A few articles ago, in Order Execution-Part 5, we discussed several structural changes and electronic “advancements” that were having some negative effects on the competitive process at the CBOE.   These changes were the rapid growth in the relative number of stocks versus competing members, the RAES system assigning trades without regard to the origin of the best bid or offer, and the singular nature of the automatic quote system. The negative competitive effects of these changes were not uniform, however, and differences began to develop in the competitiveness of the various crowds and how customer orders were treated in different sections of the trading floor.

           
To the casual visitor the trading floor of the CBOE looks like a mass of quote screens and people, some scurrying around with orders and fills, but most settled in the various trading crowds where the trades actually take place. Even though every trader has the right to trade anywhere on the floor, and some actually do shift around with increased order flow (known not affectionately as boat people), most remain in the same trading crowd virtually every day (and usually in the same exact spot in that trading crowd). People being people, it is not surprising that these trading crowds would develop their own personalities and reputations. Initially the personality part was just that, personality, with some crowds getting along and others carrying on a fairly rancorous relationship, arguing on almost every trade. There also were differences in the attitudes of the various crowds regarding new members of the crowd, none especially liking the idea but some actively colluding to give the new member as horrible an experience as possible. Some of the differences were due to whether the floor broker situation was competitive, some crowds having competing floor brokers and some having only one stationary broker.

           
When the CBOE had almost 1500 traders and only 125 listed stocks, the differences in competitive attitudes of various people and crowds were overwhelmed by the numbers. Much the same way, if anyone wants to open a restaurant in Chicago the rest of the industry may not be overjoyed, but they do not get to vote or organize to make it difficult for you. As the number of stocks per member grew, and many members were attracted to the new index products, some of the remaining stock crowds degenerated into fairly small groups acting in unison to minimize actual competition. Some crowds, like IBM, HWP, GE, and Chrysler, remained fairly large, generally competitive, and only mildly difficult to break into for a new trader. Others became a small group of one broker with four or five traders actively protecting “their” markets and turf. One can only imagine the abuse if a new trader entered one of these crowds, bettered one of “their” markets, resulting in one of the regulars getting a RAES trade on the less favorable price. The lack of numbers allowed those people and crowds harboring anti-competitive ideas to actually act on them.

           
As the number of new stocks continued to grow, with no growth in membership, there actually became an issue of where to put the new product. The CBOE management, although never possessing the backbone to actually deal with known problem crowds, was aware enough to not want to reward the problem crowds with new listings. There also was a groundswell of whining from some that those individuals and crowds receiving new product that did produce volume over time to be protected from other traders “competing,” at least for a while, as a reward. Wouldn’t you think that it would be hard to explain to an option customer that a certain trader or traders should be allowed to charge a “premium” for a while, or forever, in return for having a stock assigned to their crowd. The explanation becomes harder when that same group has decided that no new members, possibly without such caveats, were warranted.

           
The solution to this problem, according to the CBOE at least, was a quasi-specialist system known as the DPM, or designated primary market maker, system. This system established some new trading posts under a separate set of rules for the purpose of absorbing the large number of new stock listings. For this “philanthropy” of “agreeing to nurture” these stocks no one else would want, the DPM was given the right to act as both principal and agent on trades and received a “pro rata” share of every trade that took place on his market. Being able to represent customer orders as a broker, and trade against that order, was a huge change and advantage (it also was a practice that was vilified and mostly prohibited on the major futures exchanges at roughly the same time). It is hard to imagine a broker fighting for the best price when being paid by the contra-party to the trade. The DPM group was also quick to define a “pro rata” share of the trade as one half of the total traded, meaning the rest of the crowd split the other half. Although laughable, the new DPM’s got away with that definition for years, with the complicity of the CBOE staff. It may also not be surprising, but the DPM’s began to compete effectively for new stocks thought to be good listings, not just the ones “no one wanted” and “needing nurturing.”

           
How do you suppose that the fix for a system that had become, in pockets at least, non-competitive was to become even less competitive? In addition, how do you take away from the customer the protection of separate agency and principal functions as part of the solution? It is probably a safe bet that the option customer does not have a seat at the CBOE Board table. Also, the SEC has long been rumored to have insisted on separation of principal and agency in the CBOE’s design in 1973, only to give it away so easily. Are they really watching? Are they awake? Are they even there?