Arnie Staloff is the creator of the first exchange-listed currency option contract. He began his career in the Trading and Markets Division of the Securities and Exchange Commission. He later joined the Philadelphia Stock Exchange, where he introduced the exchange's first options on equities in 1975 and the first currency contract in 1982. He has served as president of both the Philadelphia Board of Trade (PHLX), and the Commodity Exchange. Since 1990, he has served as CEO of Bloom Staloff Corp., a large equity options specialist at the Philadelphia Stock Exchange and the Pacific Exchange, and options market-maker at those exchanges and the American Stock Exchange.

Derivatives Strategy: What was your first exposure to the derivatives market?

Arnie Staloff: My first job was at the SEC in Washington in 1968–1971 at the Division of Trading and Markets—it's now called the Division of Market Regulation. Among other things, the division was charged with regulating the option brokers who were then called put and call broker- dealers. Option broker-dealers would buy one-column ads in the Wall Street Journal that would say: "We have the following options available.” And then they'd list the prices of the options.

DS: They were standard options on big stocks?

AS: They'd offer call options on AT&T for X number of months, then tell you the price. If somebody wanted to take a bet on AT&T for a few hundred bucks, they would write a check. It was basically whatever price a dealer could get. There was no way to determine the efficiency or overall pricing of options. It was like going to Vegas.

DS: Did anyone ever use models?

AS: I don't think there was any such thing.

DS: Who were the customers?

AS: We never really knew (laughs). It appealed to people's gambling instincts, people who liked to control large amounts of stock for small amounts of money. They had a low probability of winning, but it was worth a shot.

DS: What happened to change the market?

AS: In the late 1960s, the Chicago Board of Trade decided it was going to start an exchange to trade options. The special counsel at the SEC said that it would never happen. They hated options at the time.

DS: They were considered low-life instruments?

AS: Exactly. It took three to four years to convince the SEC to allow trading in call options.

DS: Why would they permit call options but not put options?

AS: It was a basic misunderstanding. Short-selling was considered speculative, and so was betting on something going down in price. There was no intellectual rationale for it, but there has always been a bias against short-selling in this country.

"Although the SEC wasn't particularly thrilled about the idea of an options exchange, it unwittingly contributed to the success of the listed options market by listing what would be traded.”

Although the SEC wasn't particularly thrilled about the idea of an options exchange, it unwittingly contributed to the success of the listed options market by restricting what could be traded. You could only trade calls, and then only on 15 issues.

DS: So the SEC helped standardize and limit the contracts and that helped build liquidity quickly?

AS: Yes. The listed options market exploded. That was 1973, the beginning of the derivatives market as we know it today. I was at the Philadelphia Stock Exchange in that period. Because we started after the Chicago Board Options Exchange and the American Stock Exchange, most of the good equity stock options were already taken.

I wanted to do options on gold and silver, but then the Hunt Brothers scandal hit and I was told there was no way that we would ever get approval for precious metals. Our third choice was foreign exchange. In Chicago, the Chicago Mercantile Exchange was trading futures on currencies, but no one was offering options on currencies, or many other nonequities for that matter.

DS: In retrospect it seems obvious. If futures on currencies existed, why not create options on currencies?

AS: Hindsight is always 20/20. No one knew what the impact of options would be on the underlying currency market. They opened on December 10, 1982, and were an almost instant success. The market never looked back after that. But pricing was the key. The only way you can get decent ideas is from the historical pricing information.

Soon after the market opened, a guy named Mark Allardo came into my office from a company called Chicago Research and Trading (CRT). I had never heard of the firm. He said, "We're intrigued by this product. What kind of trade data do you have?” And I said, "I have all of this data here.” We were required by the SEC to keep spot prices, every quote and trade for each option, as well as the time to the second of each record. We had five banks feeding us spot prices. He said, "This is amazing. I want to start trading tomorrow.”

He wasn't a member and his firm wasn't a member, but I helped him get an options broker. We had all the data on microfiche in an office. He stayed on the phone in that office all day long. I had no idea what he was doing. When I came back from a board meeting at 7 p.m., he was still in the office.

