Could Philly Exchange be Next?

Here's an article from today's NY Times about ArcaEx. NY Times writer, Jenny Anderson writes that today's purchase of the Pacific Exchange could be the beginning of more Arca acquisitions. In this prose, Anderson mentions that the Philadelphia Exchange could help Arca grow market share in the options arena.:

(See the actual NY Times article here: http://tinyurl.com/3tzvw)

Market Owner Agrees to Buy Pacific Exchange

By: Jenny Anderson, NY Times News
Date: 01/04/2005

Archipelago Holdings, the owner of ArcaEx, the largest electronic stock market, confirmed late last night that it would buy the Pacific Exchange for about $50 million.

While the deal would be relatively small, it is a sign of Archipelago's ambitions, giving the company its first options trading business. The acquisition comes as electronic markets and the traditional floor-based exchanges are scrambling to diversify. It also comes on the eve of anticipated new rules from the Securities and Exchange Commission that could alter the business of every exchange and marketplace.

Many in the industry say that a deal with the Pacific Exchange may be just the first step in a larger strategy of consolidation by Gerald Putnam, Archipelago's chief executive. Other potential targets include the Philadelphia Stock Exchange, one of six players in the options trading business.

A deal with the Pacific Exchange, with which Archipelago has a longstanding relationship, would also give the company "self-regulatory organization" status, giving it more control over its regulatory arm.

Options trading is attractive because it commands higher margins and trading volume has surged.

"The margins on the cash equities exchange business are getting thinner and thinner, so I'm sure everyone in that business is looking for business lines that have less margin pressure," said William Harts, an independent consultant on best-execution and market structure issues. "If Arca can leverage the technology they have built for equities to trading options, there's no reason why expanding into another asset class wouldn't be a good business proposition."

More than one billion options were traded in 2004, a 30 percent increase from 2003. In comparison, trading volume of stocks rose only 7 percent in 2004.

There is a great deal of maneuvering among the exchanges and markets that trade stocks, futures and options. While the New York Stock Exchange has a virtual monopoly on trading its listed stocks, the trading of over-the-counter stocks is more fragmented. Major market players are trying to consolidate volume in an effort to squeeze profits from the notoriously low margin business.

At the same time, many exchanges are diversifying so as not to be dependent on a single financial product. Instinet, which is controlled by Reuters Holdings, is for sale, and Archipelago and Nasdaq are thought to have submitted bids for its electronic network business, called Inet, in the first round, people involved in the talks say.

In announcing the deal, Mr. Putnam cited the diversity that the acquisition offered.

Archipelago has a history with the Pacific Exchange. In March 2000, the two institutions announced they would form a new electronic exchange to trade stocks listed on the New York Exchange, the Nasdaq and the American Stock Exchange.

As part of that deal, Archipelago paid the Pacific Exchange $40 million in cash and gave it a 10.8 percent stake in Archipelago - a deal worth about $90 million - for the right to be a regulated entity, essentially allowing it to operate as an equity exchange.

Under the proposed deal, Archipelago is buying the rest of the Pacific Exchange as well as repurchasing the Archipelago stock that the exchange still has (about 3 percent).

The Pacific Exchange is the smallest traditional market in the options trading business. At the end of November 2004, the Chicago Board Options Exchange controlled 30.7 percent of all options contracts sold, compared with 30.5 percent at the International Securities Exchange. The Pacific Exchange had an 8.5 percent share.

The International Securities Exchange has had a meteoric rise as an electronic market for trading options. Started in 2000, it has at times surpassed the Chicago Board as the largest player in terms of market share.

Because of its electronic structure, the I.S.E. has much cheaper overhead. In 2003 the exchange controlled 27 percent of all option products (including equity options and index options). At the end of November that number was 30.5 percent.

A deal for the Pacific Exchange would be Archipelago's first acquisition since going public in August.

Archipelago has been a rare success story in electronic equity trading. Begun in the wake of the S.E.C.'s 1997 ruling on how Nasdaq stocks could be traded, Archipelago was one of the original four electronic exchange networks.

Early investors included a who's who of Wall Street: Goldman Sachs, J. P. Morgan, Merrill Lynch & Company as well as American Century and Instinet all invested in Archipelago before it went public at $11.50 a share. The shares have since risen 82 percent, closing yesterday at $20.30. For the first nine months of 2004, Archipelago earned $56.4 million on revenue of $402.6 million.