.

In August, the Chicago exchange listed options for Dell Computer Corp. and took 52% of the volume that until early this year was the exclusive preserve of the Philadelphia Options Exchange; Chicago followed last month with Microsoft Corp. and captured 30% of its options volume from the Pacific Options Exchange.

Naturally, the Chicago exchange suffered erosions in some of its single-listed options but its recent volume climbed 5%, setting monthly and year-to-date records in September. Meanwhile, industry volume jumped by a sixth, to 350 million contracts, for the first nine months of 1999, compared with the year-earlier period.

Still, the 1998 record of 406 million contracts was only a third above the 1987 figure – a far cry from the exploding volume over that stretch on the nation’s equity exchanges. And the recent blip in volume following multilisting could be only a temporary spurt.

Mr. Krell’s explanation: “The customer was taken for granted. This business will double in the next two to three years and then again.”

His market is setting up shop only a block from the New York Stock Exchange to tap a ready-made job pool, even though it will hire only about 75 people (compared with the Chicago Board Option Exchange’s 875).

It will occupy 29,000 square feet on two floors – one for offices and another for its data center, which use Stockholm software vendor OM Technology, a highly regarded supplier to other electronic exchanges, ones that – unlike the new options board – lack home-based competition and heavy quotation traffic.

“The fact that the U.S. is a highly competitive market is also unique,” acknowledges Daniel Friel, the new exchange’s chief information officer.

The technical hurdles are further multiplied by the goal to replicate a trading floor within a computer – an auction market offering the “national best bid and offer” price rather than a broker-dealer-dominated, first-in, first-served approach characteristic of overseas electronic exchanges.

Industry veterans warn that the task may overtax the new exchange.

“At some time, there will be a fierce electronic competitor out there, and it’s not clear to me that ISE will be the one,” says Lee Tenzer, chairman of Letco, the Chicago exchange’s largest designated primary market maker, responsible for maintaining trading in a particular option.

Paul Liang, chairman of PBL Partners LLC, which owns and leases seats on various exchanges, is more emphatic: “There’s no way in the world the ISE can outcompete us. We already cut our cost to customers more than what they promised they would be able to do.”

Concurrently, the Chicago board’s primary market makers have doubled their coverage to the entire floor.

This expansion, which comes at the expense of traditional market makers, is designed to reinforce the exchange’s relationship with brokerages that bring business.

Says Mr. Brodsky: “The threat of the ISE is very different than it would have been 12 months ago.”

But still a threat. The Chicago board has complained to the SEC that the upstart’s chairman, Mr. Porter, also is affiliated with Adirondack Trading Partners, which owns nearly all of the new exchange’s 110 seats.

“Obviously, conflicts can arise if the exchange is in a position to exercise regulatory authority over a member who is a major, or even a controlling, owner,” Mr. Brodsky wrote to the SEC. “In fact, it would place all exchange employees who would ultimately report to Mr. Porter in a very difficult position if they were expected to oversee and regulate the market maker entity affiliated with their boss.”

Replies Mr. Krell: “Nobody reports to Mr. Porter here. He’s not an officer here. And that’s how we address that.”

His exchange, he says, has prepared more detailed responses and expects approval by yearend.

Among other lingering questions is just how competitive the new exchange itself will be, particularly as evidenced by its planned appointment of one primary market maker (and two “competitive market makers”) for each option class, regardless of size.

“Increasing the number of market makers in each crowd would not only yield tighter markets but also reduce the cost of an ISE market maker membership, another significant barrier to entry,” Mr. Ascher, the former Chicago board vice-chairman, who is now a vice-president at market maker Timber Hill LLC, wrote the SEC.

“The ISE runs the unintended risk of serving not as a true exchange, but merely as a means by which a few members may internalize their own order flow in a non-competitive environment, matching (but not improving upon) bids and offers displayed in other market centers. The consequent diversion of retail order flow to the ISE, in turn, could weaken the other, more competitively priced exchanges….”

Crain News Service