An upstart exchange tries to turn the options establishment on its head.

By Robert Hunter

Sometimes revolutions occur right under our noses. Two years ago, the U.S. options exchanges stood by silently, perhaps complacently, while the rest of the exchange world contemplated the end of open-outcry trading. Naysayers argued that it would be difficult or impossible to move the options business, with its hundreds of products and expirations, onto an electronic trading facility.

But unbeknownst to the big three options exchanges, a couple of former options executives at the New York Stock Exchange were busy doing just that. Now, less than a year after the International Securities Exchange’s birth announcement, the fledgling exchange has already hastened the electrification of the U.S. options market—before a single trade has been executed.

The seeds of the ISE were planted not long ago. In April 1997, David Krell and Gary Katz were managing the options division at the NYSE when the Chicago Board Options Exchange scooped up the NYSE’s options business. Krell and Katz had the opportunity to stay at the NYSE, but chose instead to start up an options consultancy. Shortly thereafter, William Porter, then-chairman of E-Trade, was assembling a group of brokerage firms to find some answers to a simple question: Why was the cost of doing an option trade so much greater than the cost of doing a stock trade? E-trade had managed to execute any stock trade for $14.95, but an options trade of 10 contracts cost at least $50, and exchanges seemed to be struggling to keep costs even that low.

The E-Trade group commissioned Krell and Katz to examine options markets around the world and various electronic trading systems. The two came back with a proposed market structure fusing the principles of electronic trading with the functioning of the U.S. options market. Before they knew it, they were busy forming the International Securities Exchange LLC. They quickly tapped OM Technology in Sweden, a powerhouse in electronic trading software, to write the trade matching, and chose Compaq, fresh on the heels of its acquisition of Digital, to develop the trading platform.

The ISE’s main goal: to cut the cost of doing business. One of the big differences between the ISE and traditional options exchanges is its corporate structure. “We wanted to change the way exchanges are owned today,” says Katz, now the ISE’s senior vice president for marketing and business development. “We want the market-makers who are going to provide liquidity to own the memberships in the exchange, and we want to make sure the broker-dealers who provide the order flow, such as Merrill Lynch and E-Trade, do not have to buy a full membership but only pay a small access fee. We want to encourage order flow to come here, so we’ve created as low an entry barrier as possible.”

In addition to lower barriers to entry, the ISE promises to slash transaction costs by 30 percent to 50 percent compared with the CBOE, the American Stock Exchange and the Philadelphia Stock Exchange, which have all recently slashed their fees to prepare for the ISE. “Our cost of running this business is about 30 percent to 50 percent lower than the current market,” says Katz. “We know what the cost of running their business is, and ours is much lower. There are going to be 75 employees here; there are 700 at the CBOE.”

But the ISE plans to retain some of the characteristics of the traditional options market. Like the major exchanges, all of the ISE’s trades will be cleared by the Options Clearing Corp. And all trades executed by the ISE will come through a broker. A direct link to the ISE, says Katz, would do end-users a disservice. “If you decide that you wanted to trade options, you can’t simply connect to the ISE, because the person on the other side of the trade wants the assurance that you will be able to deliver on your contract. That’s done today through brokerage firms and through the OCC, which guarantees the contracts.”

In the end, says Katz, the actual method of trading options on the ISE won’t be different from the other exchanges. “What changes,” he says, “is the speed of execution and the amount of information available.” Katz boasts that the ISE’s total transaction time will be less than half a second, compared with anywhere from 6 seconds to a minute or longer at the open outcry exchanges. “Time is more costly than any other aspect of a trade. If I loose an eighth of a point because it takes me too long to do a trade, that costs me money.” The ISE will also show the size of its bids and offers, offering a view of the market’s depth that the other exchanges can’t match.

The ISE has also developed a quasi pit structure similar to the open outcry system. It has taken the 600 contracts it seeks to trade and divided them into 10 groups of 60 names each, balanced by volume. It assigned to each of those groups one primary market-maker, who will act much like a specialist at the NYSE or a designated primary market-maker at the CBOE. Then it split up the 100 other market-makers it had attracted into the 10 groups, so that each group of 60 has one primary market-maker and 10 competitive market-makers. Not quite the PHLX’s Dell pit, but not a free-for-all either.

Who needs the Internet?

With Internet-based derivatives trading facilities popping up all over the place, it’s striking that the ISE has steered clear of web mania. Katz offers several reasons. “First of all,” he says, “the Internet doesn’t have the ‘redundancy’ we’re looking for.”

The ISE also wanted to have managed computer lines. “You can go out and get a T1 connection for a song. But if it goes down, it may stay down until the next day. We wanted a network managed by our network partner that offers guaranteed up-time and suffers penalties for downtime and has a planned workaround if a line goes down. This can only be done using a proprietary network.”

Moreover, says Katz, the Internet, as it’s currently realized, simply cannot handle the huge number of products the ISE plans to offer. The NYSE trades 3,000 stocks, he says, but the ISE will trade multiple calls and puts with multiple expirations and strike prices on its 600 contracts. “An options market like ours will have 50,000-plus securities,” he says, “so we need to make sure we have the capacity to trade those securities. The Internet today can’t do that.”

The ISE is a proprietary trading system much like Eurex. OM’s trading software rests on Compaq Alpha servers, part of the booty from the Digital acquisition. The servers are almost infinitely scalable, and users either have a point-to-point connection to the exchange or attach to frame-relay network. “This type of a system provides the level of connection, the redundancy and the throughput capability we need,” says Katz.

Time to panic

The ISE hasn’t traded a single contract, and yet the options establishment has already started a counterattack. In February the ISE submitted its proposal to the SEC, and the SEC published the filing for a 45-day public comment period beginning June 2 of this year. There were 12 positive comments and eight negative comments—two of which, Katz points out, were received a month after the comment period ended.

The negative comments ran the gamut from trivial to substantive. “The CBOE and the Amex put together a comprehensive comment letter,” says Katz. “We’ve replied back to the SEC and addressed each issue that was raised. In some cases, we believe that they’re pretending they don’t understand certain issues when in fact the issues are perfectly clear. In other cases, they’ve raised good questions that we’ve answered. There’s nothing that we see in those comment letters that is a show stopper.”

The SEC is weighing the comments now, and Katz is confident that the SEC will grant final approval in time for the ISE to make its target launch date of March 24, 2000.

Meanwhile, the CBOE, Amex and PHLX have begun open warfare on each other and the ISE. The exchanges have all announced major transaction cost reductions, and the CBOE has drastically revised its margin rules. In August, the CBOE began listing options on Dell Computer, which had traded exclusively at PHLX, breaking a long-standing gentlemen’s agreement between the three not to cross list popular contracts. The action sparked a listings war, as the PHLX and Amex quickly began listing each others’ biggest contracts.

Another major change is in the pipeline at the CBOE as well. “The CBOE recently sent a filing to the SEC to make their markets firm. That is, they’re willing to trade at those prices, not just for customers but also for firms that are trading proprietary orders. That’s something that the firms have been begging for for 25 years. Right now, if you’re showing a bid of $4 and I tell you I want to sell at $4, you can say no to me because I’m not a customer but another firm. If you did that on the NYSE, they’d laugh at you. But on the options market it’s been that way for 25 years. That alone will increase the volume that’s being done on the floor. I think we’re the catalyst for that. Whether or not we ever do a trade, we’ve made that change in the industry.”

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