The new International Securities Exchange may give the CBOE a real run for its money.

Equity options traders complain of more than their fair share of headaches. They put up with options that can be listed on two or more different floors, fills that may take forever to complete, and brokerage pricing that is high relative to trading the underlying stocks.

But if the International Securities Exchange (ISE) has its way, trading equity options may soon be changing—one hopes for the better. On May 26, the ISE will open for business—the first new U.S. options exchange to be approved by the Securities and Exchange Commission since 1973. This exchange will not only be completely electronic, but it will be the first electronic exchange to maintain an "affirmative obligation” for market-makers to make prices within it.

Customer orders will find their way to the best market, EVen if that means trading on a traditional equity options floor.

There will be a quote display, a market-making tool, and a position-management tool all rolled into one. Better yet, the ISE's order-routing capabilities are designed so customer orders will find their way to the best market for prompt and fair execution—even if that means trading on a traditional equity options floor.

"Options are a logistical nightmare for most people,” says Gary Katz, head of ISE marketing and one of the exchange's founders. "None of the electronic communications networks out there currently has the technology to deal with them efficiently. We wanted to do this right, and combine the best features of the traditional auction markets with the speed of today's technology.”

Levels of obligation

The ISE's electronic trading system is built around the obligations of a central market-maker. The exchange plans to offer options trading on 600 underlying securities, and has divided these securities into 10 groups or "bins” of 60 securities each, with a primary market maker (PMM) assigned to each bin. The PMM will be obligated to maintain reasonable bid/offered prices within the system, loading option parameters into the ISE's Torque system, which will then dynamically reprice thousands of options as the underlying securities move. The PMM may widen its prices or reduce the size it is willing to trade in a fast market, but it cannot simply run away and stop quoting. The PMM will also be responsibile for handling customer orders in the fairest manner possible.

In return for providing these services, the PMM will stand the best chance—among all of those who contribute bid/offered prices to the system—to get traded upon when a market order or other executable limit order hits the screen. In effect, after customer orders are considered, the PMM will have the first right of refusal on a piece of business.

But PMMs will not constitute the entire market-making system. Each bin of 60 stocks will also have price contributors called competitive market makers (CMMs). CMM seat-holders will make bid/offered prices on options, but need only be involved on any given day in 60 percent of the equities in their bin. If they don't want to be involved with a given stock for whatever reason, they can walk away. Both CMMs and PMMs will also have the ability to trade on a limited basis in other bins. At the outset, these firms will request a specific bin of stocks they would most like to trade, but they must accept whatever bin the ISE allocation committee actually assigns to them.

Together, PMMs and CMMs will own the exchange, but a third class of exchange users will be allowed: electronic access members (EAMs), who will simply pay a monthly fee for system access. EAMs will be allowed to enter customer orders, but will not be able to quote options markets. They will be pure price-takers.

All of the ISE seats—held by both PMMs and CMMs—were initially allocated to a consortium of five brokerage firms called Adirondack Trading Partners, which in turn sold many of the PMM seats to customer-driven firms such as Goldman Sachs, Deutsche Bank and Morgan Stanley Dean Witter. The majority of the CMM seats ended up in the hands of smaller market-making firms such as Hull Trading, Timber Hill and Wolverine Trading. "We thought it most optimal that the PMMs be the large firms that control order flow,” says Katz. "This gives us the largest amount of capital standing behind this market as possible.”

Conflicting interests

As one might expect, there's been some grumbling about the way the ISE has set itself up. Privately, some of the new CMM participants on the ISE express disappointment that their applications to become PMM members were denied. "If the PMM always has the first shot to capture business, and the PMM keeps matching our prices, being a CMM could become a somewhat frustrating position,” says one CMM firm.

When the ISE initially applied to the SEC for exchange status, the Chicago Board Options Exchange raised a number of other objections. It questioned whether PMM firms would end up "internalizing the execution of order flow.” It also questioned whether the ISE's membership was too concentrated, and whether a for-profit exchange controlled by PMMs and CMMs would ever have the correct fiduciary motives to regulate itself and protect the public. It noted that EAMs, which have only two seats on the ISE board and no votes on issues that come before the ISE membership, "are the members that have the least influence, but are the ones most likely to represent the best interest of the public investor.”

The ISE hotly defends its proposed auction market practices and ownership structure. While it is true that a member firm could end up acting as both a PMM and an EAM on a given customer option order—perhaps actually trading a customer order against the house account—the ISE points out that an "informational Chinese Wall” is required in such instances. The two sides of the same firm cannot communicate with each other about what they are doing, and all orders must go through the ISE system for fair exposure to all market participants.

The CBOE questioned whether firms would end up "internalizing the execution of order flow.”

Rules are also in place to guarantee that an EAM order is shown to the public for a minimum amount of time before that trade is eligible to be crossed by the EAM itself. In other words, an EAM holding a customer order to buy at 71/4 and another separate sell order at 71/4 for a given option, must send both orders to the ISE.The orders must be exposed to the broader market in lieu of simply being crossed upstairs.

