The Battle Over Index Options
An industry source reminded me recently that major events happen in the financial industry for three reasons: fear, greed and regulation. I disagree. In today's equity and options world, competition is emerging as the major catalyst for change.
As everyone knows, there are two important court cases circulating in the industry right now (and a third could be brewing) that are fighting against allowing exchanges to hold exclusive rights to proprietary products. Industry executives say exclusive licenses are necessary to reward innovation. Though inventors of index products should be rewarded for their efforts, I believe that there should be a time limit on exclusive listings, and licensing fees should not be used to block competition. As each of these cases illustrates, incumbents don't share my views.
First, a licensing battle erupted because the International Securities Exchange (ISE) wanted to trade options based on Spiders - the popular exchange-traded fund (ETF) that tracks the Standard & Poor's 500 index - without a license from S&P. S&P believed that it was entitled to sell a license on the index to each of the exchanges that creates a product based on it. The court ruled that ISE needed a license to trade the option. Though ISE lost the licensing battle, the decision gave S&P the green light to sell licenses to each of the options exchanges. As a result, on Jan. 10, six U.S. options exchanges introduced options contracts on Spiders and orders now are routed electronically everywhere in the spirit of competition.
Another fight brewing is Nasdaq's suit against Archipelago and the Pacific Exchange over trading the QQQs - the ETF based on the Nasdaq 100 stock index. In September, a federal court ruled that Archipelago didn't need a license from Nasdaq to trade the QQQs (which has since been renamed QQQQs). This created a huge precedent for the trading community, especially neophyte electronic exchanges such as the ISE that aspire to trade competitive products listed on traditional exchanges.
What's next? Probably the CBOE's SPX. Since 1983, the CBOE has had an exclusive license with Standard & Poor's Corp. to trade the S&P's Index Option.
Two years ago, the ISE petitioned the SEC to ban the CBOE's exclusively listed products. In a letter to member firms, dated Jan. 7, CBOE senior management writes: "Obviously, we will vigorously defend and protect our legal rights to trade our proprietary index products."
Though I am not a lawyer and I am not qualified to analyze the legal nuances of intellectual property law - patents, copyrights and trademarks - I do know when something smacks of unfairness. Is it fair for one exchange to have a lock on trading a vital index contract?
The CBOE has been the leading innovator in index options and now other exchanges are invading its turf. While I agree that inventors should be rewarded for innovation, does that mean an exchange should have an exclusive on trading a product forever?
Perhaps there should be a time limit on licensing agreements. Look at the pharmaceutical industry, in which big drug companies like Merck and Pfizer spend millions - far more than index publishers - on developing and marketing new drugs and then the Federal Drug Administration awards them patents that expire in six or seven years. Once these patents expire, blockbuster drugs are sold under generic brands - equivalent to multiple listings. By instilling more competition, consumers pay lower prices and vital drugs reach more people.
Similarly, when securities and options contracts are traded on multiple exchanges, investors benefit because spreads narrow, liquidity deepens, volumes increase and customer service improves. And isn't that the point?
Ivy Schmerken is a 20-year WS&T veteran. As Editor at Large, she covers trading for both Wall Street & Technology and Advanced Trading. [email protected]Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio