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Is the ISE age over?

David Krell and the International Securities Exchange have revolutionized options trading. But how will the pioneering electronic exchange keep pace as once-sleepy rivals like the NYSE prepare to invade its hard-won turf?

On March 9, David Krell returned in style to the New York Stock Exchange, where eight years earlier he had been a senior executive. It was a chilly Wednesday morning, and Krell, president and CEO of the International Securities Exchange, the all-electronic options market, was meeting for breakfast with a group of his colleagues and their Big Board counterparts, led by CEO John Thain.

The occasion was a festive one -- to celebrate the ISE's initial public offering. Between bites of scrambled eggs, cereal and fruit in the 213-year-old exchange's walnut-paneled boardroom, Thain reached over to offer a congratulatory hand. "Welcome back," said the Big Board chief.

"It's good to be back," replied Krell, smiling broadly.

A few minutes later, Thain accompanied Krell downstairs to the balcony overlooking the trading floor, where the ISE chief and co-founder rang the opening bell. Shares in the options exchange, which had been issued to the public for the first time the previous night, opened at $25.75, up 43 percent from the $18 offering price, and ended the session up 69 percent, the biggest first-day gain for any IPO since 2001.

Krell, an unflappable 58-year-old, had every right to be proud. In 1997 the NYSE had dealt him what looked to be quite a career setback. He had been running the exchange's options trading unit when Richard Grasso, Thain's predecessor as Big Board chief, sold the business to the Chicago Board Options Exchange. Left on the sidelines, Krell and colleague Gary Katz, who had been his No. 2 at the NYSE, soon co-founded the ISE, which launched in May 2000. The New York­based exchange revolutionized the trading of U.S. equity options, about $1.2 trillion of which change hands annually.

Though ridiculed by other exchanges when it started, the ISE so reduced costs and improved efficiency for traders that by 2004 it had grabbed the single biggest share of the rapidly growing options market, surpassing its oldest and strongest rival, the CBOE. The ISE's profits grew by 30 percent last year, to $26.2 million. Its shares have fallen slightly from their first-day close but, at $25.30 as of June 6, are still up 40 percent from their offering price.

"Today the volume at the ISE is larger than the entire industry was" before the exchange launched, says Krell.

But the CEO has had little time to savor success. Just six weeks after the IPO, the world of securities trading was stunned by none other than Krell's cheery breakfast companion that day at the Big Board. In late April, Thain announced the stunning $3.5 billion combination of the NYSE with electronic exchange operator Archipelago Holdings. The following day the Nasdaq Stock Market revealed its planned $934 million acquisition of Instinet's electronic trading platform. The impending deals create two giants among U.S. stock exchanges, which are likely to pursue further deals in a bid to offer simultaneous trading of a wide variety of securities in all parts of the world.

The challenge to the ISE is formidable. Almost overnight it must contend with bigger and stronger competitors, as other consolidating exchanges maneuver to offer multiple products. Moreover, the ISE's first-mover advantage is ebbing, as rivals adopt the kind of sophisticated electronic platforms that give the exchange its edge. In sum, just three months after its public debut, some market observers wonder whether the ISE will be able to sustain its rapid growth and maintain its market dominance as an independent entity.

In combining with Archipelago, for example, the NYSE gains a platform not only for automating much of the stock trading that is now executed by shouting, scurrying human beings on its floor but also for trading options side by side with the underlying equities, a capability that investors increasingly want. (Archipelago in January announced that it was acquiring the Pacific Exchange, an ISE competitor that recently introduced an automated options trading system.) Thain also has made no secret of wanting to trade corporate bonds, and perhaps even futures, to put the NYSE on a par with European exchanges like the Deutsche Börse and Euronext, which combine cash and derivatives trading on one platform. The deal will turn the NYSE into a public company, giving it the currency to make further acquisitions.

Nasdaq CEO Robert Greifeld, although less aggressive about offering new products and trading overseas, has said he will actively consider any deals that would give Nasdaq global, multiproduct capabilities.

