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S&P Keeps Monopoly On Way To Count

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The Dow Jones Industrial Average is a very stupid measure of the stock market for at least two reasons, which are (1) it is an average of only 30 big stocks and (2) it is weighted by share price, an entirely arbitrary number, rather than market cap or equal weighting or anything at all sensible. Was Mr. Dow an idiot? Probably not? He was just a guy inventing indices in 1896, when computers couldn't fit in your pocket and were pulled by horses.1 Back then, to get a stock market average, some schmuck had to actually go look at a ticker tape for each stock price and then do the averaging on a ... I'm gonna say an abacus? (Slide rule? HP 12C?) So "add up 30 stock prices and divide by 30" seemed like a good plan; "take the float-adjusted market-cap-weighted average of 500 stock prices" did not. You can't really fault Mr. Dow for the choices he made at the time he made them.

It is now 117 years later and nobody really uses the Dow anymore except, like, everybody, but people do use the S&P 500 index, which has the advantage that it's a reasonable enough index of the thing it is an index of. But as with the Dow, a certain sense of "ooh the clerk is working so hard to calculate all these averages" still clings to the S&P, even though that's obviously false. The clerk is a computer and it's so bored calculating stock indices that it's mining bitcoins on the side just to feel something.

I think that has something to do with this CBOE vs. International Securities Exchange dispute over S&P 500 (and DJIA!) index options. The CBOE lists such options; the ISE doesn't but wants to. So the CME and McGraw-Hill, which together own the S&P 500 index, and the CBOE, which licenses it for options trading, sued in Illinois courts and got an injunction saying nobody else could use the index to list options. And today the CBOE finally totally won its case when the Supreme Court refused to hear it, leaving the Illinois court's injunction in place, and thus leaving CBOE with a monopoly over derivatives on the S&P 500.2 Here's CBOE's gloating.

There's no opinion from the Supreme Court and there's a lot of goofball copyright preemption law involved; the Illinois court decided the case not on (federal) copyright law, but on ... I dunno, this:

The court acknowledged that the index values “are freely copied and distributed globally on almost a real-time basis.” It also recognized that the index values, once published, “are in the public domain and may be freely used by anyone.” And it noted respondents’ concession that they “may assert no rights in the published index values themselves, which have been held by courts to constitute ‘a matter of basic market fact.’”

Nevertheless, the court held that respondents’ misappropriation claim is not preempted by the Copyright Act. It concluded that the Act had no preemptive effect because “[respondents ’] claims are not premised on protecting ‘original works of authorship fixed in a tangible medium of expression,’” nor did respondents “seek to preclude ‘reproduction, performance, distribution or display’ of their indexes.” Rather, the court stated, respondents’ misappropriation claim “is premised on ISE’s unauthorized use of the research, expertise, reputation, and goodwill associated with the [respondents ’] product for ISE’s own gain.”

The computers are working so hard you see.

I'm generally puzzled by intellectual property protections for market averages: whatever little work you're doing to design and calculate the average, surely the, y'know, market is doing a ton more work to generate the underlying prices. This case leaves me just as puzzled. For instance there are the weird possible consequences. Citadel, who like trading options and wouldn't mind doing more of it, supported ISE and had this to say to the Supreme Court on the matter:

[F]or years some shareholders and investors have advocated tying compensation of CEOs or fund managers to their performance relative to that of stock market indexes. Adopting this innovation, in 2011 General Electric CEO Jeffrey Immelt’s compensation included options that would vest only if GE’s stock appreciation equaled or outperformed the S&P 500 from the beginning of 2011 through the end of 2014. ... Months later, Warren Buffet followed with a similar scheme for two of his fund managers.

Under the reasoning of the decision below and Respondents’ arguments, [the S&P index owners] could sue GE and Mr. Immelt, or Warren Buffet and his fund managers, for misappropriation in Illinois for the “use” of the S&P 500 creators’ efforts and goodwill in creating the index. This cannot be the law, and if it is, the ruling below will chill experimentation and existing practices in the field of performance-based pay.

Or consider merger transactions that link financing required to complete the deal to the performance of the S&P 500. ... Under the decision below, this sort of contingent planning is misappropriation of the S&P 500. The decision deprives dealmakers of uniform reference points for what market conditions must be in place to close a deal.

More broadly, if you do any sort of private/OTC trade, not publicly advertised or listed on any exchange, referencing the S&P 500, it would seem that CME/McGraw-Hill/CBOE/whoever could sue you. Wait that actually happens? "S&P DJ Indices generate revenue through ... index-related licensing fees, which are generally either annual fees based on assets under management or flat fees for over-the-counter derivatives and retail-structured products," says McGraw-Hill's 10-K. Do you think everyone who trades OTC options pays those fees?3

Also weird: anyone can list options on index ETFs without the permission of the index (or ETF) provider, because basically there was another unrelated court case about that and ISE won.4 So ISE can and does list options on SPY, the S&P 500 ETF; in fact SPY options are their best seller. You might think that an option on an S&P 500 ETF is a pretty good substitute for an option on the S&P 500 index, and I would agree with you, but I'm sure someone who actually trades the things will chime in and say that they have slightly different pricing times or settlement mechanics and so are TOTALLY DIFFERENT AND NOT AT ALL SUBSTITUTES and hey that's super.

Speaking of substitutes: you know who has computers? Citadel! And ISE! Also: Google, Wikipedia,5 Bloomberg ... really, I must be missing something, but how hard can it be to create a public domain index that is 99.5% as good as the S&P 500 at 0.0% of the price? Put it in the public domain, charge HFT firms for the real-time official feed or whatever, and try to convince everyone that the Nonstandard & Free 505 index is a better tool for macro hedging than the S&P 500. And, y'know, charge less.

I know, I know, the S&P 500 has all that goodwill built up - which is why ISE wants to piggyback on it in the first place. And that's definitely true: considering that ISE can't seem to convince enough people that an S&P 500 ETF option is a good substitute for an S&P 500 index option, they'll have a rough time marketing a public domain index as a good substitute. But consider that, just a few thousand miles away, another index with massive name recognition and market attention, which happens to underlie a vastly larger pot of derivatives than the S&P, is being ... er ... sort of slowly maybe replaced somehow. Here we are in what might be a brief window of market-index modernization and rationalization. Someone should really take advantage of that.

Supreme Court Denies Appeal on Options Dispute [WSJ]
International Securities Exchange, LLC v. Chicago Board Options Exchange, Inc. [SCOTUSBlog]

1.This sentence may contain small historical inaccuracies.

2.From ISE's cert petition:

By one measure, this is literally a $10 billion case. Petitioner ISE’s expert, a respected former SEC Chief Economist, estimated that the deadweight loss from inflated trading costs on the CBOE exchange, due to CBOE’s monopoly over the trading of options on the S&P 500 Index (“S&P 500”), was $9.7 billion per year, and this case involves CBOE’s monopoly over options on both the S&P 500 and the Dow Jones Industrial Average (“DJIA”).

Ponder for a moment that CBOE's yearly revenue - not from S&P 500 index options, from everything - is around $500 million a year, or 1/20th of that number. I'm no respected former SEC Chief Economist but I've read Coase and I'm gonna take the under on that $10 billion estimate.

3.Did Intrade?

4.See page 7 of their cert petition.

5.I fell into a little reverie thinking about the potential for Libor-style (but worse, and sillier, and more public) manipulation if your stock market index was a wiki that anyone could edit. Wouldn't that be so fun? Maybe just for me.



S&P 500 Finds Convenient Excuse To Not Let Snap Hang Out On S&P 500

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