From the December 01, 2006 issue of Futures Magazine • Subscribe!

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The exchange-traded derivatives world may be a high-tech global community, but it often resembles a chatty little village — complete with that one guy and gal who everyone agrees would be just perfect for each other if only they could get past their own bullheadedness. Thus, the blending of the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME) into an entity that might best be called the Chicago Megalithic Exchange comes with an air of both inevitability and surprise.

“The problem was always, ‘Who’s going to be the top dog?’” says former CBOT boss Les Rosenthal, adding that, in the end, it was the market price of the two exchanges’ shares — and warm relations between CME boss Terry Duffy and CBOT boss Charles Carey — that provided an objective way of establishing pecking order. “You have one that has a stock of $500 and another of $150,” he says. “The Merc has the coin, and they are paying a price that the CBOT thinks is fair.”

Despite lingering rumors of a CME purchase overseas, he says the crowning achievement would be integrating the Chicago Board Options Exchange (CBOE) into the new CME. “It is easier for them than looking at something in France or Germany or London or wherever because it is the Chicago culture,” he says. “Can you imagine the behemoth you’d get by assimilating the CBOT, the Merc and the [Chicago Board Options Exchange]? It would be something in the financial industry that is probably bigger than the market cap of all of the U.S. automobile companies put together.”

And, of course, the Chicago exchanges aren’t the only ones hooking up. This year, Euronext solidified its pan-European structure and absorbed cash bond-trading platform MTS before embarking on its current bid to merge with the New York Stock Exchange, the outcome of which we’ll be better able to gauge in December, when Euronext shareholders have their say. Then there’s Scandinavia’s always fascinating OMX, which in October officially completed its multi-year task of forging a slew of northern European exchanges into the OMX Nordic Exchange.

Meanwhile, in the developing world, the story is proliferation rather than consolidation. Some of the new projects have been launched in cooperation with developed exchanges, as is the case with the Joint Asian Derivatives Exchange (JADE) set up by the Singapore Exchange and CBOT, but more and more of them are home-grown entities using home-grown business models and often home-grown technology, like the Multi-Commodity Exchange of India (MCX).

And all this is happening against a backdrop of major regulatory and technological upheaval. The European Union, for example, is hammering out its Markets in Financial Instruments Directive (MiFID), which will finally bring European regulators into line with each other. Many in the United States are calling for the creation of a single regulator for derivatives and securities, and the regulatory regimes of India, China and scores of smaller countries across Africa and Latin America are all watching each other in an effort to remain compatible while meeting local needs.

And how are futures commission merchants (FCMs) responding? Mostly with yelps of euphoria, tempered by the knowledge that competitive pressures apply to them as well.


Technology, like consolidation among exchanges, bestows both blessings and burdens on FCMs. “People are getting more focused on what technology can provide them with,” Rosenthal says. “People still shop commissions and margin as well as technology, but technology has gone from number three to number one.”

And not just because of what it does at the point of execution, says

Peter Green, chief executive of London-based FCM Kyte Group. “It speeds product innovation,” he says. “Exchanges can be much more adventurous in trying

out new ideas, and now we’re likely to see alternative trading platforms, look-alike contracts, etc.”

And we can credit technology with bringing once distant markets ever closer. “On a geographical basis, you will see numerous exchanges coming onto our radar that G10 traders have almost never heard of before,” says Richard Berliand, head of futures and options for JPMorgan. “Look at Taifex (Taiwan Futures Exchange). They are celebrating their 10th anniversary, but it wasn’t until three years ago that many people in the international community really started to notice them.”

Joe Guinan, chairman and CEO at Advantage Futures, agrees. “Asia will try to get their products more mainstreamed. Asian exchanges will become more integrated into the rest of the world electronically, and the CME and CBOT can now work together as one to make deals and MOUs with Asian exchanges instead of each one making a deal with each Asian exchange. And that will bring more new Asian products to U.S. customers,” he says.

But for now, the biggest growth is closer to home. “The speed with which grain markets are becoming electronic is far faster than any other past market,” Guinan says. “It’s really showing customer preference for electronic trading.”