"The trend is toward convergence of the cash equity markets and options exchanges," says Jerrell Watts, head of Lehman Brothers' options market­making desk. "That is going to lead to more partnerships between stock exchanges or electronic communications networks and the options exchanges, and to the creation of more integrated products."

As if to underscore the threat to the ISE, Gerald Putnam, the Archipelago CEO who will become an NYSE co-president, recently cited the ISE as one of several potential merger partners for the growing ranks of publicly traded exchanges eager to expand. "Today's exchanges have to trade stocks, options and futures and do so on a global platform," he said. "The ISE is a public company and just trading options today."

The ISE's dominance of U.S. options trading is starting to show signs of weakness. In its IPO prospectus it acknowledged that its early advantage as the only electronic options exchange "has begun to dissipate and will continue to dissipate." Such competitors as the Pacific Exchange and the CBOE have produced electronic systems to complement their trading floors. Another new, all-electronic market, the Boston Options Exchange, has steadily gained market share since its launch in February 2004. As a result, the hectic growth of the ISE's early years has leveled off. Although the exchange boasted the largest share of trading volume in 522 of the 720 options it traded as of last summer, that level has remained virtually unchanged for the past year, according to its IPO prospectus. And the ISE still lags behind the CBOE and other floor-based markets in index options and highly complex, multipart trades that are better suited to manual execution.

Moreover, many experts think there are too many U.S. options exchanges for all to remain independent. The ISE's triumph, they argue, had more to do with the need for innovation than the need for another market; as its electronic formula is copied, consolidation is inevitable.

"Six exchanges may be too much of a good thing," says David Kalt, CEO of electronic options brokerage OptionsXpress. Richard Repetto, an analyst who covers exchanges and electronic brokers for Sandler O'Neill & Partners in New York, concurs: "It's like having six gas stations all near the same corner -- one may be the newest and have the best pumps and top-quality service, but they are all pumping the same gasoline at prices that are getting lower and closer together. The ISE is the best-positioned options exchange. But if it is going to continue to grow, it will have to devise new products and new strategies and find new sources of revenue."

Krell acknowledges the challenges. "Our philosophy is to take nothing for granted," he says. But he also insists that there's no need to rush into a deal or plan a major strategic departure. He cites the banking and brokerage industries as examples of markets where a wide array of competitors have survived for decades. "If those six gas stations are all on a highway with lots of traffic," says Krell, referring to Repetto's analogy, "there's probably lots of growth to go around."

Recent history bolsters that argument. In 2004 some 1.18 billion stock and index options contracts changed hands, up 30 percent from 2003 and a whopping 320 percent from 1994, according to the Options Clearing Corp. Krell reasons that as long as institutions continue to embrace options trading, the ISE will keep growing at a rapid clip. Only about half of options volume comes from institutions today, compared with about three quarters of all stock trading. The ISE has championed structural improvements and new technology that will allow institutions to take big enough options positions to hedge their giant stock holdings, something they're often unable to do elsewhere in today's market. And it is seeking to automate the complex, multipart trades that many institutions prefer, which have been harder to execute electronically. The ISE also plans to introduce a new range of index options, an area that the CBOE has so far dominated through a series of exclusive licensing agreements with index providers, such as Standard & Poor's.

And although speculation has persisted virtually since its launch that the ISE, as its name suggests, would eventually offer trading of stocks, futures and other instruments globally, top executives remain noncommittal about their plans. "Where we believe there is an opportunity, we can provide the market," says exchange co-founder and COO Katz.

But in private Krell is, well, keeping his options open. During the past several months, he has held a battery of meetings with equity trading executives to solicit input about how the ISE might offer its current customers the ability to trade stocks side by side with options. "It was a general discussion," says one person who had such a conversation with Krell. "I'd be surprised if they did anything big anytime soon, but they're clearly thinking about it."

KRELL'S CAGINESS REGARDING STRATEGY IS MORE characteristic of the ISE's style than was the hoopla that surrounded its IPO. Indeed, the venture was conceived and hatched as stealthily as a coup d'état. William Porter, who had already upended the securities industry by developing the technology behind online brokerage E*Trade, launched in 1992, dreamed up the idea for ISE with longtime colleague Marty Averbuch, a former manufacturing and leasing industry executive. They then recruited Krell and Katz to make it happen. Fearful that the concept for the new exchange would leak to rivals, the founders required that prospective investors sign confidentiality agreements before they disclosed details of what they were seeking financing for.

