With the CBOT's hope for new business and academia's hope for a better trading system, the Chicago Board Options Exchange was launched in April, 1973. Membership of the new exchange was somewhat unique in that memberships (seats) were sold specifically for the new CBOE, but also every full member of the CBOT had a perpetual right to exercise for the privilege of trading on the new exchange. The total number of active traders on the CBOE, then, became the number of CBOE seats available, around 970, and however many CBOT exercisers there were at any given time out of a possible total of around 1400 CBOT seats. This rather odd membership structure had some advantages, namely that the grain markets on the CBOT were usually busy in the summer and slow in winter, opposite the pattern in the options business, thus creating a natural safety valve for members to follow the business. The bad news was that decisions regarding membership issues became very cumbersome.
    
What was the actual set-up of the new exchange? Individual trading pits, containing from one to several stocks, were dispersed around a trading floor. Initially this trading floor was the CBOT cafeteria, but fairly rapidly there was a real floor constructed, actually suspended above the old CBOT trading floor. In these pits, or trading stations, people were performing three distinct functions.

1. Maintenance of the customer order limit book: This function, originally performed by members known as Board Brokers, essentially maintained and organized those customer limit orders that were away from the market. For example, if a particular option was quoted a $2 bid, $2 ¼ offer, a customer could still enter an order to sell some at $4. The floor broker may not want to watch an order that far from the market, or the customer could request that order to be placed in the book. Once placed in the book, and only a customer could do so, that order gained priority over any other order or trade at that price. Simply put, the customer order represented in the book would be filled at $4 before anyone else traded at $4. This book maintenance function was taken over by exchange staff in the late 1970's.
   
2. Floor Brokerage: The floor brokerage function, defined as those members who execute orders for others and not for their own account, was basically divided into two types. The first were those, many of whom were employees of major brokerage houses, who essentially roamed the floor and went pit to pit with orders to execute. The second were those who essentially set up shop in an individual pit, and looked to use their proximity and market awareness as an edge to gain business in that pit. None of these brokers were able to trade for their own account, they strictly worked for the customer.  When I started, in 1981, there were several of these competing floor brokers in virtually every pit.
   
3. Market Making: To replace the specialist, each pit at the CBOE had a number of members who were charged with the task of making a two-sided (meaning they would buy or sell) market in every option series in that pit. In busy pits, like IBM, there could be 70 to 100 of these market makers actively bidding and offering the various options. Any bid or offer better than the one currently displayed was immediately reflected to the outside world by exchange employed quote reporters in the crowd. These members traded solely for their own proprietary accounts, and were prohibited from executing customer orders. In the early 1980's the large amount of market makers, relative to the number of stocks and the ease of movement from pit to pit, insured competition and made collusion very difficult.

What about my order? In those days, it was simple. Your broker, or the order routing room of your brokerage firm, either called or teletyped the order to their booth on the edge of the trading floor. From there, either a broker would take the order to the trading pit with the intention of executing the order himself, or a runner would take the order to the broker standing in the crowd. If it was a market order, the broker would ask for a market, and complete the trade with either the highest bid or lowest offer, or the first person responding at that bid or offer. Upon execution of the order, the filled order would be returned to the booth for reporting to the broker, then to the customer. With so many people touching the order, the potential for bottlenecks and errors on busy days definitely existed, but each order was forced to be exposed to the competitive process in open outcry. Also, and remember this, the system was designed to reward the best competitive bid or offer, either customer or market maker, with the trade.

Next week we will talk about how changes over time began to erode this competitive process, and how the SEC stood by and watched.

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