2011 has been a remarkable year for William Brodsky and the Chicago Board Options Exchange with the launch of a new exchange, a market beating share price rise and numerous front page interviews and behind the scenes discussions extolling the benefits of the futures and options industry. However, 2011 will be remembered as the year that the exchange’s Volatility Index, the VIX, came of age. Elise Coroneos caught up with the man at the helm of the US’s largest independent derivatives exchange for his take on a busy year.
In his book The Fear Index – released this year - Robert Harris tells the story of Dr Alex Hoffman, a legendary physicist who develops an algorithm that can measure human emotions: the name of his algorithm is, VIXAL-4, a nod, along with the title of the book to CBOE’s Volatility Index, the VIX.
However, this year was remarkable for the VIX not only as it entered common parlance (in our industry usually always a negative as complex concepts become over simplified and misconstrued). The VIX has broken all records in 2011. As market volatility reached unprecedented levels, investors sought refuge in the contract, resulting in record trading.
According to figures from FOWintelligence.com, over 100m VIX contracts changed hands in the year to November, with 92m VIX options contracts and 11m of the futures contract being traded. In the month of August amid market turmoil following the US debt down grade (see page 32), 13.4m VIX options contracts and 1.8m futures contracts were traded.
A new asset class
The success of the VIX contracts this year are the culminated of over a decade’s work and a long term vision of Brodsky. Upon his arrival at the CBOE in 1997, after a tenure of some fifteen years at the
Chicago Mercantile Exchange, Brodsky set to work to explore an idea that had occupied him for some time: how to trade volatility.
“It was an elusive concept, a dream,” he reminisced at his office in downtown Chicago one afternoon in late November. “There were issues to overcome and no text book we could look up.”
From a single room at the CBOE, the VIX went from a concept, to a theory with parameters, to a product. “We met with traders, with people from the major firms, and our own research people, and we came up with a way we thought we could do it,” he says.
In 2004, the CBOE Futures Exchange, began trading with the futures on the CBOE Volatility
Index (VIX), launched as a precursor to an options contract. Once sufficient volume in the future was in place, the option was launched in February 2006. In the option’s first full year of trading, it became the exchange’s second busiest cash settled index option contract.
“We believe the VIX is the most important exchange traded futures or options product to be launched globally in over 20 years,” says Brodsky.
“A lot of other products have been tried but this is the most successful because we filled a need and essentially created a new asset class.”
Another hallmark of its success is the fact that some 40 products have been launched benchmarked to VIX type strategies with over $2.7bn in assets under management. While not surprised by its success, Brodsky said he did not foresee this kind of reaction in the marketplace.
“We did not expect to see this. I have been involved in lots of product launches, but one of the great things about these products is that you do not know how people will ultimately use them,” says Brodsky.
While a portion of its success in 2011 can be attributed to increased volatility in the markets generally, Brodsky says that every time the trading volume on the VIX futures and options spikes, it will then plateau higher than before the spike.
“My view is that the product is still in a very embryonic state,” he says.
Brodsky has no qualms with the phrase which has been coined to describe VIX - the fear index - and believes it is a catchy way of saying what it represents, noting that in an exchange a few years ago with JP Morgan’s Jamie Dimon the two discussed the merits of the index as a gauge of the “temperature of the markets”.
However, the success of the S&P Volatility Index has not been matched in the Gold Volatility Index, options on which were launched in April this year to muted trading. “Gold has a different dynamic,” says Brodsky. “VIX on the S&P 500 is an equity market vehicle and there are many equity market players who understand options and volatility. But the gold markets are not the same group of players.”
Brodsky says to expect more volatility related products in the future, particularly on the CBOE Futures Exchange.
“We are creating the VIX network with our S&P to sub-license the methodology to other exchanges around the world,” says Brodsky.
Another product success this year came with the October launch of the S&P 500 options contract, SPXpm, the fully electronic version of the SPX launched on the C2 Options Exchange.
While growth in the CBOE’s flagship SPX contract, the most traded options contract in the US, is up 62% over a year ago for the third quarter, Brodsky did not want to rest of these laurels.
“We wanted to have SPXpm because different users wanted to trade something that wasn’t just an electronic version of SPX. We wanted to create something different,” he says.
SPXpm, with PM, not AM settlement, is ten times the size of the SPDR offering traders cost efficiencies on larger trades. It is European exercised and cash settled, as opposed to the SPDR which is
American exercised and physically settled. “We are offering all the good things about the Spider without all the negatives,” Brodsky says.
Off the bat in October, the exchange saw the SPXpm trade an average of 5,000 a day. More significantly, the open interest is now in the vicinity of 70,000 contracts, impressive statistics on a contract value of over $100,000.
The launch of the SPXpm, marked the C2 as the only exchange using a maker-taker model, on a proprietary product. Since its launch in October 2010, volume on the C2 was averaging 255,000 contracts a day.
Given the highly competitive environment in which options exist in the US – a market currently with nine exchanges and at least one more expected to launch next year (see page 30) - Brodsky is pleased with the CBOE’s share of the market, which stands at around 28%.
“You always want more market share, but what is significant about us is that while we have good market share against enormous competition from the NYSE and Nasdaq, from the point of view of being a for profit exchange we make much more money from SPX, SPXpm and VIX. So that is imbedded in the numbers,” says Brodsky.