"We really didn't want to tip our hand before we knew exactly where we were going with this," says Porter.

Only after Krell told Porter and Averbuch that the secrecy was hampering his ability to recruit staff did they convene a press conference, in November 1998 -- timed to coincide with Porter's 70th birthday -- to announce the venture. Reporters summoned to the event weren't told what was being announced, only that it would be "worth your while" to attend. "The news was a bolt from the blue for nearly everyone," recalls Sang Lee, managing partner of Aite Group, a Boston-based research firm.

By the time of the news conference, Porter had been exploring options trading for nearly three years and actively planning the new exchange for more than 18 months. His initial goal was modest: find a way to make options trading more profitable for E*Trade and less costly for its clients. Stock trading costs had shriveled throughout the 1990s, but options trading remained expensive, cumbersome and sometimes downright slow. One reason, Averbuch told Porter, was a gentleman's agreement among the several options exchanges not to trade one another's listings. Options on IBM, for instance, traded only on the CBOE; Dell Computer was listed exclusively on the Philadelphia Stock Exchange. Brokers thus had to have employees, memberships and communications connections on all four extant exchanges, each of which had its own monopoly. Another problem: Trades could be routed electronically to exchanges but were executed by humans at a trading post. Even the fastest runner took 30 seconds to get an order to a trader, and it could take five or ten minutes before confirmations reached customers.

To Porter, who was looking for a new challenge after stepping back from running E*Trade's day-to-day operations in 1997, the process seemed irrational -- and represented a huge opportunity. He first tried to agitate for change at the existing exchanges, but they proved unwilling to alter the status quo. Porter recalls visiting the American Stock Exchange and talking with one of its top officials while overlooking the bustling options trading floor, where traders scooted from telephone to trading post brandishing wads of paper order tickets. "It's a hell of an operation," said Porter. "It ought to be," replied the executive, whom Porter declines to name. "It's a monopoly."

That was like waving a red flag in front of an agitated bull. "You just don't say that to an entrepreneur," says a still incredulous Porter. "I didn't say anything, but my next stop was Washington, to the SEC."

At the Securities and Exchange Commission's spartan offices in downtown Washington, Porter met with Richard Lindsey, then head of the agency's division of market regulation, and asked how to go about starting a new exchange. "Well," Lindsey told him, "just fill out a Form 1, and in a few months or so, we'll give you an answer."

It turned out to be a little harder than that. The last new exchange approved by the SEC had been the CBOE, which opened its doors in the smoking room at the Chicago Board of Trade in 1973. No one at the SEC could remember what a Form 1 looked like or how to undertake the process of approving a new exchange. And the regulatory challenges were just the preliminary hurdles. Over the next three years, Porter and Averbuch also confronted technological, financial and competitive obstacles. Knowing little about the arcane world of options trading, they approached Krell and Katz. When the NYSE sold its options business to the CBOE, Averbuch decided the chance was too good to pass up. "I called Bill and said, 'We've got to hire these guys. It's a natural fit,'" he recalls.

The combination proved powerful. Krell and Katz had deep knowledge of options markets, and Porter and Averbuch were proven entrepreneurs.

Their biggest challenge: finding and deploying the right technology. For every stock on the NYSE or Nasdaq, there can be hundreds of options contracts. Some give the holder the right to buy shares of the stock in the future; others confer the right to sell. Both varieties can bear multiple strike prices -- the prices at which the future buying or selling will take place -- and expiration dates. If Dell shares are bid up a penny in Nasdaq trading, the quotes for hundreds of options contracts tied to the stock also change, creating a huge technological hurdle for any electronic options market. "The NYSE has 3,000 stocks, but we have to disseminate quotes on 77,000 securities," says Katz.

The ISE's co-founders hired Stockholm-based trading system developer OM Gruppen, which assigned more than two dozen engineers to customize its off-the-shelf order-matching software. Says Krell: "Even five years earlier we couldn't have done this. The technology and the bandwidth just weren't available."

