The value of CBOE

The Chicago Board Options Exchange (CBOE) is on the cusp of an IPO while risk and opportunity remain pervasive. U.S. equity options markets have always been competitive, although to the chagrin of the incumbents, none of them spotted the electronic trading niche brilliantly exploited by ISE. There are also other threats: True, an ISE legal challenge to the CBOE's exclusive trading of various indices is probably unlikely to succeed. However, the outcome of an infringement lawsuit concerning an ISE patent on proportional allocation of trades is less clear cut. The ISE may not benefit from a willful infringement order claim of up to $900 million but even a fraction of the base $300 million claim provides cause for CBOE shareholder concern.

The CBOE float was long delayed by the CBOT ownership rights dispute. This has led to an interesting anomaly in the pricing of CBOE seats. Where quoted exchanges once rose to lofty peaks, the FTSE Mondovisione Exchanges Index is now less than half its all-time highs. The CBOE seat price has retraced much less from its 2008 all time high of $3.3 million. As the ISE patent infringement suit has become public knowledge, CBOE seat prices dipped to post bubble lows of $2.2 million on June 1 and 3. Prior to this, the Caldwell's loudly trumpeted their purchase at $2,350,000 May 20th (they hold more than 50 seats). In recent days a trio of seats sold at $2,474,900 on June 4 but these seem to have been transactions between related parties. June 6 and 7 saw trades at $2,250,000 and $2,400,000 respectively.

Scanning the recent market share numbers, it seems seat holders are understandably transacting via CBOE. However, I am not entirely convinced that such volume will entirely remain once CBOE equity can be freely traded. At least in the short term, this could undermine the CBOE assertion that their new C2 options exchange will be a big factor in volume growth. Rather CBOE may struggle to maintain market share at the end of the lock-in period. Likewise profit margins: CBOE is under pressure to reduce costs by the SEC, who are seeking a 30 cent options transaction fee cap. Here, one can feel certain sympathy with CBOE as the perils of member ownership have meant that despite stringent efforts at creating electronic capacity, their market is still hampered with the entirely outmoded open outcry floor which is expensively inefficient compared with a computerized marketplace. This is clearly apparent in CBOE's headcount which at nearly 600 is approaching three times that of the lean ISE!

As a standalone business case, CBOE represents a very significant business with strong operational management. However, it is tough to value the CBOE at a multiple remotely equivalent to CME Group for one simple reason: CBOE has no clearing house. True, CBOE will soon be the only single American girl at the prom. However, the frenetic deal making surge of 2006-2008 was very different to the world into which CBOE now goes public. Potential suitors may prove thin on the ground for quite some time. Who wants to be brave making an acquisition at high (dilutive) multiples when a core regulatory risk is stalking all markets?

As I podcasted over a year ago, there may be considerable value in acquiring a company run by Bill Brodsky who is certainly the best connected exchange official with the current White House. With a successful IPO completed and stock options exercised then once his ground-breaking term as Chairman of the World Federation of Exchanges ends early next year, Brodsky will presumably progress to a new career in Washington D.C.

The CBOE IPO will doubtlessly succeed. The actual IPO amount is fairly modest. The company is a good one with experienced management and much potential. However, it is really difficult to justify the notion that CBOE is going to explode in public trading simply because it is a major exchange. In recent days there has been clear evidence that many regard exchange IPOs as simple 'slam dunk' affairs. The CBOE floatation looks more like a case of "stags beware."

As usual, I am available for CBOE and other calls via the usual channels throughout European and US working hours.

With best wishes,

Patrick L Young
patrick@derivativesvision.com

Patrick L Young, author of the bestselling "Capital Market Revolution!" books is an accomplished trader who has advised many leading exchanges world-wide. Nowadays he concentrates on advising investors in exchanges and financial market infrastructure. He is also actively involved in emerging markets, particularly Eastern Europe.
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