Demutualization & Price Improvement Rock the Options Markets

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The bloody battle for supremacy in the U.S. options industry is growing fiercer by the day. This brutal struggle has ushered in an era of unprecedented change in the options marketplace and given rise to one of the industryís newest buzzwords - demutualization.

DEMUTUALIZATION
For those of you who arenít up on the latest jargon, demutualization is a fancy term that describes an exchangeís transition from a limited membership organization to a share-based corporation. This trend is becoming more prevalent within the options industry, and the days of individual seat owners are quietly drawing to a close. Although many die-hard Chicago traders are skeptical of this process, demutualization does have significant advantages. One of these advantages is the ability to attract new strategic partners who can provide investment capital for new trading technology and new trading products. The PHLX was the first U.S. floor-based stock exchange to undergo the demutualization process. Meyer ìSandyî Frucher, Chairman and CEO of the PHLX, thinks that demutualization is a natural response to the competitive environment in the industry today. ìWhen you talk about demutualization, what that really is is an intermediate step toward a certain amount of repositioning. What you needed to do in this industry is to position yourself so that you have currency with which you can strike strategic alliancesÖ(This) is key because what you are going to be doing is having exchanges become one stop shopsÖYouíre going to have to go more toward the European model, the Eurex, Euronext model which has equities, options, futures and a technology company all under the same roof.î



THE PIP
Demutualization is already affecting the options landscape as more exchanges are looking to reposition themselves for the future. The struggle to stand out in this crowded field has become even more difficult now that the Boston Options Exchange (BOX) has joined the fray. Their controversial price improvement process (PIP) is the BOXís main selling point, although the firestorm surrounding the PIP has forced Kenneth Leibler, Chairman of the BOX, to town down his sales pitch at recent industry events. ìPIP represents 10-15% of our overall volume, certainly a minority of total trading volume in the BOX market. Average price improvement has been over $2 a contract. It is not penny pricing but actually forty percent of the nickel spread is returned to the customer in the form of price improvement.î

The PIP has prompted a competitive backlash from the other players in the field, and Leiblerís claims of price improvement have been met with skepticism. Michael Bickford, Senior Vice President of the AMEX, had the following to say about the cost savings from the PIP: ìKen talks about two cents out of nickels, but Iím willing to be that a lot of that is two cents out of dimes.îThe only thing that seems to unite the warring exchanges is their universal condemnation of the BOX and the PIP. Representatives from the AMEX, CBOE and PHLX all dismiss the PIP as worthless while simultaneously vowing to create their own versions of the process. ìYou have to be crazy to ignore things that are going on in the industry even if you donít philosophically agree with themî said Bill Brodsky, Chairman and CEO of the CBOE. ìWe are not going to sit by and just allow one aspect of the business to go on without having a response. Our thought is that there are inherent flaws in the PIP process and we would rather improve on it rather than just copy it.î

Meyer Frucher added that the BOX has put additional pressure on the already strapped business models of the exchanges. ìThere is no question that the BOX coming into the space causes us to reassess our financial and fee structuresÖ There is no question that the BOX is accelerating internalization models on every exchange.î The constant sniping against the PIP is music to Leiblerís ears. ìThe PIP is a small percentage of our business. Iím actually pleased that most of the competition is obsessed with it.î

While Leibler may downplay its significance, the PIP poses two significant threats to the U.S. options industry. First and foremost, the lure of price improvement may draw order flow away from competing exchanges. Although the BOX only accounts for about 3% of total U.S. equity options volume, that percentage is likely to grow as more firms learn about the price improvement process. The second threat from PIP is that it offers price improvement in one-cent increments. This may seem benign, but competing U.S. exchanges still quote their prices in nickel and dime increments. The PIPís penny price improvements pave the way for the inevitable switch toward penny option pricing, a move that the exchanges are dreading due to the exorbitant costs of upgrading their technology."

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