Meanwhile, Averbuch went about raising capital. The first $6 million of seed financing had come from KAP Group, a private partnership whose name came from the initials of Krell, Averbuch and Porter, and from E-Trade. The founders set up Adirondack Trading Partners to help finance the rest of the start-up costs, which rapidly ballooned from an estimated $20 million to nearly $60 million. A group of discount brokerage firms and KAP were the major investors in Adirondack. In return for $35 million, Adirondack was allocated nearly all the seats on the exchange.

But the SEC insisted that the exchange be owned by a more diverse group of members. So Adirondack offered its seats to Wall Street firms: Fifteen million dollars bought one of ten primary market maker (PMM) seats, with 100 less-lucrative competitive market maker (CMM) seats going for $1 million each. Each PMM oversees a "bin" of options contracts, with responsibility for ensuring an orderly market and serving as a single point of contact for customers who have questions. Each of the ten bins can have as many as 16 CMMs, which are required to post continuous quotes in at least 60 percent of the options classes in their assigned group. Firms were allowed to buy a maximum of one PMM seat and nine CMM seats. As an added incentive the ISE offered buyers the right to sell the seats back to Adirondack should the exchange fail. Nevertheless, firms were slow to join. "They were positive on the project but didn't want to take any risk," recalls Averbuch. "It took literally years to get a 'yes' from them."

Getting Wall Street firms on board was critical. The ISE had to start with enough trading interest to ensure more attractive buy and sell quotes than its competitors. "No one wants to leave a liquid market for a less-liquid market, so once you have liquidity, it's tough to lose it," explains Aite Group's Lee.

Ultimately, several big firms, including Goldman, Sachs & Co., Morgan Stanley & Co. and Bear, Stearns & Co., bought seats. All were funneling a lot of options orders to other exchange floors, using local market makers and specialists. In the ISE they saw the possibility of quicker, cheaper execution. "Because they were investors, they had a vested interest in bringing orders to the ISE rather than to other exchanges, as long as our quotes were competitive," says Averbuch.

By mid-1999 the ISE's staff of 50 had moved into its current headquarters at 60 Broad Street, barely a block from the NYSE. The team was now working in the spotlight, however, and rivals were preparing a series of counterstrikes. That summer the CBOE eliminated trading fees for its customers, wiping 30 to 40 cents off the cost of executing a typical contract. And it took the first step toward demolishing the exclusive listings system (already under attack by the SEC and the Department of Justice) by beginning to trade options on Dell and making plans for more such cross-listings.

But the moves were too little, too late.

"All they were doing was talking about competing with the ISE, not innovating," says OptionsXpress CEO Kalt. "We knew that our customers still weren't getting the best pricing."

Even as exclusive listings waned, the various exchanges weren't required to match or even publicize one another's quotes. Customers still had to scan all markets in search of the best prices. The solution seemed to be an electronic exchange that opened itself to all market participants -- market makers, Wall Street firms and end customers -- a novel concept that the four traditional options exchanges were still unwilling to embrace.

On February 24, 2000 -- nearly three years after Porter first met with SEC officials -- regulators approved the creation of the ISE, applauding the customer-friendly improvements that looming competition had already inspired at the other exchanges. The first ISE trades flickered across a giant computer screen in the exchange's boardroom in late May. It was a modest debut: Options on only three moderately active stocks, Alcoa, LSI Logic Corp. and SBC Communications, changed hands. Trading in them amounted to less than one third of 1 percent of all options trading that day.

Right from the start, though, traders cottoned to the ISE's electronic platform. "They revolutionized every part of what we do as market makers and traders," says James Harkness, chief operating officer at Wolverine Trading, a big options trading and market making firm. "Trading options suddenly became faster, cheaper, more transparent and more efficient."

One result: far smaller differences between the best buy and sell quotes for a given option class than in other markets. The superior prices attracted more volume, creating still-tighter spreads.

