"My resolve to compete electronically went back to my days at the AMEX and my great respect for what CBOE meant as an institution. I was not going to allow CBOE as an institution to slide into an abyss during my tenure because of some narrow-minded floor traders who were only worried about their own short-term income."
Market competition had concerned CBOE officials since 1976 when they listed options already being traded on the Philadelphia Exchange. A short time later, after the SEC approved "multiple listing" of options on the CBOE and AMEX, market surveillance began detecting fictitious trades done presumably to attract investors away from the AMEX. The problem surfaced again in the late 1980s but the SEC did not consider it systemic.88
All options exchanges expressed concern over market fragmentation caused by competition. In 1991 the SEC, determined to let competition lower consumer prices, removed priority rules that restricted multiple listings. Technology was the key to survival in this newly competitive atmosphere. By the mid-1990s, the CBOE floor featured an electronic order book, handheld terminals for market makers, and automated routing for brokers. These innovations did much to revive CBOE business. Even equity options, which had been in a long decline, bounced back, in part because the NYSE sold its options business to the CBOE in 1997.89
But the options exchanges, including the CBOE, had employed another means of averting competition in the years of unlimited multiple listings. In 2000, the SEC and the U.S. Justice Department charged the exchanges with conspiring to restrain trade by dividing up the market informally, much as they had formally done before.90
On the heels of that settlement, another practice—payment for order flow, in which competing exchanges pay order entry firms for their business—permeated the options business. Many viewed the practice as inevitable, as exchanges sought to offer new incentives in increasingly competitive markets. But payments for order flow also created additional transaction costs and ran counter to an exchange SRO's responsibility to provide best execution to its members. Despite conducting a study and issuing a Concept Release in the early 2000s, the SEC has yet to forbid the practice.91
In some sense, the SEC countenanced market fragmentation and payment for order flow as a cost of maintaining price competition through multiple markets. William Brodsky, an industry veteran who took over as CEO of the CBOE in 1997, believed it was his responsibility to enable the CBOE to meet this competition. In 1999 and 2000, the members approved innovations that strengthened the exchange at the expense of the floor, including extension of the designated primary market maker system, reductions in fees, and creation of a "hybrid trading system" that combined an open outcry floor and fully electronic trading.92
It seemed almost to be too little , too late. In mid-2000, the International Securities Exchange (ISE) opened its all-electronic options market with near-instantaneous market maker quotes and tight bid and ask spreads. Customers abandoned the CBOE for the ISE. Brodsky acknowledged that the "ISE has changed the model." The crisis began to lift in mid-2003 when the hybrid trading system CBOEdirect went on line.93
(88.) Chicago Tribune, July 8, 1976; New York Times, May 12, 1989.
(89.) CBOE Annual Reports, 1993, 1995, and 1997; Carrie R. Smith, "CBOE Systems: Sharpen Edge, Tighten Spreads," Wall Street & Technology, April 1995.
(92.) January 5. 2010 Interview with William Brodsky; CBOE Annual Reports, 1999 and 2000.
(93.) Osten, "Three Decades of Options"; Ivy Schmerken, "CBOE Bets Streaming Quotes Will Cool ISE," Wall Street & Technology, July 2003; Barron's, May 31, 2010; Robert Sales, "U.S. Options: Electronic Revolution Pits ISE vs. Floor-Driven Exchanges," Wall Street & Technology, November 2002; CBOE Annual Reports, 2003 and 2004.
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