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For nearly two decades, four exchanges controlled the $650 billion-a-year world of U.S. stock options. A close-knit oligopoly ensured that IBM (IBM
) options traded only on the Chicago Board Options Exchange (CBOE), Dell Computer (DELL
) at the Philadelphia Stock Exchange, Apple Computer (AAPL
) on New York's American Stock Exchange, and Microsoft (MSFT
) at the Pacific Exchange in San Francisco. The arrangements--and a tacit understanding not to poach each others' most lucrative products--kept fees high and competition low.
No longer. An upstart, New York's International Securities Exchange, has blown the comfy cartel apart in little more than two years. Since it began trading, in May, 2000, the ISE has grabbed a 25% share of the trading volume in U.S. equity options, closing in on the fast-shrinking share of the market leader--the venerable CBOE--which pioneered stock options 29 years ago (table). The ISE is attracting orders even from traders on the CBOE. "It's a testimony to our efficiency," says ISE Chief Executive David Krell. "We are cheaper, faster, and better."
Superb timing--with help from high places--powered the all-electronic ISE's liftoff. Since 1989, the other exchanges had sneered at Securities & Exchange Commission requests that they give up their monopolies. Then, in January, 1999, the Justice Dept. launched a probe into complaints that the exchanges were illegally refraining from listing some stock options in more than one place.
Within a month, the ISE--backed by E*Trade, Ameritrade, Scottrade, Knight Trading, and Deutsche Bank (DB
)--filed for exchange registration with the SEC, after announcing earlier that it would list 600 of the most active options traded at all the existing exchanges. That sent a shiver through the options industry and achieved what even the government hadn't been able to do: By August of that year, the exchanges gave up exclusivity and each started offering all the options. William J. Brodsky, CEO of the CBOE, ruefully admits that the ISE's impact on the industry seemed greater than the government's actions. "The ISE had a tremendous effect; if they were planning to cherry-pick our best options, then we had better be prepared for that kind of competition," he says.
The ensuing wave of competition was so strong that the exchanges stopped charging a fee of 36 cents per contract. In 2001, the total volume of stock options soared to 723 million contracts--60% more than in 1999. TowerGroup analyst Jean-Paul Carbonnier attributes much of this growth to retail customers, pointing to the success of several small specialty-options brokers in the last two years. In September, 2000, the SEC and Justice reached settlements with the four U.S. exchanges, which agreed to spend $77 million collectively on surveillance and enforcement.
Customers have clearly benefited. Costs have dropped, and spreads between sell and buy prices have narrowed. "ISE has made the market quicker and more accessible, which has a lot of appeal for our customers," says Tony McCormick, vice-president for equity options at Charles Schwab in Chicago.
Several investment banks have become ISE market makers because the cost of entry is so low. "Morgan Stanley (MWD
) was not in the business pre-ISE because we didn't deem it financially appropriate to maintain a staff of many brokers and floor traders in various exchanges," says Thomas R. Cardello, a managing director at Morgan Stanley. Using ISE's automatic trading system and algorithms derived from the stock prices, volatilities, and interest rates, Cardello says he can quote 50,000 options at any given time. (Morgan Stanley, Goldman Sachs, Bank of America, and Bear Stearns are now ISE shareholders.)
The ISE, however, must watch for challenges on the horizon. The Boston Stock Exchange, along with the Bourse de Montreal and the Interactive Brokers Group, have formed a new electronic exchange for options called the Boston Options Exchange. They are awaiting approval from the SEC and hope to launch later this year. The CBOE isn't sitting still, either. On July 18, it introduced new technology to bypass its trading floor and match large customer orders electronically--something it previously did only for smaller orders.
Fierce competition is good for markets and customers. It also keeps the ISE on its toes. For now, the ISE is profiting from its innovations, but if it grabs the top spot, plenty of wannabes will be ready to knock it off its perch. By Pallavi Gogoi in Chicago