In part 4 we talked about the original design of the CBOEas a competitive system with strict separation of principal and agent. Only a few years later a competing options exchange opened at the American Stock Exchange, but this trading system did involve a specialist system with additional competing market makers. Over time there became a competition of sorts between the competitive market maker system at the CBOE and the modified specialist system at the AMEX. What caused the evolution of the CBOE, and to a certain extent, the AMEX, from competitive ones to essentially strict specialist systems with combined principal and agency functions?

1. The first, and probably most important, is the change in the relative numbers of members versus listed stocks over time. When I started trading on the CBOE in late 1981 the CBOE had 971 full members, approximately 500 Board of Trade members that had exercised their right to trade of the CBOE, and roughly 400 "special" members able to trade 20 stocks that were acquired from the Midwest Stock Exchange. The total number of stocks listed on the CBOE was roughly between 125 and 150. In June 1990 the "special" seats expired per agreement and the total number of members was reduced by that 400.  Also, the CBOE had successfully launched the OEX and SPX index products that attracted as many as 450 members into those pits on any given day. Combine that with an aggressive listing program that now has the CBOE with around 1700 listed stocks.
   
   How can this be? How can anyone think that there can be competition when there are as many stocks as competitors? How can the same exchange that had the foresight to build a potential additional trading floor during original construction not see the need for any new members as the stocks listed grew at least 10 times? Why wasn't it a part of the CBOE constitution or ongoing SEC policy to require at least one new member for every new listing? The answer is that in most peoples' mind competition is the greatest thing for industries other than your own. It is a pretty hard sell to get the five traders semi-colluding in a particular pit to vote for the welcoming of five new traders in that pit for the purposes of better pricing to the investment public. Isn't that the same as worse pricing and a smaller slice of the pie for those five traders? One needs only to look at the regulated airline industry for another example of industry members convincing federal regulators how no new airlines were needed from the mid-1930's to the mid-1970's despite geometric growth in the industry. Should it have been their decision?
         
2. One of the weaknesses in the CBOE system outlined last time was the difficulty in moving the paper orders and fills back and forth from the trading pits. Of particular concern was the paper jam in the CBOE's busiest pit, the OEX. At the time, the OEX was doing a volume roughly equal to the rest of the floor combined, and greater than any other options exchange. Research indicated that a significant percentage of the orders, roughly 20%, were in lots of from 1 to 5 contracts, and that these orders totaled less than 5% of the contracts traded. To solve this problem, the CBOE designed and instituted a retail automatic order execution system, or RAES. Under this system market or marketable limit orders would automatically be executed electronically with members that had signed up for the program. These trades would be assigned sequentially in alphabetical order. Eventually this system was expanded and brought out floor wide. The problem was that the system was inherently flawed, the market maker offering or bidding at the best price, or the customer order that bettered the market, would probably not get the trade. Imagine the situation where the market is $2 bid, $2 ¼ offered, and you as a market maker decide to be $2 1/8 bid. An order to sell ten at the market comes in through the RAES system and is assigned to a trader on the system. Not only did you not get to buy them on your bid, you are probably hearing loudly that you cost the other trader $125, for he surely thinks that if you did not "narrow" the market, he would have bought the same ten lot at $2. The system was a huge disincentive to compete.  Despite knowing of these anti-competitive flaws in the system, the CBOE has not seen fit in over 15 years to fix it.
         
3. The third anti-competitive "development" was the invention of auto-quote. As the amount of stocks, or stocks per member, grew and the amount of listed individual strikes grew even more due to market volatility, it became virtually impossible for members to manually update all the quotes disseminated to the public. The solution was an automatic quote system that would automatically update quotes based on stock movement and preset parameters. The problem was there is only one system per pit, and competitive quotes became "our markets" and the competition became more for a larger share of the order traded at the "common" price.

Taking the above three developments together it can be seen that the competitive process had been seriously eroded, even before the later developments of the specialist system and declines in fiduciary responsibility of member firms. We will talk about those developments later. As to where was the SEC or the public board members of the CBOE on the above three developments? I read once that there are three types of people in the world, some people make things happen, some people watch things happen, some people wonder what happened. We must have had some people in category three.

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