CBOE Can Grow Without Merger Partner, Brodsky Says

Brodsky Says U.S. Options Exchange Can Grow Without Partner
William Brodsky, chairman and chief executive officer of the Chicago Board Options Exchange. Photographer: Ramin Talaie/Bloomberg

CBOE Holdings Inc., operator of the largest U.S. options exchange that went public last month, has no need for a merger partner, Chief Executive Officer William Brodsky said.

“We’re not in need of someone else’s money,” Brodsky said in a July 26 interview. “We’ve shown we can run ourselves as an independent company, be profitable and produce a lot of cash. Other exchanges were new at managing themselves as for-profit companies” when they made initial public offerings, he said. Chicago-based CBOE has been a for-profit exchange since 2006.

CBOE sold shares on June 14 at a price that was 53 percent more expensive than NYSE Euronext and Deutsche Boerse AG after exchange operators saw at least $61 billion of acquisitions since 2007, data compiled by Bloomberg show. Nymex Holdings Inc., CBOT Holdings Inc. and International Securities Exchange Holdings Inc., which went public in 2005 and 2006, were all bought within three years of their IPOs after government regulations boosted competition.

Shares of Chicago-based CBOE traded for $26.45 at 11:25 a.m. New York time today, down 8.8 percent from the price they were sold for in an initial public offering on June 14.

‘Enticing Target’

CBOE is “likely an enticing target for larger exchanges,” Macquarie Group Ltd. analyst Ed Ditmire, who has an “outperform” rating on the stock, said in a July 26 report. Ditmire estimates the shares may rally to $33 within the next 12 months. CME Group Inc. is the U.S. largest exchange with a market value of $18.6 billion, followed by NYSE Euronext’s $7.5 billion and Nasdaq OMX Group Inc.’s $4 billion. CBOE is valued at $2.71 billion.

The company plans to expand its volatility trading and derivatives business as the U.S. Securities and Exchange Commission considers rules that, if approved, could shrink options revenue for CBOE and other venue operators. U.S. trading volume has increased almost fivefold in the past decade, according to data from Chicago-based Options Clearing Corp.

CBOE will extend the franchise based on its proprietary Chicago Board Options Exchange Volatility Index, or VIX, a benchmark measure of expectations about volatility known as the “fear gauge,” to other products via licensing agreements, Brodsky said. VIX options traded about 30 million contracts in the first half of this year, compared with less than 12 million a year earlier, OCC data showed. Futures on the VIX traded 1.7 million contracts in the first half of 2010, outpacing last year’s total 1.2 million contracts, according to CBOE.

‘VIX-Like Products’

“In some places CBOE is better known by VIX than by our own name,” Brodsky said. “There will be other VIX-like products that we hope will trade in different countries and on different exchanges. That will add to our profitability over time.”

CME, the world’s largest futures exchange, is licensing the VIX methodology from CBOE to create volatility indexes in commodities including corn and crude oil, CBOE said in March. Through a licensing and marketing deal with Standard & Poor’s, a unit of McGraw-Hill Cos., CBOE has agreements with Euronext in Paris, Taiwan Futures Exchange, India’s National Stock Exchange and the Australian Stock Exchange to apply the VIX methodology to products on those markets. Euronext is owned by New York- based NYSE Euronext.

Options Growth

Brodsky said growth in options trading may accelerate as firms shift to trading on exchanges rather than over the counter. Volume in index products that trade only on CBOE could also rise, he said. The company has exclusive licenses for options on the Standard & Poor’s 500 Index, S&P 100 and Dow Jones Industrial Average.

Index options account for a quarter of CBOE’s volume, with fees from those trades providing about 45 percent of operating earnings, Richard Repetto, an analyst at Sandler O’Neill & Partners LP, wrote in a note July 26. An Illinois circuit court earlier this month upheld CBOE’s exclusive licensing agreements with the owners of the S&P 500 and the Dow, preventing the ISE from listing or trading options on the gauges. ISE is owned by Frankfurt-based Eurex.

CBOE plans to introduce a second, electronic platform called C2 to trade options later this year with its matching engines in Secaucus, New Jersey, to appeal to high-frequency trading firms that execute orders in millionths of a second. CBOE’s new venue will “bring its biggest revenue producer, S&P 500 options, into the electronic age,” Ditmire said in his report. The contract currently trades only on the CBOE’s Chicago floor. “We expect C2 to increase CBOE’s market share and the appeal of S&P 500 options,” he said.

‘Consolidation Wave’

The company may face competition for its index products from options on exchange-traded funds, which are traded on all exchanges, said Roger Freeman, an analyst at Barclays Plc in New York, in a July 26 report. Freeman, who has an “equal weight” rating on the stock and expects CBOE to trade around $27 in the next 12 months, also said the “consolidation wave” among exchanges of the last decade is dissipating.

Eleven out of 15 analysts tracked by Bloomberg have a “hold” rating on CBOE, with three recommending investors buy the stock. Ticonderoga Securities, which suggests the shares be sold, expects CBOE may decline to $24.50 in the next year. CBOE competes with seven exchanges for options on stocks and ETFs.

As CBOE expands, the SEC may introduce rules that would reduce profitability on some options contracts. The regulator in April proposed capping fees exchanges charge at 30 cents a contract to make the prices investors see from multiple markets comparable. The cap would also apply to contracts listed on a single exchange such as CBOE that may pay license fees to trade index-based products.

‘Rate-Making Business’

In the proposal, the SEC said a cap could shrink CBOE’s $314.5 million in annual revenue from transaction fees by $23.9 million, or 7.6 percent. CBOE, whose own calculations showed a potential loss of $14.2 million, said the restriction would harm competition between exchanges and impair its business from products used by individual investors and asset managers.

CBOE wrote a 42-page letter to the SEC criticizing the rule and Brodsky held meetings to discuss regulatory concerns with four of the five commissioners including SEC Chairman Mary Schapiro and executives in the trading and markets division, which writes the rules governing the marketplace.

“The SEC shouldn’t get into the rate-making business,” Brodsky said. Fee caps in equities “helped force” stock exchanges to adopt a pricing model that pays people for providing liquidity and charges those executing against orders in the market, he said. Regulators shouldn’t push the market toward a single business model, he said.

Flash Orders

The SEC in September also proposed banning flash orders in equities and options, which the agency and NYSE Euronext said could create two-tiered markets. Supporters of the orders, including discount brokers, said the mechanism in options allows investors to reduce the fees they would be obliged to pay on some markets.

“Flash in options came up because Senator Charles Schumer raised it in the context of New York Stock Exchange and its competition with others,” Brodsky said of the Democrat from New York. “Just because the SEC did something in stocks doesn’t mean that should automatically apply in options,” he said.

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