From inception the ISE did its best to cater to its customers. Recognizing that firms making markets on the exchange would be highly dependent on the reliability of its technology and communications infrastructure, the ISE allowed market makers to pull their quotes in the event of a technical malfunction that prevented prompt quote updates. And when things did go wrong, the exchange bent over backward to keep customers happy. When an OptionsXpress client faced a nearly $30,000 loss because a network fault delayed his order for more than ten minutes last year, Krell and Katz told Kalt the exchange would make the customer whole. "They stepped up and took care of it," Kalt says today. "My business and the exchange's reputation were most important to them."

More recently, the ISE has made changes to encourage more trading by institutional investors. In January 2003 it required that market makers execute all orders at the prevailing quoted price, regardless of whether the buyer or seller was a customer or a rival market maker. Previously, market makers could opt not to fill orders placed by other professionals. ISE members at first opposed the change, known as "one size fits all," but Krell and Katz convinced them that in the long run, it would bring them all more business.

"Before we introduced one size fits all, you could look at a screen and see a price, but you never knew if you could actually get that price," explains Katz. "Market makers coveted customer flow above other professional orders. But institutions kept telling us that if we really wanted them as customers, we would fix this. So we did."

Big investors seem to appreciate the effort. "That's the kind of innovation we needed to see in order to launch our new fund," says the manager of a New York­based hedge fund that specializes in profiting from market volatility, which requires the heavy use of options. "We needed the ability to execute rapidly, in size, in very liquid markets and with confidence, and we got that at the ISE."

Before its debut Krell had predicted that the exchange could eventually seize one fifth of options trading volume. Skeptics scoffed. "I remember laughing at that prediction," says Aite Group's Lee. But supporters and naysayers alike were dumbfounded by how quickly the new market grew. Its share of all trading in single-stock options soared from 8 percent in 2001 to 33 percent in 2004. The ISE has held steady at that level so far this year; the long-dominant CBOE is a distant second with 25 percent, followed by the Amex (16 percent), the Pacific Exchange (11 percent), the Philadelphia exchange (10 percent) and the new Boston exchange (5 percent).

But the ISE wasn't just taking a bigger piece of the pie. Options trading itself was expanding at a brisk pace, to more than 4 million contracts traded daily last year from only about 1 million when the ISE debuted in 2000. Many market participants credit the ISE for much of that growth, noting that it has made options trading faster, easier and less risky.

"We could never have gotten into trading options significantly as long as it was a floor-based business," says Matthew Andresen, president of Citadel Execution Services, a division of Citadel Investment Group, the huge Chicago hedge fund firm. "The ISE made this possible. In some ways our two businesses have grown up together: Their arrival on the scene changed our own business." Citadel is now one of the options industry's biggest market makers and is the biggest single user of the exchange.

AFTER SURGING TO THE TOP OF THE OPTIONS trading world in 2004, the ISE seemed perfectly positioned for the next step: a public offering of stock. Its founders hoped to duplicate the runaway success of another derivatives market, the Chicago Mercantile Exchange, whose shares are up 468 percent since its December 2002 IPO. To be sure, the parallel wasn't perfect; the 104-year-old CME, after all, had a monopoly on many of its key products, more revenues and profits and a longer operating history. But the boom in the options industry created a buzz that was hard for potential investors to resist. Certainly, those able to buy the stock near the IPO price have fared well. Though ISE shares are trading below their high of $31.69, the current price, $25.30, represents a 40 percent profit in just three months. And the shares have ticked up since late April, when the ISE announced that first-quarter earnings had jumped 20 percent over the previous-year period, to $8.9 million.

But Krell must prove that he can meet the serious threats posed by the NYSE-Archipelago and Nasdaq-Instinet mergers, not to mention contend with the speed at which rival U.S. options exchanges are narrowing the technology gap.

"The ISE got a boost because it started from scratch with technology that wasn't available before," says William Brodsky, CEO of the CBOE. "But we haven't been sitting around doing nothing. We are rolling out our own technology innovations. We are alive and thriving in this environment."

