Financial golden boy loses some gloss

While overshadowed by the Chicago Board of Trade’s well-documented travails in the futures business, the Chicago Board Options Exchange confronts eerily similar perils in the market for stock options.

Those perils are market share erosion, upstart rivals, fractious internal debates and, above all, questions about the viability of the exchange in a computerized world.

And looming on the horizon is another huge headache – the newly legislated right of the board of trade and its futures industry brethren to trade single-stock futures (and essentially poach the exchange’s order book).

“The CBOE has been the golden boy of the Chicago exchange community, but it now finds itself in a relatively mature industry that is being redefined by the second,” warns Thomas Ascher, executive vice president of Interactive Brokers LLC and a former vice chairman of the options exchange.

Last year, for the first time, the exchange’s piece of the options industry pie dropped below 50%. To retain what it has in a business it invented, it is engaged in a costly bidding war for customers, a situation that diminishes the automatic lure of its brand name.

In turn, the economic upheaval has created political waves the unsettled board of trade would recognize. Last month, in turning out the incumbent, the option exchange’s 1,640 members narrowly elected a vice chairman, Mark F. Duffy, who is perceived as a traditionalist interested in protecting the franchise of pit brokers and traders against inroads by off-floor electronic upstarts.

Then there’s the courthouse showdown over the right of board of trade members to trade at the options exchange, which was founded in 1973 as an offshoot of the board. Options exchange executives argue that the board of trade’s plan to restructure as a for-profit corporation would torpedo the pact.

Challenges compounded

The options exchange’s chairman and CEO, William J. Brodsky, who turned 57 last week, weighs his multifold challenges: “It’s like a tapestry. You can’t look at any one thing in isolation.”

Not every hue is subdued for the exchange, of course. Like the options industry overall, it set one volume record after another during the bull market for equities – a run that has yet to fizzle. But when it does, the exchange’s challenges will only be compounded.

“We’re not going to sit by and let somebody take our business,” promises a feisty Mr. Brodsky, soon to observe his fourth anniversary at the helm after nearly 15 years at the Chicago Mercantile Exchange. “The next 12 months are going to be a significant period for all our exchanges,” he says.

Topping the agenda will be what to do with a still-underemployed electronic-trading system that the exchange spent more than $40 million to develop, aiming to blunt the all-electronic International Securities Exchange. But with that entity off to a slow start, the urgency has waned for the Chicago exchange’s system.

Describing the computers as still in the “testing stage,” Mr. Brodsky is equally equivocal over how to blunt the single-stock-futures threat.

In some respects, the options exchange is more vulnerable than the board of trade, the Merc and other futures exchanges because the options business is more fungible – susceptible to flight – than futures contracts, such as the board of trade’s Treasury instruments, that are traded only on specific exchanges.

Increasingly, because of technical advances, Wall Street firms and others that have brought customers to the CBOE are turning into competitors by “internalizing” the business of an exchange.

Meanwhile, traditional exchanges, notably the once-moribund Philadelphia Stock Exchange, are brazenly taking business away from the options exchange by literally buying it – paying for order flow – after Mr. Brodsky’s organization couldn’t get regulators, who were more concerned about lack of competition, to stop the practice.

Between autumn 1999 and last spring, the options exchange’s market share in such high-volume stocks as America Online Inc., Cisco Systems Inc. and Yahoo! Inc. plunged a third or more.

“Business was literally evaporating overnight,” acknowledges Mr. Brodsky.

Agrees Jack Kennedy, a former independent trader who is executive director of a group that represents options exchange specialists: “We had a large chunk of market share that was basically bought away from us.”

To stay in the game, a trader might have to pay $8,000 to $10,000 a month – about as much it costs to lease a seat on the exchange, he estimates. “Even though we don’t like it, you just can’t have everything walk out the door, and sit on your hands.”

Another sea change, in late 1999, was the end of exclusive listings in various stock options. Competitors also had exclusives, but the granddaddy exchange had the most to lose.

“The homogenization is an advantage to the small and is invariably a cross to bear for the large,” points out Meyer “Sandy” Frucher, chairman of the Philadelphia exchange, which has doubled its annual volume to 62 million contracts in the past three years. “When you’re the big guy on the block, it’s harder to make changes.”

Classic Chicago-based options firms such as Letco Trading Co., as well as newer firms such as Botta Capital Management, no longer find themselves moored to the options exchange.

“Liquidity becomes the brand name,” notes Botta chairman Kevin Lurthringshausen. “All things being equal, if the liquidity provider is doing his job – service, best execution, filling orders, having a payment plan in place – the brand name starts to go with the liquidity provider.”

Whereas exchange members once competed against each other, adds Mr. Brodsky, “now they’re competing with national firms that have tremendous scope.”

And the competition is fierce. Recalls Philadelphia’s Mr. Frucher: “When I had to deal with asking our folks to make cultural and institutional changes, I had the political advantage of saying to folks, if you don’t make these changes, you will die.”

Related Topics: Chicago, Options / Futures