Archipelago Plunges into Options Trading with PCX Acquisition

With options trading volume growing faster than equities, Archipelago says it will acquire PCX Holdings, parent company of the Pacific Exchange and Pacific Equities, in a move to offer options trading side-by-side with stock trading on its all-electronic platform.

Gerald Putnam, Chairman and CEO of Archipelago, said there were synergies between the two markets as well as potential for cost savings during a briefing on Tuesday for analysts and media.

The deal, which depends on winning approval from the Securities and Exchange Commission (SEC), will diversify Archipelago's revenue stream into a fast growing market, by allowing Archipelago's equity customers to use the same platform for options trading.

"I think it's going to infuse blood into the Pacific," says Damon Kovelsky, analyst with Financial Insights, based in Framingham, Mass., noting it had fallen behind some of the other options exchanges in recent years. He predicts this may be a harbinger of more exchange consolidation in the U.S. where exchanges are going to diversify into more asset classes like derivatives.

Chicago-based Archipelago will pay PCX shareholders approximately $51 million in cash and stock. In addition to purchasing the options business, Archipelago will also acquire the self-regulatory organization (SRO) of the PCX and its 20 percent ownership interest in the Options Clearing Corporation.

Analysts however were not surprised by the deal noting that both entities had an existing relationship and that PCX is the regulator of Archipelago.

"I think this is the natural evolution of the Arca-PCX relationship," says Kovelsky. In 2000, Archipelago took over the Pacific's equity-trading business - which previously had two floors in San Francisco and Los Angeles. PCX kept the options business, while stock trading moved to Archipelago's screens. As part of Archipelago's conversion from an electronic communications network (ECN)to an exchange, PCX then became its regulator. Today, Archipelago Exchange (ArcaEx) operates as the exclusive equity trading facility of the PCX.

Putnam said one of the reasons for combining with PCX was a push by its customer base - especially where there is an overlap in stock and options trading -- because it would be cheaper to consolidate the activity via Archipelago's infrastructure.

But first, Archipelago needs to integrate its electronic platform with PCX-Plus, PCX's new electronic options trading platform.

PCX currently operates a hybrid options-trading model with a floor in San Francisco and the new PCX-Plus trading system. It's been transitioning from a floor-based options market to an electronic model since 2003 As of the end of 2004; all 1,200 options were trading on PCX-Plus.

"That platform is built and running; it's a distributed platform. So it's like ours and the two systems can talk to one another," says Putnam. "It's been running well and it's increased volume," he says.

Kovelsky of Financial Insights, says he expects the integration to take about a year. Noting that Nasdaq linked up BRUT ECN, Kovelsky says these things can take longer than expected.

However, PCX has been losing market share to the all-electronic International Securities Exchange over the past 18 months, analysts said during the briefing, noting that Archipelago is acquiring one of the smaller players.

PCX ranks in fifth place among the six options exchanges. Its market share -- 9.2 percent of individual equity and index options in November, versus ISE's 30.8 percent -- has been rising since the transition to PCX-Plus. For December PCX averaged 12.3 percent of the market, which was a high for last year, said Philip DeFeo, chairman and CEO of PCX and the Pacific Exchange at the Tuesday briefing.

With competition among the options exchanges heating up, PCX plans to migrate to an all-electronic platform by 2006, said DeFeo, adding that the need for a floor would fade by the end of 2005. "There's enormous costs involved in running a floor as well as the legacy systems that supports that process," says Defeo. He said the transition to a hybrid market required a massive integration between the older system POETS and the new PCX-Plus; in 2004 PCX continued to run both systems.

Analysts however pressed Archipelago and PCX to explain how they were going to save costs and where the growth in revenues was going to come from. Archipelago officials said the acquisition would not add to revenues until 2006. Putnam said that close integration between the two systems would come by late 2006 and at that time he would expect complex options trades.

"Give it a year. If they improve the technology and demonstrate some competitive advantage beyond the ISE and CBOE (Chicago Board Options Exchange), beyond liquidity which will be tough to beat," says Kovelsky. "With some technological innovations, I think they're going to be able to grow the Pacific's options business," "It's not going to be easy," he adds. "It's a challenge." 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