Gary Katz is president and CEO of the International Securities Exchange (ISE), this year’s host of the Options Industry Conference in Phoenix, Arizona. The interview was conducted two days before the conference by Sarah Rudolph.
Q: As the 28th annual Options Industry Conference gets underway in Phoenix, there are a number of important issues facing the industry, including some potentially big regulatory changes. ISE is hosting the conference this year. What do you expect will be the hot topics at the conference?
A: We’re very excited about the conference; I think we’re close to the record for attendees…more than 500 are coming. Everyone will be interested in hearing our keynote speaker from the SEC, Jamie Brigagliano [deputy director of the SEC’s Division of Trading and Markets]. He’s been involved in a number of these [regulatory] issues and in setting policy and developing the questions the SEC has been asking the industry to respond to so that they can make the right decision. This seems to be just the right time for a conference like this, and more importantly it’s a good time to hear from the SEC on such issues as short sales, collocation, sponsored access, and caps on access fees. They all seem to be coming around the same time, and it’s a great time to talk about them, not just on the exchange side but on the market making side and the brokerage side. We have a nice mix of people to debate and discuss these issues.
Q: How would a cap on options access fees affect ISE, and the industry?
A: We’ve looked at our fees at the ISE, and except for a minor percentage of the time, all our fees are below that cap, so it doesn’t affect us. A recent SEC release tried to quantify the impact by exchange, and the ISE really wasn’t affected. It’s too soon to tell what the other exchanges will do in response to this change. I think we’ll see a variety of responses.
Q: Of the various regulatory proposals, are there some you think are more likely to take place than others?
A: I finally learned after 24 years of doing this that I’m a very bad predictor of what the SEC is going to do. Unlike the time they banned short selling literally almost overnight, with all of the current proposals, they are taking the time to ask the industry for opinions so they can uncover some of what the unintended consequences might be. I don’t have a guess as to which ones they’ll move forward with, or whether it will be all of them. ISE will respond the way we always have, by talking to customers and members and developing policy and functionality based on the current structure the SEC feels comfortable with.
Q: What are some technological innovations that people will be talking about at the conference?
A: At the ISE, we are continuing to develop our new trading platform, which we plan to launch in the fourth quarter of 2010. We’ll be moving from the current one we licensed from Nasdaq OMX and moving on to a brand new trading technology that we and Deutsche Borse, our parent company, are helping to develop. It’s the next generation for both Deutsche Borse and ISE. That’s a huge technology change for us and everyone here is very excited. We’ve built two brand new data centers and have been hard at work for more than two years now on this project.
I can’t tell you what the other exchanges are working on, but I know there is a panel at the conference that’s not exactly on technology but on social networking and the technologies available today for that. This is maybe the second year the options industry has covered how things like LinkedIn and Twitter are being used and what are the opportunities and concerns.
Q: Are you on any of those yourself? Twitter or Facebook or LinkedIn?
A: I think I just struck out on all those three pitches! I’m not on any of those three…but my wife is on Facebook and loves it. I’m fascinated by our marketing team’s ability to use them for webinars and help our customers understand the options products. We as an exchange use the technology.
Q: I just saw ISE’s announcement today that you will be adding 17 new options symbols trading under a new maker-taker pricing. What’s the future for the competing market models –maker taker versus customer priority? ISE has a model that is a hybrid of both, right?
A: We have what we call a modified maker taker model. A maker taker in a classic model makes money by getting a rebate every single time their bid or offer is taken. We wanted to encourage higher quality markets, so the only time a market maker can get a rebate from an exchange is when they are either on the bid or on the offer of the NBBO, which is about 80 percent of the time the entire month. The design of the program is to encourage our market makers to put up the best market possible, and when they do we pay them a rebate, and when they don’t they pay a fee. The ISE has always felt it’s important to use the fee structure as a way to encourage behavior—in this case a higher quality market. It’s what makes ISE different.
Q: “Higher quality” meaning…?
A: A tighter bid ask spread. If you’re a market maker and you’re never on the best bid or offer, why would anyone send their order flow to the exchange? So a higher quality is the spread, and also the amount of size available at that quote. ISE has always been very strong in that because of our pro-rata customer priority model, which is patented. We wanted to protect that by modifying the market maker approach and we continue to offer trading for customers for 99 contracts and lower for free. That combines the best of both programs, the market structure and the price structure.
