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CBOE RMC: Q&A With Ed Tilly


The Chicago Board Options Exchange is ramping up VIX trading hours, tweaking variance contracts, launching a new short-term vol index and firing up new small cap vol products. Ed Tilly, chief executive, sat down with Derivatives Week Executive Editor Peter Thompson to outline the rationale in an exclusive interview Tuesday at the CBOE’s Risk Management Conference Europe, at the Penha Longa Resort in Sintra, Portugal.

Ed Tilly
Ed Tilly

The Chicago Board Options Exchange is ramping up VIX trading hours, tweaking variance contracts, launching a new short-term vol index and new small cap vol products. Ed Tilly, chief executive, sat down with Derivatives Week Executive Editor Peter Thompson to outline the rationale in an exclusive interview Tuesday at the CBOE’s Risk Management Conference Europe, at the Penha Longa Resort in Sintra, Portugal. Tilly, who took over the chief executive slot from longtime incumbent Bill Brodsky in May, also outlined the exchange’s new product development process, which he says has a full pipeline of new ideas. Bio

Ed Tilly came to CBOE straight out of college as a trading floor clerk in 1987, working at the firm founded by Steve Fossett, the colorful trader and adventurer, who told Tilly he would never trade for the firm as he required traders to have advanced degrees. Tilly became a floor trader at the firm and CBOE member in 1989. He traded as both a market maker and a designated primary market maker until joining CBOE's executive management team in 2006. He became chief executive in May, working with Executive Chairman Bill Brodsky.

Derivatives Week: How has the transition to chief executive gone?

ET: The move has been according to plan. Bill put this in motion some time go. We’ve been working so closely together. The team is intact which is very important. There are no surprises.

As far as the vision for CBOE and our future as a public company, I was involved in the IPO process and the roadshow. So the strategy is really still intact. It is still the same vision. It is really the continuation of what we stand for. Differentiation is really product development and education, filling the gaps from the investors’ perspective. That really remains the goal of the day.

DW: In terms of the split with Bill, he’s concentrating more on Washington?

ET: As chairman, Bill continues to chair all the board committees. That hasn’t changed much. His presence in D.C. both from the SEC/regulator’s perspective and from anything that is affecting us in policy coming from the Hill—there is no one like Bill and no one better at it than Bill. So that divide is natural. I have been involved in the product development and the business development at the CBOE since Bill hired me as executive vice chairman.

DW: What excites you about the product side? Obviously you’ve got the trading background.

ET: That’s where it starts. From a trader’s perspective, it’s listening to ideas that just come out of our own team. We have our own internal product development division and what they do is really engage our end users. First, it’s the liquidity providers: those trading firms that are permit holders at CBOE. All the liquidity you see in the S&P500 products and now our volatility suite, our new product development team brings that liquidity to the table no less frequently that once a month. Bouncing ideas back and forth, back to the drawing board, back to the committee, tweak, change, back to the committee, back to the new product development team is what we do. We think we’ll be on to something and then we’ll go out beyond and we’ll get to the buyside. “Hey, this is where we’re going? We think we have a liquidity base. Does this fill the gap that we think we’ve seen or you’ve articulated to us? Have we nailed it? Are we close to it?” This back and forth process never ends and is something we really enjoy doing. We’ve got the right group doing it.

DW: Are there any products you’ve launched that you’ve thought would be a surefire success and not turned out that way?

ET: Some products look great on paper. We can all sit around the room and even our liquidity providers will say, “I can post some liquidity.” And, they don’t have to miss by much, but if they miss they’re simply not going to trade. When they click and when you have it, it’s amazing. The floodgates open. There is demand, there is liquidity and it all works. It’s amazing to watch and amazing to watch the growth.

