Philadelphia Stock Exchange Takes Lead In Listing Cash Index

Founded two years before brokers gathered under a buttonwood tree in lower Manhattan, the Philadelphia Stock Exchange may be stealing a march on the New York Stock Exchange once again.

Philadelphia has become the first marketplace to adopt the recommendation of several post-crash studies that stock exchanges provide a vehicle for portfolio trading.

The exchange has filed with the Securities and Exchange Commission for permission to trade Cash Index Participations, which will allow investors to participate in the stock market as a whole.

Like shares, CIPs will pay dividends, require initial margin of 50% under the Federal Reserve Board's regulation T and will not expire. PHLX officials believe the instrument will be considered a stock for tax purposes.

PHLX plans to list one CIP that will track the Standard & Poor's 500 index and another to mimic the Dow Jones Industrial Average. Bridge Data will calculate the index for each contract and provide dividend flow information to the exchange and the Options Clearing Corp. of Chicago, which will issue and guarantee the CIPs.

Although Instinet Corp. and Jefferies and Co. Inc. have developed off-exchange crossing networks for basket transactions, the only liquid markets where investors can trade a portfolio as a unit are in the futures and options pits of Chicago.

In a study commissioned by the NYSE, former U.S. attorney general Nicholas deB. Katzenbach said buying index futures and options "is trading only the grin of the Cheshire Cat, not the Cat itself."

Although the announcement of the CIPs appear to respond to the Katzenbach study and other crash post-mortems, PHLX officials say they have been working on the cash index concept for nearly two years.

PHLX President Nicholas Giordano says that if CIPs are approved by the SEC, they could restore investor confidence and reduce gyrations that occur when program traders flood the stock market with buy or sell orders.

While Giordano says CIPs will "act, feel and smell like stock," they have certain characteristics of options. Indeed, they will be cleared and settled on a next-day basis by the OCC, compared with five-day settlement for equities.

For every long position in a CIP, there must be corresponding short. The investor who sells the contract is required to pay the owner a proportionate share of the dividends on the underlying stocks in the index.

"CIPs represent a perpetual call that pays dividends," says Arnold Staloff, president of the Philadelphia Board of Trade, PHLX's futures subsidiary.

But a provision allowing CIP owners to "cash out" on a quarterly basis if the contract trades at a discount to the underlying stocks means a short seller faces assignment risk.

Staloff says preliminary research indicates it is likely CIPs would trade at a premium to the underlying index, but that a discount might result from an imbalance of sell orders.

A specialist will be responsible for maintaining a fair and orderly market in CIPs and will be designated under the same allocation procedure used for equities. CIPs are expected to trade without price limits.

Although the equity-option hybrid may appear confusing at first, the simplicity of CIPs "is a breath of fresh air," says Tom Dorsey, president of the investment advisory firm Dorsey, Wright and Associates. "Most people don't understand options. This is as simple as buying 10 shares of IBM."

PHLX officials say they decided to use a synthetic instrument to allow portfolio trading in the stock market because it is less cumbersome than listing an index of physical securities. Giordano says he expects other exchanges will offer their own version of CIPs.

Robert Gordon, president of Twenty-First Securities Corp., says CIPs could help convince futures exchanges to move from cash to physical settlement of stock index futures because the instruments will provide a convenient delivery mechanism.

"Cash settlement has created an illusion of liquidity" which the stock market crash demonstrated did not exist, Gordon says.

The next-day settlement feature of CIPs could make the product more attractive to some investors than a basket of physical securities and create pressure to shorten the settlement period for stocks.