Why Did The PHLX Do It?

February 03, 2006

In McGraw-Hill vs. ISE, the judge found that exchanges don’t need to pay licensing fees for index-linked ETFs. But the PHLX will anyway.

In the landmark McGraw-Hill vs. International Securities Exchange ruling, Judge Harold Baer, Jr., of the U.S. District Court for Southern NewYork, found (some would say incorrectly) that exchanges do not need to pay licensing fees to indexers to launch options on index-linked exchange-traded funds (ETFs).  Judge Baer essentially ruled that once ETFs were sold, indexers no longer had an ownership interest in the product.

The ruling sent a shockwave through the indexing industry, as it potentially undercut all of the lucrative index licensing agreements between indexers and the options industry.  After all, why pay a licensing fee to launch and market options on the S&P 500, when you could launch and market options on an S&P 500 ETF for free?

Despite this, on February 2nd, the Philadelphia Stock Exchange (PHLX) announced a major new ETF options licensing agreement with Dow Jones Indexes. The deal is a "long-term agreement" to trade options on "Dow Jones Index-Linked ETFs," according to the company's press release, and covers sixteen Dow-related funds.  The options will launch on the PHLX in the next few days.

"It is very satisfying that the Exchange recognizes the value of entering into a licensing relationship with the owner of the underlying indexes," said Michael A. Petronella, President, Dow Jones Indexes/Ventures.

"Our goal is to put in the hands of investors more ETF options," said Daniel Carrigan, vice president of new product development at the PHLX. "Interest in these products shows no signs of abating."

Carrigan highlighted the fact that PHLX will list options on four ETFs which are not currently offered at any other exchange:

iShares Dow Jones U.S. Consumer Goods Sector Index (IYK)

iShares Dow Jones U.S. Consumer Services Sector Index (IYC)

iShares Dow Jones U.S. Financial Sector Index (IYF)
iShares Dow Jones U.S. Financial Services Sector Index (IYG)

Carrigan would not comment, however, on why PHLX felt it necessary to enter into an agreement with Dow Jones in the first place, when the court ruling suggests that those agreements are unnecessary.  Perhaps the exchange is making a bet on the likely outcome of the upcoming appeal, which could easily reverse Judge Baer's ruling.  Perhaps the agreement lays the groundwork for exclusive licensing deals if Judge Baer's ruling is vacated.  Or perhaps there is some other cross-promotional reason why an agreement with Dow Jones makes sense.

The PHLX wouldn't comment.

The agreement covers ETFs from three separate providers: First Trust (Dow Jones Micro Cap Index, or FDM), State Street Global Advisors (DJ Wilshire 5000, or TMW, and DJ Global Titans, or DGT), and Barclays Global Investors (13 funds, including the iShares Dow Jones Select Dividend Fund and eleven sector-based funds).

Interestingly, the PHLX already trades options on the Dow Diamonds (DIA) ETF. In fact, the PHLX launched those contracts just days after the original ISE ruling, moving fast to take advantage of the "open source" market.

The PHLX wouldn't say how this new deal impacts that product.

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