Despite the flurry of exchange mergers that have been put forward in the last year, many subsequently being withdrawn (see page 28), Brodsky says that although he is always interested in ways to increase shareholder value, any bid for the CBOE would have to trump its existing and potential organic growth.
While a lot of exchanges drive growth by synergies, or partnerships, Brodsky says the CBOE stands apart because its growth has been grown organically - “the right way”.
“We are not growing market share just for the sake of growing market share. We are growing in the right way by developing products that can drive the bottom line,” he says. The CBOE’s stock performance from January to early December 2011, is up about 15% in its first full year as a listed company.
“Compared to all other US exchanges, we are way ahead of the pack,” he adds. Over the same period, the Chicago Mercantile Exchange saw its stock price plummet 22.6% and the NYSE Euronext was down 5.9%. In positive territory are the Nasdaq OMX Group, up 10.6% over the same period, and the Intercontinental Exchange, up 3.3%.
The CBOE listed its shares in June last year, Brodsky describes the process as “the biggest challenge of his career”. Five years of litigation with the Chicago Board of Trade to free itself of legal impediments, pre-empted the listing. Brodsky believes the central core of the company has not shifted - and remains to be “the most innovative options exchange in the world”.
What has shifted, says Brodsky, is the level of transparency on everything he and the exchange does. One of the most vivid differences was the pathway to get the SPXpm approved by regulators, which took nine-months.
While an approval of such length might not be especially unusual, what was unusual was the reaction of analysts and the public to any delays that occurred because of the process. “In the past, it could take a while, but it was not something people were looking at,” he adds.
It is not just for the success of the VIX and the company’s share price that FOW has recognised, Brodsky as its inaugural Person of the Year. He has also become a champion for the futures and options industry in the face of attacks from regulators.
Travel between Chicago and Washington DC has become a familiar path for Brodsky this year. He has taken up the mantle of educating legislators on what kind of rules and regulations make sense for options markets and, equally, what don’t.
Whether it has been high frequency trading, or the Occupy Wall Street protests, Brodsky has been at the forefront of the industry’s response to the many challenges it has faced since the financial crisis.
“One of my major objectives in Washington is to ensure that we do not have one-size-fits all regulation without understanding the unique differences between a stock exchange and an options exchange,” says Brodsky.
However, overall Brodsky sees the much maligned Dodd-Frank Act as a positive move for the industry. He believes the mandate that over-the-counter trades, wherever possible, be done on an electronic platform, and to be centrally cleared as an opportunity.
When it comes to over-the-counter derivatives, Brodsky believes there needs to be an “intellectually honest” discussion. He believes particular regard should be paid to the end-user exemption due to the systemic risk at the financial institution level.
Though he warns that it is still “too early to tell how this will work out”.
At a time when certain market participants are lobbying purely to protect their interests, an industry leader taking a holistic view is a welcome change. Brodsky is pleased about aspects that the industry as a whole, has been able to get in the Dodd-Frank inspired rules.
He draws attention to areas such as how the regulators handle rule filings for new products, including the time frames in which these are approved and requirements that foster portfolio margining, which exists in other markets around the world, “but not as much as it should in the US” as key inclusions for futures and options.
However he remains concerned over his belief that the Dodd-Frank bill, intended to be a response to the financial crisis, has become too politicised.
“There has been an attempt to politicise the bill and implementation is going to take a lot more time. There are people who want to water down the regulation, but it should address the problems that existed. There are issues, we did have a crisis, let’s look at legitimate solutions - don’t throw out the baby with the bathwater,” says Brodsky.
Brodsky has also been vocal on other challenges to the industry such as attacks on high frequency trading. In an October interview with the Financial Times, Brodsky labelled attempts to slow down high frequency trading “absurd”. Brodsky, like most familiar with the facts, does not equate the May 6 Flash Crash with HFT. “Don’t shoot the messenger,” he says.
Nevertheless, Brodsky hails the benefits that HFT brings to the market, narrowing spreads and increasing liquidity, however, he acknowledges that some level of oversight is called for to ward off potential abuse while the ground rules in this relatively new concept for markets are established.
Brodsky says that HFT is an evolution of trading. “When I was a kid and worked in a brokerage firm, there were old men smoking cigars who were sitting in front of a tape up on the wall. They’d read the tape. If the tape said one thing, they’d ‘buy’ and if it said something else, they’d ‘sell’.
“It was not fundamental trading. Just because your computer is faster than someone else’s, does that mean you have done something wrong? There are always people trying to legitimately access a market in a rapid way. That is a good thing, not a bad thing.”
Fundamental long-term investors, says Brodsky, need to understand that if there is to be a ready market for a stock they want to buy and sell, that market will be brought to bear by a variety of different people, in a variety of different ways.
2011 has been a superb year for the CBOE and testament to Brodsky’s hard work and vision over the 14 years since he joined the exchange. Having played a major role in bringing options in the mainstream, Brodsky is enjoying the fruits of his labour.
Instead of being looked at like “a snake oil salesman in the early days”, he says he now is invited to speak and represent the options industry at many major financial forums and conferences. “I love what I do and the variety of what I do, and I plan to keep doing it,” he says.