The Power of Blockbuster Products

Try to imagine being “in the shoes” of Dr. John Lechleiter, CEO of the venerable pharmacy company Eli Lilly (LLY). Of the world’s top three “blockbuster drugs” that are due to lose their patent protection in 2013, Eli Lilly has two of them:

1. Cymbalta:  Although Lilly did manage to successfully manage a six month “stay of execution” on the patent expiration of this $5 billion sales/year antidepressant drug (it will expire in December instead of June), analysts have been warning investors of a potential 8% decrease in sales beyond 2013 due to the difficulty of replacing the void left by the loss of exclusivity on Cymbalta sales.

2. Avonex (estimated 2012 sales: $2.9 billion): This drug belongs to Biogen Idec (BIIB), so Leichleiter is spared the headache of replacing it.

3. Humalog: Sales of this diabetes drug have already fallen (third quarter of the 2012 year) because of two factors: 1) the pressure brought to bear by third-party payers to be granted discounts; and 2) competition from newer drugs, including one (Tradjenta) co-marketed in the U.S. by Lilly. Leichleiter will have his hands full finding a way to fill this additional $2.5 billion “sales hole” in Lilly’s financials as they move into the future.

As you know, these patent protection expirations were in no way the result of any wrongdoing by Lilly. These periodic losses are simply a “given” mandated by federal drug regulation – an industry challenge with which every major pharmaceutical company must wrestle.

Imagine Dr. Lechleiter sitting in his Indianapolis office in the middle of March when he reads this news report: “S&P Dow Jones Indices, which has granted the listing of key index options to the Chicago Board Options Exchange (CBOE) since the early 1980’s, has now extended that exclusive licensing agreement through 2032!”[1]  Surely the Lilly CEO would shake his head and mutter: “All my troubles would be over if I could get a break like that — retaining my biggest selling products for twenty more years!”

IMAGE: The graph above illustrates the growth and power in index option trading in the CBOE.

How central are index options in the financial success of the CBOE? In one word, index options are simply “blockbusters” for the CBOE.  Allow me to illustrate for you.

Just released financial data reveals that the CBOE had a great quarter – earning $.48/share versus $.37/share one year earlier. Amazingly, the CBOE accomplished this despite a steep drop in the trading volume of options on individual stocks. This disconnect between volume trends on stock options and the exchange’s earnings per share can be accounted for by just one overriding factor: index options!

One year earlier, index option volume was stellar – accounting for a full 25.4% of trade volume. But this year, index option volume catapulted to almost 38% of total trades!! Even more astounding, because these key index options are exclusive to the CBOE, the exchange can extract much higher fees when they are traded. For example, the average single-stock option trade commands a 14 cent fee, while the average index option fee is almost 5 times larger (at 67 cents)!

As a result, these index options are clearly the CBOE’s equivalent of the “blockbuster drugs” that power the financial strength of big pharmaceutical stocks like LLY.  The magnitude of their financial impact is best summarized in one data point revealed last week: more than 60% of CBOE’s transaction fees are attributed to index option transactions.

Obviously, the February extension of exclusive rights to the options on SPX and DJX, as well as other related S&P Dow Jones Indices was a mammoth development for the CBOE. Competitive jealousy runs rampant within the investment world, so the CBOE knows that each day, competitors are feverishly looking for ways to get more business from the CBOE. (Other exchanges have taken the CBOE to court a number of times in an effort to overturn its exclusive right to index options.)

IMAGE: Above is a chart that lists the indices for which S&P has granted exclusive rights to the CBOE (from the CBOE website).

It is in the light of this index option “exclusivity” and the tremendous financial leverage that they hold for whoever controls them that the events of Thursday, April 25 and May 2 hold so much peril for the CBOE.

On April 25th, trading in some key index options was halted at the CBOE from the open at 9:30 AM (EDT) until about 1:00 PM (EDT) due to software system issues at the CBOE. Options not tradable included the SPX and VIX options – which have immense daily volumes. (During 2012, options on the SPX averaged a daily volume of 700,000.) Floor traders, fund managers, and retail traders were naturally outraged at the CBOE, especially since this event occurred within just days of the hacking of the AP news service’s Twitter feed (which made the investment world believe, during the course of minutes, that the White House had been attacked … resulting in a steep spike downward in market prices, followed by an equal spike back upwards once the hacking was revealed). Reflecting the tension within the investment industry regarding its maddening technological vulnerability (2010 Flash Crash, Knight Capital blowup, NASDAQ’s system failure one year ago during the FB IPO, etc.) – the initial report from the vaunted Wall Street Journal was that the cause of CBOE’s outage was “an attack by the Chinese military”.

Fortunately for international peace and wellbeing, the CBOE later reported that the outage resulted from a “software glitch”. The next day, during an interview on CNBC, CBOE CEO William Brodsky was grilled about the incident. It was obvious that Brodsky had been barraged by a lighting storm-like torrent of criticism and second-guessing. He was extraordinarily defensive and quite terse in his explanation of the source of the “glitch”. The clearest answer he offered was “it is an internal issue” – which I interpreted as meaning that one or more persons had dropped the ball. If that is the case, then to his credit, Brodsky refused to throw such person(s) “under the bus”. However, it still leaves those who depend upon the CBOE for access to the ability to hedge billions of dollars in financial risk wondering when the next such incident will put them at risk.

To that point, it was not encouraging that another much briefer interruption in trading took place just one week later (May 2). That prompted the CBOE to publicly announce two related developments:

1)  An indefinite in the implementation of expanded trading hours on their VIX futures platform (it had been scheduled for the end of May); and

2) The hiring of a technology consultant firm to perform a comprehensive systems review. That work begins Monday, May 6th.

Obviously, ramping up for the expansion of hours was the primary cause for the CBOE “software glitch”. In Brodsky’s words: “We are taking a deep breath. Our concern is, let’s stabilize things, because when you make a change like this, you are basically running your computers all day long.”

It is an understatement that these issues have made the CBOE painfully aware of their now urgent need to develop a fail safe back up system.  Retail and professional option traders would offer a resounding “Amen” to Brodsky’s confession that recent delays in providing investor access to stock index products was “unacceptable”

IMAGE: CBOE CEO William Brodsky is shown above responding to interview questions on a recent video highlighting the 40 year history of the CBOE (from the CBOE website).  

Addressing the back-up system issue, Brodsky emphasized that the CBOE does have a back-up system. However, he admits its limitations: “Although CBOE has a backup system in case of trading disruptions, it takes a long time to get up and running”.

Of course, in a world of high stakes global trading that depends upon split-second execution of orders on which the fate of billions in investment risk hangs each minute of every trading day – Brodsky’s terminology (“it takes a long time to get up and running”) reflects blatantly poor planning by the CBOE. However, given the pressure brought to bear on Brodsky and his team, there is every reason to expect that they will pull no punches in efforts to remedy this gaping hole in their systems integrity and security. In Brodsky’s own words, the CBOE needs a “faster alternative backup for our proprietary products.”   (To which I would respond: “Duh!”)

The CBOE knows (to borrow a chant from an infamous 1968 Chicago event, outside the Democratic Convention venue, during a so-called “Police Riot”) that “the whole world is watching”. They are therefore “highly motivated” to straighten this out as quickly as possible. As Lilly’s Lechleitner knows first-hand, Brodsky and the CBOE can absolutely not afford to risk losing its exclusive rights on the index options that are now the bedrock upon which it stands!

Submitted by Thomas Petty

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