I said, "I guess you aren't trading tomorrow.” He says, "Absolutely. I'm going to take the train home, change my shirt and come back in the morning.” It turns out he was on the phone all day reading all these prices to somebody who was entering them into their computer. Of course, CRT went on to become a significant player in the early derivatives markets. But it became the most active player in the Philly currency options market from that day on.

DS: When did you first hear about Black-Scholes?

AS: In the 1970s, you heard talk that people in Chicago were trying to price options. I looked at it from a practical standpoint, as opposed to an academic or theoretical perspective. I thought what Black and Scholes did was put on paper what people in the trading pits were doing on a daily basis.

DS: Instinctively?

AS: Instinctively.

DS: So in the early years of the CBOE, market-makers and locals were trading instinctively, without any thought of the Black-Scholes model?

AS: Exactly. And it took a while before they could adapt the Black-Scholes model to currencies. Some of the people who came to Philadelphia to make markets were from Chicago. A lot of those firms hired academics to apply the Black-Scholes model to currencies but found they couldn't make money. And they were trading against local Philadelphia people—who were making money but didn't really understand the model.

DS: Was it some kind of a misfit between the model and market?

AS: The relationship between different countries' interest rates was giving people a lot of difficulty. The real problem is that we didn't have a good run of historical prices. In stocks, you had a trade-by-trade analysis against the underlying stock movements. We didn't have that in foreign exchange, or any other instrument for that matter.

"What Black and Scholes did was put on paper what people in the trading pits were doing on a daily basis.”

That was what Lisa Polsky at Citibank eventually figured out. It was something of an embarrassment to the banks that a little exchange could do currency options when they had been failing for years.

Importers and exporters had real foreign exchange exposures, but they didn't know how to hedge themselves against foreign exchange risk. Bank customers wanted options, but the banks didn't know how to price them, and they lost money every time they tried.

DS: But currency futures were already trading at the International Money Market in Chicago.

AS: The banks had enough of the IMM. It was a nuisance, like a junkyard dog. Me, they liked even less. In New York at the time, there was a group of international treasurers that met monthly to talk about where foreign exchange prices were going. No bankers were permitted. Somebody invited me to give a presentation. I showed them a 20-minute film and passed around some brochures we had made up. There was stunned silence. It was exactly what they wanted.

The next day, all their bankers started getting calls about what was going on at the Philadelphia Stock Exchange. That was the detonator that started this whole thing off. But there was still some obstinacy. I was literally thrown out of two or three banks.

DS: The banks thought clients would go to the Philadelphia Stock Exchange instead of buying spot?

AS: They were not receptive of someone moving into their area of expertise. Lisa Polsky was one of a very small group of people from the banking side who embraced the product and saw the benefits. Citibank was the first major institution to compete directly with the Philadelphia Stock Exchange by creating an over-the-counter market for currency options.

DS: So you managed to create the first successful currency options market from scratch, without the support of the banks. It seems unthinkable now.

AS: I was able to create a currency market in Philadelphia because nobody else at the Philadelphia Stock Exchange cared. I had no committees. I structured this market to be very friendly to the ultimate customer—to the detriment of the individual on the floor. This made people on the floor wealthy. They made a lot of money by not looking to make the last tick in every trade.

"The banks had enough of the IMM. It was a nuisance, like a junkyard dog. Me, they liked even less.”

As our market evolved and became more successful, the traders on the floor began to set the rules and structure the market more to the trader's benefit. Philadelphia wasn't able to compete this way. The market dried up.

DS: I suppose that's a lesson for Chicago, particularly the Board of Trade.

AS: Absolutely. After I stopped working for the Philadelphia Stock Exchange, I became a member of the exchange. I was a broker in currencies. I am still a major market-maker in equity options and a specialist in stocks. I see it now from a different perspective. An exchange is better off giving the off-floor participant the better deal.

DS: The IMM has also collapsed. All listed currency trading is dying.

AS: The banks got smart. Banks learned from the exchanges. The exchanges became less important because they didn't innovate or make their customers feel comfortable.