Deeper Data

The ISE, for its part, also promises a number of other improvements over the existing equity options markets.

To date, options exchanges have offered consolidated quotes on the Options Price Reporting Authority (OPRA), but that system has never displayed the volume bid and offered.The ISE will.This will be important to retail and institutional clients alike, providing them with a better handle on the depth of a market and where one can expect to get a reasonable fill.

The ISE also allows customers to execute trades in complete anonymity, something impossible on a crowded exchange floor and generally perceived to be an attractive attribute of electronic systems.

Finally, the ISE will also offer a single electronic order book in which both customer and institutional orders will be able to participate. Under current floor practices, some 83 percent of the small-customer order flow is already executed electronically via systems like the CBOE's Retail Automatic Execution System, and further customer interests are executed off an electronic customer order book. But if Merrill Lynch or some other member institution has a house-account order for 1,000 lots, a broker must physically stand in the floor crowd and work that bid or offer. This interest cannot be placed in the electronic order book. Under the ISE, on the other hand, such an order may be left as an electronic limit order just like any other.

The ISE promises "a slow rollout” of just 30 stocks at first, building to its 600 stock target over time, so don't expect the earth to move in Chicago all at once. At a minimum, floor-based exchanges will still represent the primary destination for all spread orders since the ISE will not compete for such business at first. Indeed, the ISE says it will be pleased if just 20 percent of the total options volume in its 600 stocks migrates to the ISE within two years.

But if the ISE is seeking just a 20 percent market penetration at first, isn't this just one more step toward a dangerous "fractionalization” of our markets—something that has historically so concerned the SEC? The answer is probably no. The SEC approval of the ISE exchange application may actually represent a hope that the ISE will bring a uniform platform to the mad rush. After all, if the CBOE still has the best bid or offer on a given option, the ISE promises to protect a customer order from a poorer execution.

As of May 26, we will begin to see just how well the ISE can accomplish this task—not just in theory but in practice.

Getting ready for the ISE

How are people preparing for the first day of ISE trading? The principal problem confronting CMM and PMM participants is how to interface the ISE with their firm's systems. "Every firm has its own internal options software,” says Norman Friedman of Stafford Trading, an affiliate of GPZ Trading, "and it is only going to be natural for us and others to want to integrate this software on top of the ISE.” Henry Schwartz, head of ISE trading at Banc of America Securites LLC, a future PMM, says that its systems team is working "round the clock” to prepare trading and quoting interfaces, and that its top-level control system is programmed to "respond dynamically to market conditions and new trades.” Much of this technology is proprietary among market-makers, but the general goal is to look at one's portfolio of options as that portfolio builds and to adjust volatility pricing accordingly. For example, if one is given too many long call positions in Dell and IBM, it would be desirable not only to lower one's call bids in those stocks, but also to lower one's bids and offers automatically on similar-termed Gateway or Compaq calls. Wolverine Trading, already a Designated Price Maker on a variety of exchange floors and a future CMM on the ISE, wants to make sure that the ISE's own software is functioning correctly before it starts placing layers of other systems on top of it."Wolverine will start by simply using the Torque interface the ISE provides,” says COO Jim Harkness. "If everything goes well with that, and the ISE has fully debugged any problems that it has on its side, then we will look to integrate the ISE into our proprietary in-house systems—but not on day one.” As a general goal, all three of these future ISE participants hope the creation of the ISE will allow them to trade a greater number of stocks with fewer people. "A major advantage of the ISE system is that we will be able to make markets in options on several hundred stocks with greater efficiency of systems and staff. It would take a hundred people across several trading floors to do this on traditional exchanges,” says BofA's Schwartz. "It's potentially a vast improvement in information delivery, risk control and logistics.” This promise of enormous savings has persuaded most of the leading option market-making firms to give the new exchange a shot. Exchange execution fees for market-makers on the ISE will slide lower as the exchange's volume grows, but that potential benefit will be peanuts compared to the savings if the firms can make do with fewer floor-based and upstairs traders for the same number of stocks. "We don't expect to cut personnel per se,” explains Wolverine's Harkness, "but we do expect to reallocate our upstairs staff a bit and see if we can't end up trading options on more stocks with the same number of people. If we can, the net-net result should be greater profitability.” The ISE will not initially be competing with the floor on complicated spread orders, and for this and other reasons, the floor market is unlikely to die away immediately. Stafford Trading's Friedman personally believes that the floor will always survive, "but if you asked others at this firm, you would get a very different answer. All we know for sure is that the ISE has already changed the face of the options world in more ways over the past year than this world changed over the past 10 years.The ISE has put everyone on alert that a truly electronic age of options trading is coming. It's going to give us the first truly open electronic book. That's a huge step. It's certainly the CBOE's game to lose.” —B.L.