VIX is the most obvious success. But, the story that doesn’t get told much is the Weeklys contract. It was 2005 when we brought the SPX out to the market. It took the back and forth discussions with the end user. What is it we are missing? Why isn’t the SPX Weeklys taking off? SPX Weeklys were traded open outcry like the big contract. We negotiated face-to-face, brought it over to our hybrid trading platform and turned on the electronics. We have allowed for the interaction between broker and liquidity provider but also the electronics and we were able to capture a completely new user base. So the design was prefect, the Weeklys concept was great. It wasn’t until that final tweak that we where off to the races.

The new variance contract I would have thought would have started with a higher trajectory or growth rate. Being able to trade realized volatility on a contract that’s listed on a futures exchange, I thought would have started off a little bit more interest. But the realized market in this low vol [market], we’ve seen the user migrate to our VIX contract and the OTC variance swap market is kind of slow at this point.

DW: Are you planning any tweaks to your variance offering?

ET: We just did. When we re-launched variance in December, we brought it to the market as a soft launch, and it hit the Street after it launched. There was some interest. The difference we had—which was slight—between the OTC variance swap market and our listed CFE contract was one observation. We began calculating realized vol at the beginning of the day and the OTC market waited until the end of the day. So that one observation was enough for us to go back and redesign, change our process so that we would begin calculating realized with the observation of closing price of the S&P500. So we do this all the time. We think now we’re positioned should the OTC variance swap market pick up again, then this exchange listed OCC-cleared contract is lining near identical to the market you would see if you called up an OTC variance swap dealer. We are not afraid to change things. I love that kind of stuff. It’s just listening. It’s just having the conversation with the end user.

DW: Can you talk about the extended trading hours change you announced on Tuesday morning?

ET: The extended trading hours really goes back to globalization and the story on calculating a benchmark that measures not only primarily the implied volatility U.S. [Home market, overseas] volatility contracts have not developed, with the exception of the VSTOXX which has some traction. It’s been limited, but we can point to it and say that’s probably the next one. But everywhere else–we have six or seven licensed globally—no other home market has really been able to develop a volatility market.

So when we wake up and there is a hiccup some place, the entire world to the downside correlates a lot higher than it does to the upside. VIX is perfect as a negatively correlated asset. We are teaching that exposure in the deepest liquidity pool for volatility will serve your purpose when the global economy is under stress. Not only can you hedge U.S. uncertainty, but really when you need it most VIX exposure will give you the negatively correlated hedge that you’re looking for should the world really be under pressure.

It’s only interesting if you’re trading in the London market at 2am Chicago time and there is something happening globally and you can’t hedge vol. You have to wait until we open in Chicago? That doesn’t make sense to us. So by peeling back that start time and eventually trading 24/5 is really the goal.

The extension at the end of the day is really the run-off period. We have a lot of exchange-traded products tied to various expiration cycles in the S&P 500. Sometimes they are unable to affect their hedges by the end of their trading day, so allowing them to hedge right after we close and not keep that risk round the clock, that’s really the essence of the afternoon run-off. Then opening at 2am really opens up to the London market. Now eventually, continuing the gap between 4.15 and 2am would give us the Asia market, but really it’s to answer the demand that we know is in Europe.

DW: What is holding back these home markets in volatility?

ET: There are a number of things. By keeping VIX open during VSTOXX hours we will create a trade that already exists between VSTOXX and VIX. Having them side-by-side will boost the volume.

Looking at other markets, VIX is tradable and uses real time prices, there is perfect convergence from a trader’s perspective because we use the opening prices on expiration to settle the futures contract. We can’t dictate settlement process in the foreign markets. We just provide them with the methodology and the roadmap. Foreign markets can choose to settle their contracts anyway they like: could be average price over a certain of time, could be split price opening—it’s a little different from a trader’s perspective. Our tradable methodology lines up the best so far from a trader’s perspective in being able to converge those prices.

There are a number of other issues that contribute to the success. There is terrific liquidity in each underlying strike of the S&P500, certainly 30 days out. The settlement process is considered fair and representative of both the listed futures contract and the OTC volatility contracts whatever they may be.