Indeed, now that rivals are automating more trading, the ISE will find it harder to hold on to its market share. And in some cases, customers may actually prefer a combination of electronic and manual execution. That can be particularly true for complex trades or during times of market stress. Consider April 15, when options volume hit a record 10.1 million contracts amid a big stock market decline. The ISE still executed the biggest share of single-stock options trades that day, but its 32 percent take only narrowly bested the CBOE's 30 percent. And more than half of the volume in options on the popular Standard & Poor's depositary receipts, which follow the performance of the S&P 500 index, traded on the CBOE. The ISE, despite being the first market to list the SPDR options in early 2003, garnered only 20 percent of their volume that day.

"Many of our users want to be able to harness the intellectual capital of the people on the trading floor and still provide an electronic execution ability for those who want it," says Brodsky.

Growing competition is one reason Sandler O'Neill analyst Repetto has rated ISE stock a "hold" at its current price. A self-described "strong believer" in ISE's model, he nevertheless points out that, comparatively speaking, the CME generates stronger profit margins in a market in which barriers to entry are more substantial.

The latest wrinkle is the NYSE's reentry into the options trading business through its combination with Archipelago. If approved by members and regulators, the merger would simply intensify the competitive threat. Although the NYSE's Thain and Archipelago CEO Putnam made only fleeting mention of options trading at their joint press conference announcing the deal in April, Thain did refer to the exchange's interest in other asset classes. "The growth and profitability of the NYSE will be constrained as long as we are limited to one product," he said.

Traders would welcome an electronic trading platform that offers seamless trading between stocks and other equity-related securities, particularly options. "Exchanges used to compete by having unique products; now they compete on how easy and transparent the trading system is," says Lehman's Watts. The next logical step, he adds, is to offer a system that allows users to manage both stocks and options together.

The ISE isn't taking the threats lightly. It has a modest war chest: Sandler O'Neill's Repetto calculates that it generates about $10 million of free cash quarterly and that its share of the IPO proceeds boosted its cash position to $82.6 million from $44.8 million. It also has a new staff member charged with figuring out how to deploy that cash: Thomas Ascher, a former CBOE vice chairman who joined the ISE as chief strategy officer just days after its IPO.

So far, though, the exchange continues to eschew bold plans, at least publicly. Though Krell has held exploratory discussions with equities executives about potentially launching stock trading, any such move isn't likely to come soon. The only thing that Krell and Katz will acknowledge publicly in the way of product innovation is a continuation of efforts to lure more institutions into options trading. The ISE has asked the SEC to allow its users to trade big blocks of contracts at price intervals finer than the current five-cent minimum for most options, a step that would make it easier for fund managers to take large positions. It is also focusing on developing technology that will allow certain complex transactions, such as those known in the industry as spread trades and butterfly trades, to be executed electronically.

Meanwhile, the ISE will try to create new index products along the lines of the SPDRs options, though relationships between existing exchanges and index publishers present a challenge to doing so. Indeed, late last month Dow Jones & Co. won a temporary restraining order from a federal judge to prevent the ISE from listing options on the publishing company's Diamonds investment trust, which is based on its Dow Jones industrial average, without a license. Last month the ISE cross-listed a series of options on Russell stock indexes, though these products trade lightly on competing exchanges and aren't expected to boost the ISE's market share significantly. Potentially more promising are options on a series of proprietary indexes the exchange plans to launch, as well as planned options on FTSE global stock indexes.

Overseas expansion might be more likely in the near future than branching out into stocks or other derivatives. Despite its name the only international dimension to the ISE's current operations is the fact that it makes markets in options on the U.S.-listed shares of foreign companies. But the IPO prospectus hints at initiatives in this arena, including allowing members to trade from overseas, a move that would generate a new source of access fees. That strategy, the prospectus says, may include "relying on distribution systems established by our future strategic alliance partners." Krell, Katz and Porter, who's still a director of the exchange, decline to comment on what alliances might be in the works.

Regardless of what happens next, Porter, now 76, says he is already satisfied with what he accomplished in launching both E-Trade and the ISE. "I feel really good -- I changed the whole brokerage business, that whole industry, for the betterment of the country, and then went out and changed the whole financial landscape again with ISE," he says. "How many people have created two entirely different new business models on Wall Street in a single lifetime?"

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