An Educating Innovator


A new financial-services product might be the best thing ever, but if market participants don’t ‘get’ it, that product will die on the vine.

For CBOE Holdings, which operates the Chicago Board Options Exchange, the mission is not just to innovate, but to educate.

“Being focused and committed to product innovation requires us to do a good job of explaining our products,” said CBOE Holdings Chief Executive Officer Ed Tilly. That entails “spending time to educate new and potential users,” he said.

CBOE knows a thing or two about successful innovation, as the biggest U.S. options exchange operator is arguably best known for its CBOE Volatility Index. Introduced in 1993, the VIX has gained massive popularity over the past decade, to the extent that the mainstream financial media often cites the index alongside long-established benchmarks such as the S&P 500 and crude-oil futures.

Ed Tilly, CBOE

Ed Tilly, CBOE

“For us, new product efforts have focused on the continuation of the interest we’ve seen in volatility,” Tilly told Markets Media in a Nov. 6 interview from CBOE’s headquarters in downtown Chicago. “Primarily, that has been U.S. demand, and we’re making sure we have educational content that satisfies those end users. Early adopters of VIX are turning out some good, sophisticated trading scenarios around volatility, and our new entrants are looking for back-to-basics in volatility.”

Indeed, CBOE is hands-on with regard to education, as the company’s Options Institute provides instruction in two on-site classrooms, seating about 150 total. Tilly said takers of classes run the gamut from beginning to advanced options users, from retail and  institutional capacities; on Nov. 6, one classroom was occupied by options users from China.

“We use both traditional classroom instruction and online education,” Tilly said. “This fall we completed a build-out of beautiful new space for our Options Institute…We’re committed to classroom education, but we’re also doing more webcasts and online courses.”

Founded in 1973 and publicly owned since 2010, CBOE Holdings operates two options trading venues: its eponymous exchange, which had 26.6% market share in November, and C2, a three-year-old all-electronic exchange that had share of 1.8%, according to Options Clearing Corp. CBOE’s combined options-trading market share of 28.4% leads a hotly contest space, ahead of Nasdaq OMX (three exchanges, 24.9%) and IntercontinentalExchange’s NYSE Group (two exchanges, 24%).

About 57.8 million equity-option contracts changed hands on the CBOE options exchange in November, along with 25.9 million index contracts, according to OCC data. CBOE Holdings also owns CBOE Futures Exchange and the CBOE Stock Exchange.

The CBOE exchange has market share of 20% in equity options, and a dominant market share of 97.5% in index options. That stranglehold can be expected to continue, as earlier this year CBOE extended its license agreement with S&P Dow Jones to exclusively list contracts based on certain indices through 2032.

“CBOE has a suite of proprietary/exclusive products, such as options on SPX products, that have historically done very well for them, and their futures franchise in this area is growing,” said Gaston Ceron, a Morningstar analyst. “They face a much tougher fight In the more commoditized options categories, but they’re not as important to their bottom line. The more profitable products are the proprietary/exclusive ones, and in general they are doing fine.”

CBOE Roots
Tilly, 50, is home-grown. A Northwestern University graduate, he started at CBOE in 1987 as a trading-floor clerk, became a floor trader and CBOE member two years later, and moved into executive management in 2006. Tilly took the CEO reins this past May, when long-time CBOE head William Brodsky stepped aside from day-to-day leadership to become executive chairman.

Tilly and Brodsky often represented CBOE  as a team at industry events in recent years, and Tilly indicated the baton passing has been steady-as-she-goes for the company.

“It would be difficult to identify a change,” he said. “Bill and I worked together closely for years, including my years as executive vice chairman and president and COO. Over the years — long before the (initial public offering) roadshow — I assumed more and more responsibility and was directly involved in the exchange’s corporate strategy.”

“My day-to-day role has changed in the way I interact with our shareholders,” Tilly continued. “But the strategy for CBOE since I’ve taken over as CEO is an extension of our previously existing strategy. This includes developing new products and bringing them to the marketplace, broadening the appeal of our volatility complex, and continuing to focus on education.”

The VIX, which measures market expectations for near-term volatility and is known as the ‘fear gauge’, has expanded from a concept described in an academic research paper to essentially an entire complex of traded products, spanning options and futures, of varying duration and size. Financial innovations rarely attain even a small fraction of VIX’s success, so it stands to reason that CBOE would channel some of its bandwidth for ongoing innovation toward a bigger and better VIX.

On Nov. 27, CBOE said it created a mid-term volatility index to measure the expected volatility of the S&P 500 over a six-month period. The VXMT index offers a macro view of market risk tied more to broad economic factors and less to event risk, according to CBOE.

Other releases issued by CBOE in November pertained to its recently launched short-term volatility index, which looks out just nine days, as well as planned options and futures on the Russell 2000 Volatility Index. CBOE also has partnered with across-the-street exchange counterpart CME Group to use the VIX methodology to measure volatility on the 10-year U.S. Treasury note.

Dispersing time horizons on VIX contracts allows traders to express a wider range of opinions. CBOE’s short-term volatility product, VXST, “is very responsive to news and events in the short term,” Tilly said.

