When CBOT members wrote the bylaws for Chicago Board Options Exchange (CBOE), they did not explicitly give themselves ownership over the fledgling exchange. In an effort to avoid regulation by the Securities and Exchange Commission (SEC), they gave themselves access to the CBOE trading floor through an Exercise Right Privilege (ERP). Owning an ERP entitled CBOT members to trade on the CBOE at will; when things slowed down, CBOT members could simply walk across the street and trade equity options.
The arrangement made for periodic battles between the two neighbors, which where exacerbated by two movements that radically altered the exchange world: the massive push to convert mutually owned exchanges to publicly traded for-profit corporations, and the exchange consolidation movement. Until the CBOE can answer who owns the CBOE and how much they own, the CBOE’s efforts to raise cash through an IPO or take part in a merger will be stymied.
Last year, the CBOE declared that because the surviving entity in the CME/CBOT merger was the CME Group, there were no longer CBOT members to exercise the 1,322 ERPs they held. Their right to do this is being challenged by CBOT members in a Delaware Court and the CME Group has pledged to support the cost of the litigation.
The SEC agreed to CBOE’s rules change, and now the economic rights of the former CBOT members will be decided by the Delaware Court. And it’s safe to say that given how long the issue has been disputed, how much money is at stake and the fact that the CME Group has removed a $15 million cap on litigating the issue, any decision is likely to be appealed. Efforts to settle out of court have repeatedly failed.
“To get a decision could take so long that I buy into Bill Brodsky’s argument that a reasonable settlement on a timely basis could be more valuable to us than the correct settlement that takes an awful lot longer,” says Brendan Caldwell, president and CEO of Caldwell Investment Management LTD. Caldwell owns 44 CBOE memberships, which he values at more than $100 million. He also notes that the CBOE is now the last privately held equity options exchange in the United States, and should become a publicly traded corporation soon. “It’s not now fighting against Philadelphia or even the ISE. It’s fighting [NYSE Euronext], the Nasdaq, the Deutsche Bourse – the biggest exchange on earth by market cap. That’s who their competitors are now. It’s pretty hard to compete on a level footing if you don’t have the same access to the capital markets as the people you’re fighting.”
In midst of the conflict, industry consolidation and larger international competition, William Brodsky, CBOE chairman and CEO is unbowed.
“It has virtually no effect,” Brodsky says. “They are all dealing with integration issues,” he says of the NYSE, which merged with Euronext and is integrating Arca and potentially the Amex; the Nasdaq, which acquired the Philadelphia Stock Exchange; and the ISE, which is now part of Eurex. “We are what we have always been: totally focused and dedicated to the options and options-related products. So even though we own our own futures exchange, where we traded a million VIX futures last year, it all feeds our options business. We created our own stock exchange so we could have the synergy between options and stocks. So CBOE has been and continues to be the leading options exchange in the world.” And while CBOE has not demutualized, it has been operating as a for-profit corporation for three years, and Brodsky says 2007 results, which haven’t been released yet, “blew away” last year’s.
Brodsky says that the utility of the new products, such as the VIX and Buy/Write indexes, has increased the CBOE’s user base. The recent market volatility caused by the U.S. economic crisis has increased volume for CBOE because the CBOE suite of volatility products is now being used by investment consultants for clients who had never previously used futures or options. “When you have institutional money managers who understand what has happened in the stock market for the last 12 months, they usually show the S&P as the indicator, if you overlay the VIX against that, you will see how counter cyclical that is. So we have really created a new asset class here.”
And while CME Group likes to cite its history of innovation, CBOE has had great success with new product offerings. “We have created a cottage industry of products that different types of investors can use. On top of that, we have firms that have been spawned out of the CBOE: Options Express, Think or Swim, or OptionsHouse, all homegrown Chicago firms where their founders came off the CBOE floor and where they have made their raison d'ê·tre to educate retail investors,” Brodsky says.
CBOE’s unique hybrid strategy, where open outcry and electronic trading are integrated on the CBOEdirect trading platform, has allowed CBOE to fight off competition. “We now do 96% or 97% of our trades electronically. The 3% that we are not doing electronically represents about 25% of our volume. The floor is still adding value, providing liquidity, handling complex orders,” Brodsky says, adding, “The future of trading on the CBOE floor is brighter because of the way we developed our system, which I predict is not the case for other floors in town as it relates to futures.”
