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Industry Spotlight > Broker Dealers

CBOE to Try Stock Trading

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CHICAGO (–The Chicago Board Options Exchange on Thursday announced plans to begin trading equities by early 2007 via a hybrid electronic and open outcry trading system.

The CBOE Stock Exchange LLC, as the entity will be known, is actually a collaboration between the CBOE and four partners, each of which has taken a monetary stake in the new venture. Those partners are VDM Specialists LLC, Interactive Brokers Group LLC, LaBranche & Co. Inc., and Susquehanna International Group LLP.

“We’re privileged to be partnering with some of the largest, most respected trading firms in the securities industry to launch this exciting new venture,” said William J. Brodsky, chairman and chief executive of the CBOE, in a statement accompanying the announcement. Mr. Brodsky, along with Edward Provost, executive vice president of business development; Edward T. Tilly, the CBOE’s new executive vice chairman; and John Smollen, the CBOE’s newly named member vice chairman, delivered the news about the stock trading venture at a news conference in New York.

The new venture is the CBOE’s way of elbowing further into the equity trading world. Already, the exchange trades single stock futures products on the OneChicago platform, and obviously options on stocks and stock indexes are its main business. The exchange also launched the CBOE Futures Exchange in 2004.

Now the CBOE is taking direct aim at individual equity trading. Its announcement came three months after the options-focused International Securities Exchange said it would launch its own electronic stock trading program, MidPoint Match, in the third quarter of 2006.

It seems the pending Regulation NMS trade-through rule, passed by the U.S. Securities and Exchange Commission in April and set to take effect in February 2007, is keying a spurt of competition in the equity trading space. Reg. NMS shifts the market emphasis away from solely offering best execution. Under the new regulation, brokers and exchanges must be able to guarantee the best price and be able to execute orders automatically.

CBOE officials acknowledged the ISE’s earlier move, but said they think their Hybrid market model, which provides for both electronic and open-outcry trading, gives the CBOE Stock Exchange an edge.

“One of the unique attributes of the market model we’re offering is the Hybrid trading system,” Mr. Provost said at the news conference. He said each stock would have its own designated primary market maker, located at a designated trading post on the CBOE floor, with further liquidity added by multiple competing remote market makers, who can stream quotes and trade electronically from any location, according to the CBOE. The hybrid system will accommodate screen-based electronic trading and include open outcry on a portion of the CBOE trading floor.

The CBOE Stock Exchange will trade the most active 2,500 securities listed on the New York Stock Exchange, the Nasdaq and the American Stock Exchange, as well as exchange-traded funds and other listed securities. The CBOE’s own CBOE Direct trade engine, which already handles CBOE options, OneChicago and CBOE Futures Exchange trading, also will be used for equity trading.

Orders will be matched most likely using an algorithm that places a priority on price and time.

Access to the system will be via permit. All current CBOE members will be given a permit as part of their membership. Non-members will have to apply for a permit. CBOE will be the self-regulatory organization for the CBOE Stock Exchange. The exchange will be regulated by the SEC.

Mr. Provost said the new CBOE Stock Exchange has been designed not only to enhance the CBOE’s business model, but to compete as a viable stock exchange in its own right.

But why open outcry, particularly when markets appear to be moving away from it? Mr. Provost said the CBOE’s customers have indicated they prefer to have a choice: electronic or open outcry. He said that although 95% options orders are completed through the electronic system, the 5% that trade on the floor account for one-third of all CBOE contracts.

“There are customers ?? 1/2 that will use brokers,” he said. “This gives them the choice.”

The CBOE’s insistence on including open outcry in the new venture is notable given the presence of Interactive Brokers as one of the partners. Interactive Brokers is also a partner in the ISE’s all-electronic stock exchange, and Steven J. Sanders, managing director for marketing and business development for Interactive Brokers, said his firm wanted to get involved in both projects specifically as a way to push markets toward electronic trading.

“We have stakes in a number of exchanges,” Mr. Sanders said, among them OneChicago and the Boston Options Exchange, as well as of course the ISE and CBOE initiatives. “From our point of view, we like to hook up liquidity to our smart router. If we can do a trade faster and cheaper, that’s our goal. We invest in these ventures not because we’re going to make a lot of money off them, but because we want to push the industry to do things more efficiently. It’s another opportunity for us to have a say in that.”

Mr. Brodsky said the CBOE wasn’t prepared to disclose the specific cash contributions of the four partners, but he characterized them as being “seven- or eight-figure” amounts. In terms of percentages, VDM Specialists’ contribution is 18% of the total, with LaBranche, Interactive Brokers and Susquehanna International each chipping in 9%. The CBOE’s contribution will be 46%, mainly via technology, systems and regulatory work. Other smaller investors make up the final 9%.

At the same press conference, Mr. Brodsky announced that the CBOE’s board of directors unanimously voted to file an S-4 Registration Statement with the SEC, another step in the process of demutualizing the CBOE and turning it into a for-profit venture.

In the demutualization process, memberships are converted to shares of the new company, according to the CBOE, paving the way for the exchange to pursue an initial public offering down the road.

According to a news release, the CBOE actually began its transition to a for-profit company in January 2006, when it streamlined its operating budget and made other governance changes. The exchange reported that through June of this year, revenues were $129.6 million, up from $98.2 million during the same period in 2005. Income before taxes through June this year was $32 million compared with $8.7 million in the January through June period last year. Retained earnings so far this year were $139.2 million, up from $114.3 million in the first six months of 2005.

“Demutualization provides the ‘strategic optionality’ necessary to chart the course for years to come,” Mr. Brodsky said in a statement. “The conversion of seats to shares allows us to deal in the same currency as our competitors and potential partners at a time when the marketplace embraces the new structure.”

In still another announcement, the CBOE said Mr. Tilley, who had been a CBOE member on the board and vice chairman, would take on an executive position at the exchange as executive vice chairman. He will terminate his member status prior to assuming that position, opening the door for John Smollen, currently a CBOE floor director, to succeed Mr. Tilly as CBOE member vice chairman.

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