Price-Fixing, the Amex Way
Two-tier pricing can guarantee a tidy profit

Options have never been more crucial for the American Stock Exchange. In the first quarter of 1999, the Amex reported a 30% growth in options volume over the year before--vs. a mere 5% gain in stock-trading volume. But beneath the cheery statistics is one of the dirty little secrets of the Amex floor: two-tiered options pricing that, as described by people familiar with the practice, amounts to a form of price-fixing.

Early this year, the U.S. Justice Dept. initiated an antitrust investigation into how options are traded at all four major options exchanges, and nine class actions alleging anticompetitive practices were filed against the exchanges in federal court in Manhattan. The Chicago Board of Options declined comment, and the Pacific Exchange pledged cooperation with the probe.

The investigation was sparked by the exchanges' reluctance to list options already listed by other exchanges. Critics have long maintained that this practice keeps customers from getting the best possible prices. That may be so. But current and former Amex floor personnel point to another, more direct reason.

BIG MONEY. According to these sources, investors often pay too much when they buy an option and get too little when they sell. It means they put in ''limit orders''--orders specifying prices--based on incorrect information. If just one-tenth of options trades, now about 120 million a year, are skewed against the public by merely an eighth of a point, investors are hurt to the tune of $150 million a year.

Here's how Amex options price-fixing is said to work:

The specialist establishes the option's publicly quoted price.
Specialists are traders who buy and sell options but with special responsibilities--and power. And that includes the power to establish the prices that appear on trading screens worldwide. Prices of both stocks and options are expressed by two numbers--a ''bid'' and an ''ask.'' The bid price is the price a member of the public can get when selling an option. The ask price, which is higher, is the price an investor will have to pay when buying the option. The difference between the bid and ask is the ''spread.''

At the same time the specialist establishes the official bid-ask prices of the option--the prices disseminated on trading screens--the options market makers establish their own price, often with narrower spreads.

In the example described on this page, based on the recent pricing of a widely traded option, the trader was able to offer a spread of 4%--versus the 8% spread set by the specialist. Market-maker firms frequently can meet their expenses, and turn a handsome profit, while offering more modest spreads to traders on the floor. By offering better prices, they can draw business from professional investors who use floor brokers to negotiate better prices.

Ordinary investors pay the prices set by the specialists--and not the better prices available from the market makers.

That's because they don't know that better prices--narrower spreads--are available. The trading screens show the wider bid-ask spreads set by the specialists. Floor traders can insist that specialists display their better prices on the trading screens. But they don't. One reason is fear. As one trader points out, ''it is well known that specialists don't like it''--and can retaliate by excluding traders from getting a share of large trades that come in to the floor. But fear is not the only reason traders don't insist.

Traders and specialists alike benefit from wide spreads. ''Market orders''--at the prevailing bid-ask price--are usually executed at the prevailing bid-ask spread set by the specialists. And investors base their limit orders on the same artificially wide bid-ask spreads. One trader notes that the growth of automatic execution of trades means that more and more trading is at prices set by the specialists.

There are exceptions to the dual-pricing scheme. The vast majority of Amex options are very thinly traded. For such options, the bid-ask spreads quoted by everybody--specialists and traders alike--are wide. But the practice is described by floor sources as an everyday occurrence for more widely traded options. ''All the public sees is that their trade is executed instantly. They have no idea what's going on,'' says one trader.

How widespread is this practice? Well, the class actions, filed in early February in the wake of the antitrust probe, allege that improperly wide spreads and price-fixing occur on all four options exchanges because of their supposed ''conspiracy'' against multiple listings. Each of the suits contends that market makers and specialists ''agreed not to compete by seeking to offer narrower spreads.''

But at the largest options exchange, the CBOE, the form of price-fixing allegedly occurring at the Amex seems less likely. At the CBOE, market makers shout at each other to compete for business, in this fashion exchanging bid-ask quotes that are written down by exchange employees and then shown on trading screens. By contrast, at the Amex, prices are set by the specialists, and floor price ''reporters'' do not play the active role of their counterparts at the CBOE.

Resolving this problem would require a change in the way prices are reported--which SEC Chairman Arthur Levitt Jr. proposed in a letter to the options exchanges on Feb. 10. He observed: ''It is now feasible for each competing market maker to publish its own quote''--an innovation that would do away with any two-tiered pricing at the exchanges, the Amex included. With that proposal, Levitt appeared to acknowledge at least the potential for discriminatory pricing at the exchanges.

Amex Chairman Richard F. Syron expressed surprise and chagrin when told of the alleged two-tier pricing. Syron says even the most informal price-fixing arrangements are simply not acceptable at the exchange. ''That would be wrong. That should not happen....There can't be tacit agreements.'' Syron, however, does not believe the allegations. ''It is not at all infrequent to have one group [the traders] complaining about the other group [the specialists],'' he says.

Syron believes that such allegations underscore--rather than undermine--the importance of the system of self-regulatory organizations. ''The reason you have SROs is, these things are so complex that the only people who really understand all of the details of this in toto are the people who are there, engaged in it, on a moment-to-moment basis,'' says Syron. The complexity and speed of the options market, he notes, point up ''the degree of responsibility and the importance of SROs doing a good job.''

That's precisely the point. But just how well does the Amex regulate itself? If the allegations concerning options pricing have any validity, they indicate a deep malaise--one that permeates the Amex.



The American Stock Exchange: Scandal on Wall Street

COVER IMAGE: Scandal on Wall Street

TABLE: Why Are These Options Spreads So Wide?

TABLE: How the Two-Tier System Hurts the Public

A Double Life at Spear Leeds?

Did a Specialist Break the Rules?

The Flaws in Self-Policing

The Gadfly of Trinity Place

ONLINE ORIGINAL: Why More Investors See Options as a Necessity

E-Mail to Business Week Online

Copyright 1999, Bloomberg L.P.
Terms of Use   Privacy Policy