PHLX Veterans Plan New Venue in Crowded Options Market
April 27, 2009
Several former Philadelphia Stock Exchange executives are planning to start an options exchange and have begun soliciting support from liquidity providers.
According to sources with knowledge of the initiative, former PHLX vice chairman John Wallace is involved, as are at least two other executives from the Philadelphia options venue, which was purchased by Nasdaq OMX Group last summer. Wallace, a longtime PHLX market participant who twice served as chairman during the 1990s, declined to comment. Wallace left the Philadelphia exchange following the acquisition, said a Nasdaq spokesperson.
Representatives from three major options market makers and one of the largest order providers said last week that they have been approached by the prospective exchange to provide liquidity, but they requested anonymity and declined to comment further, citing confidentiality agreements. Dubbed the Miami International Stock Exchange in documents seen by sources, the nascent all-electronic market center has received at least a portion of its financing from investors in Dubai.
The initiative raises questions about how many exchanges the rapidly growing U.S. options market ultimately can support. Nasdaq last spring launched the seventh such venue--the Nasdaq Options Market (NOM)--and the Chicago Board Options Exchange is readying a New York-area exchange. "The market probably isn't big enough for 10 or 11 exchanges," said Sang Lee, managing partner of Boston-based Aite Group. "Capitalism will take care of itself in terms of natural selection."
As the new venues do battle with their more established counterparts, execution and pricing structures could help determine the winners. According to a source at a major liquidity provider, the Miami exchange is considering payment for order flow, an approach in which market makers return a portion of their exchange-generated revenue to the venue. The pool of funds is then used to pay broker-dealers for their orders from retail and institutional investors.
Such a model, pioneered by the International Securities Exchange (ISE) in 2000, contrasts with that of NOM, which accounts for about 3 percent of volume. The Nasdaq venue applies a maker-taker pricing schedule, providing rebates for posting liquidity and charging to remove it. NYSE Arca and the Boston Options Exchange offer maker-taker pricing for the 63 options classes that are currently quoted in penny increments, rather than nickels or dimes.
CBOE's C2 exchange, which is expected to gain Securities and Exchange Commission approval in June, may also be leaning toward the maker-taker approach. According to vice chairman Edward Tilly, CBOE recognizes that the high-frequency traders entering the options market find such pricing attractive and wants to capture their business. For high-volume classes like SPDRs, the maker-taker model "may make sense," said Tilly, but CBOE's core business focuses on market makers and specialists.
"C2 may potentially be a combination of models that would contemplate these new users while recognizing current customer preferences," said Tilly, adding that an option could trade simultaneously on both exchanges, each appealing to different types of market participants.
The pricing model used by CBOE and ISE--which generally vie for the lead in equity options volumes at about 30 percent each--is attractive to retail and institutional investors because they trade for free. That order flow in turn draws market makers.
Institutional investors have been credited with much of the options market's more than 20 percent annual growth over the past five years. Phil Gocke, who heads up the Options Industry Council's research and education program for institutional investors, said that the firms have increasingly turned to options to hedge risk and generate revenue through strategies like covered calls. "That increased interest began in earnest in summer 2007, and it's accelerated ever since," said Gocke, who also runs options trading firm Brite Sky.