“Say we have a news event today that’s short-term in a trader’s expectation. The 30-day number shouldn’t move around a lot, because by the time the contract expires, that news will have passed and we’re looking forward on our expectations,” Tilly added. “But if expiration is in a week, that event may still affect the market flow, and the short-term volatility contract will be very responsive to that information — much more so than longer-dated VIX options.”

As with any financial-services innovation, the ideal case for the innovator would be to attract all new users, i.e. ‘growing the pie’, but typically the result is some new users, and some users shifting over from existing products. Weekly options, which market participants say have exceeded expectations across the options sector since their launch a few years ago, have brought in their share of new customers for CBOE, according to Tilly.

CBOE’s SPX Weekly volume increased 120% in the first 10 months of 2013 compared with the year-earlier period, Tilly said, and a closer look at who is transacting what provides encouragement. “It’s a different user base,” he said. “If we look at the top five users of the S&P 500 third-Friday expiring contract and compare that with the Weeklys contract in SPX, the names aren’t the same.”

Added Tilly, “we’ve attracted a new user base to the SPX complex, and we think we can attract new users that are interested in short-term volatility, as well.”

Looking Abroad
“VIX futures and options have grown dramatically over the last several years, and we’re thrilled with that trajectory,” Tilly said. “Most recently, we’ve been focused on raising the visibility of VIX outside of the U.S.”

As part of the effort to boost VIX order flow from traders and investors outside the U.S., CBOE has added trading hours, including a 2 am-to-7 am Chicago time session that corresponds with the opening of the European trading day. Tilly indicated very early returns for this initiative, which commenced in late October, were positive.

Aside from volume, “we also look at who’s engaged in trading during the extended hours,” Tilly said. “If we have X number of futures traders from 8:30 am to 3:15 pm in the U.S., how many are committing capital in our extended trading hours session?”

Of CBOE’s regular futures traders, 20% to 30% participated in extended trading hours in the first days, according to Tilly. “It wasn’t just one market maker trading with another pro and putting up a print in the off-hours,” he said. “We are building the critical mass of liquidity that’s so important for sustained interest in off-U.S. trading hours.”

Extended trading hours, new volatility products and the C2 exchange are just some of the initiatives  CBOE has rolled out to stay king of the hyper-competitive options-exchange hill. C2’s market share isn’t robust by the standards of a stand-alone exchange, but Tilly said the venue has a distinct value proposition and it has been a successful add-on to the core franchise.

“We have a unique pricing model, one that’s completely different than our competitors by factoring in the bid-ask spread and the size of the top of the market,” Tilly said.

C2’s strength is in SPDRs and other heavily traded options contracts listed on multiple exchanges, Tilly noted. “Have we extended that success to all multiply-listed classes? Not yet,” he said.

“We look at C2 and CBOE together,” he continued. “What has having C2 allowed CBOE Holdings to do? It has allowed us to remain committed to a traditional market, traditional pricing and matching algorithms that favor dedicated liquidity on CBOE, our primary exchange, while experimenting with different algorithms and pricing models on C2.”

Added Tilly, “we are committed to leading in market share in multi-listed classes. I would consider CBOE plus C2 in measuring whether or not we’re fulfilling that goal, and we are.”

Hardened Systems
CBOE is not immune from the technological glitches that have vexed the exchange sector over the past few years, as evidenced by brief systems outages in April and in September. The exchange operator is working closely with the U.S. Securities and Exchange Commission as well as its exchange competitors to address the ongoing concerns, according to Tilly.

“It’s a collective approach to outages and systems issues,” he said. “Specifically for CBOE, we’ve taken steps to harden our systems. Eliminating downtime is the number one priority, and also identifying ways to return to the market with more efficiency and more communication.”

With regard to regulation, the options sector has been especially alarmed by a proposal from U.S. Rep. Dave Camp that would step up the taxation of options transactions and potentially drive away retail users. Brodsky, a veteran of legislative advocacy, has been outspoken on the issue, and Tilly has taken up the cause.

“We’re optimistic we’ll be able to make a case that, while well-intentioned, the unintended consequences of the Camp proposal, if enacted, will be very damaging to our retail users,” Tilly said. “We have not budged from that as part of an industry effort on education on the Hill. We have taken a leading role in that coalition, which includes all of the option exchanges and many discount brokers.”

CBOE Holdings went public in a June 2010 initial public offering that raised $339 million and valued the company at more than $3 billion. CBOE shares have increased to more than $50 from $29 at the time of the IPO, driven by generally strong earnings results plus some measure of speculation that the company is an attractive takeover target.

CBOE has maintained a robust market share, though overall options trading remains tepid. Year-to-date volume increased 3% in the first 11 months of 2013, but 2012 volume in the same period was down 13%. “The main challenge for CBOE is to expand its product offering as the sector further consolidates,” said Diego Perfumo, an analyst at Equity Research Desk. “The opportunity is for CBOE to buy either Nasdaq or NYSE and integrate equity options with their underlying stocks. It makes a lot more sense to combine NYSE with CBOE than with a commodities exchange.”

Tilly noted that CBOE is balancing the goal of long-term growth with the often shorter-term nature of shareholder expectations. “Our approach hasn’t changed” since the IPO, he said. “Certainly, our shareholders look forward to the quarterly report. But shareholders also get the CBOE story, which is about innovation…Our shareholders are as focused on how R&D can pay off in the long term as we are.”

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