Q: We know the basic story about how ISE began – that William Porter, then-chairman of E-Trade, and Marty Averbuch approached you and David Krell to start an options exchange, but can you flesh out some of the details?
A: David and I had left the New York Stock Exchange; the options business we ran over there had achieved in the best of times a 1.5 percent market share. We started a consulting firm we very creatively called K Squared (for Krell and Katz). When Bill and Marty showed up with this idea, we really didn’t think starting an options exchange made sense since we had just left an options exchange and sold that business to the CBOE. What was intriguing was Porter himself. He is an entrepreneur and a very dynamic individual. At the conference he will be receiving the Sullivan Award, which is one of the highest honors in the options industry. He had a vision for something that had never been developed in the U.S. before, which was an all-electronic options exchange with no trading floor.
While today you might think that an all-electronic options exchange seems obvious, in 1997 all four options exchanges had floor based trading, there was no size available in the market, you couldn’t see a quote on the screen, no front end screens, and a relatively small market of around 1.5 million contracts a day. So the idea of starting an electronic exchange was what got us excited about following him and using the skills we had developed at the NYSE and, in David Krell’s case, years of options industry experience. It was nerve racking at the time. It took more than two years to get SEC approval. These days, new exchanges are approved all the time, but back then, the previous exchange had been approved was in 1973! So the idea was different, and new to the SEC as well, and certainly one of the most exciting projects I’ve worked on – and the rest is history, as they say. Very quickly we showed that it could be successful and you could trade options electronically in the U.S. We’re celebrating the 10th anniversary in May of this year, and it’s been a wonderful experience.
Q: ISE has been outspoken about its view that dividend arbitrage trades, which ISE does not use, artificially inflate options volume reports. Have you made headway on that issue and will ISE continue to pursue it?
A: I think we are making headway in that the issue is becoming more well-known and people are talking about it. Making the industry aware that there is a problem was the first step. How many times have we heard, with these bursting bubbles, that there were nefarious activities that everybody knew about but nobody did anything about. That’s a common statement that’s made.
Before the rules separating an analyst from a brokerage firm that was taking a company public, if you read the articles from that time you see that everyone knew there was a conflict of interest but nobody did anything. We are going to try to do more of that, share this information with everyone so they can see how prevalent it is and how specific to only a few options exchanges that are promoting this kind of trading, not for economic reasons, but so they can put volume on the screens and tell everyone their market share is going up. I think that’s an abusive practice, but more importantly it’s a mine waiting for someone to step on it, and one day a clearing member will do something wrong and end up not being flat or hedged in their position and the clearing firm could become seriously exposed. And when that happens, at least I’m not going to say, ‘I knew about it but didn’t say anything.’
Those exchanges have all created fee caps in their rules specifically for this dividend trade, and its designed so that if you don’t put a cap on the fees, if the regular fees were applied, the market makers wouldn’t be able to do this.…so for you and for me, it would be very difficult to do, but not for them.
Q: What initiatives are forthcoming from ISE?
A: We’re hoping this year the SEC will approve the international link we have developed with Eurex, our parent, that will allow Eurex members to send order flow directly to the ISE from outside the U.S. through the clearing facilities they already have in place with Eurex. All the technology is in place and we’ve tested all our systems and are now awaiting SEC approval. We hope to start that in 2010.
We continue to talk about the strategic partnerships we’re involved with, such as Ballista, Direct Edge, Quadriserv, and Hanweck Associates. We’re encouraged by the growth those companies have exhibited and we continue to look for other opportunities for ISE to plant seeds in places adjacent to our core business to diversify our revenue stream and grow the business.
Q: Will regulations on high frequency trading have any ill effects on options trading?
A: I think the SEC wants to understand high frequency trading rather than stop it. They want to make sure there are no abusive practices they are unaware of that would take advantage of investors. That’s why they are asking the industry to help them understand how high frequency trading has grown.
A very good example of high frequency traders in the options business are the market makers that are streaming in quotes on a regular basis. That’s high frequency trading that is not abusive, it’s providing liquidity to the marketplace. The SEC just wants a better understanding of the practice. And I know people are writing comment letters and providing the input the SEC is asking for.