DW: And you’re launching VXST as well.

ET: This is an exciting one. So, it’s a nine day expiration cycle. Every Wednesday will be a settlement of the nine-day forward weekly contract. From a trader’s perspective, as you reduce the cycle that you are measuring, you’re higher and higher in implied volatility.

So the implied volatility of VXST is 1.5-2 times that of the 30-day implied of the VIX. What does that mean? Let’s take this week for example. My option was—if there was no weekly—I would be hedging with the third week in October SPX. Well I was only looking to get through this last week in September and the Friday expiration on the 4th. I didn’t know what the government was going to do. That’s really all I wanted to hedge. You made me buy all this all other premium. Out three more weeks in October. That is not what I wanted. So the weekly SPX contract comes in to play. Now, you’re a vol guy. I’ve got my book kind of hedged and in a good spot. But vol will blow me up if I’m wrong. I just want to hedge this uncertainty around what is the U.S. government going to do on Monday night before Oct. 1. So I get to a buy a contract. I could have bought it last week if we were listed already. Last Wednesday I could have bought the contract that expired on Friday that would let me pinpoint the implied volatility exposure for just that period of time I’m interested in.

DW: You’re clearly excited.

ET: I really am. The VXST makes a lot of sense. Pinpointing and giving more points in the term structure just gives another trading opportunity. Calendar spread traders find the volatility an interesting trade.

Taking yesterday as an example, nine-day vol was 17.8 and the 30-day was about 16.2. So again, it’s higher vol and a different term structure. It’s just another trading opportunity from a trader’s perspective. So it kind of works: end user gets what they want to pinpoint, trader gets more visibility in to the surface of volatility.

DW: In terms of the feedback you’re getting from the development process, is this the one people are most excited about?

The volatility traders who are here are really excited about a higher volatility product, but [also] the visibility into the surface and what that means for exposure and being able to offset and manage that risk.

DW: When would you know whether you’re on to a winner with this? Do you have a timeline?

ET: We are extremely patient. VIX futures took forever to grow. They were really the hedging vehicle, and the process and the settlement allowed us to trade VIX options. So how would you have gauged the success of VIX futures? You would have scratched your head if that was the only product. Boy, you’re not trading many futures for the first few years. But VIX options were growing and growing so were VIX futures a success? Absolutely. Sometimes benchmarks—tradable or not—provide us triggers to other trades. So let’s say we have this weekly VXST number and we don’t see futures exploding, we don’t see options on VXST exploding, but som ething kicks off in SPX. The weekly just popped. You go in to the weekly contract in the SPX and or hedging because you see volatility increasing—that’s a successful benchmark, although it may not have been a successful tradable product. We measure these successes in all different ways. From a public company, it has to show up in trades at some point. That’s really what I’m trying to drive is value to the shareholder.

From a trader’s perspective there is success in other ways. People are using or looking at your benchmark, to make decisions to hedge, to pull triggers on other trades and that’s a different measure of success.

DW: Any other areas you’re looking at the moment which is in the more initial stages?

ET: Oh sure. We announced, even before we have given the specs, our agreement with the CME to use their prices on the options of the 10-year to bring to the market a volatility futures contract that we will trade. It’s at a different stage. It goes back to the settlement process I talked about. CME opens their contracts different than CBOE does. So, how does a split price open effect the settlement of a volatility product based on those option? We go back to the drawing board and we try to come up with a formula that makes it tradable—a tradable settlement. So it’s a different runway and path to market because the entire process is not under our control. So it just takes a little bit longer time.

DW: And anything else brewing?

ET: There are always things brewing. The pipeline is always full, at various stages of readiness. People bring us ideas all the time. Everyone thinks their concept is tradable, whether CBOE internal product development...same thing with people from the outside—“This is going to be the next great trade.”

From my perspective, product development still reports to me so it’s an important part of our future going forward.

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