And that preference is showing up in FCM bottom lines. “Our revenue is up over 75% so far this year,” Guinan says, crediting the surge in electronic commodities trading — even though the bulk of Advantage’s volume still comes from government debt trading.It’s a similar story at Xpresstrade, says principal Dan O’Neil. “As of the end of Q3 2006, our futures and options volume was up 67% over the previous period in 2005,” he says, again laying the credit on the combination of electronic trading and commodities.

Green reminds us that electronic trading more and more means algorithmic trading. “Kyte recently recorded 55% of its monthly volume from algorithmic trading,” he says. “This can only grow as the user base expands, programming becomes more sophisticated and tick liquidity deepens. It is perfectly feasible that algorithmic trading expands to 80% to 90% of total volume in the next few years.”


When evaluating the pros and cons of exchange consolidation, Berliand cautions us to do so on a case-by-case basis and offers a balance sheet analysis, with five benefits flowing from consolidation and three drawbacks. “On the plus side, consolidation reduces operating costs, reduces the number of technology interfaces you need, and in rare cases where floors still exist it allows us to reduce the number of people required to cover a given amount of businesses,” he says.

“Arguably, where consolidation results in a concentration of liquidity pools, you could say it reduces the bid-offer spread as well and finally, on the clearing side, consolidation can reduce margin requirements at the exchange level due to risk offsets.”On the negative side: “As a user, the biggest single negative is the pricing power of a vertically-integrated monopoly or near-monopoly organization,” he says. “The second is that exchanges with big monopolies and SRO (self-regulatory organization) status have potential conflicts that need to be managed. And third, the reduction in competition potentially stifles innovation in both product and process.”

Michael A. Manning, president and CEO of Rand Financial Services, says the plus side far outweighs the minus. “There is some fear that it will have monopolistic pricing powers, but I am not fearful of that,” he says. “There’s plenty of competition out there and there are plenty of efficiencies to be gained from the merger at the exchange and at the clearing FCMs.”

For his money, Interactive Brokers Managing Director Steve Sanders liked it the old way — when scores of smaller exchanges were competing for liquidity. “It means lower fees

and more innovation,” he says. “When you have a public company and their number one goal is to their investors, it would be hard to explain to investors that you want to lower your fees.”

Alaron CEO Steve Greenberg points out that the new CME hasn’t altered the landscape in terms of market share per particular product. “These exchanges did not compete on the same products,” he says. “If they had, it might be cause for worry because there would be a loss in competition, but what’s important in such mergers is that the efficiencies benefit the end user.”

Rosenthal agrees that the merger hasn’t altered the competitive landscape as much as some think, but he still worries about exchanges getting too much pricing control. “The problem is that it doesn’t matter whether or not the CBOT and Merc are put together; they already had pricing power,” he says. “They were exercising it separately, so I don’t think it makes any greater concentration.”

Green notes ruefully that “after the CBOT had seen off Eurex-US, the exchange proceeded to remove the fee discounts that they had introduced to combat the European threat and then subsequently raised them. If anything, there is more competition on the clearing front these days, as that’s where fee reductions are being promised.”


And that brings up another long-simmering issue that has come to a boil of late: the convergence of OTC and exchange-traded products, especially the clearing of OTC products. Bill Marcus, head of business development, North America, for Calyon Financial, says the trend towards ever smaller players engaging in OTC derivatives transactions will keep this development in an uptrend. “Credit sensitivity will drive product creation but also increased infrastructure cost,” he says. “It will also result in new revenue opportunities.”

Patrice Blanc, chairman and chief executive of Fimat, notes the blending of exotic structured products with more standard listed ones offers opportunities for clearing FCMs like his. “FCMs differentiate themselves by adding value in terms of execution and clearing,” he says. “If you are just providing basic execution or clearing services, the exchange can push you away from the market. Sophisticated execution means mixing futures and cash products or offering trading strategies. Added-value clearing means to be able to offer cross-margining and portfolio margining services,” he says.

And Green says we can expect a new wave of listed products such as credit default futures, which resemble or are built on OTC products. “As exchanges find it harder to introduce more pure futures contracts into their offering, so they will find a way of bridging with the OTC markets,” he says. “And the OTC markets, of course, are increasingly looking to the central counterparty model for credit risk mitigation. Both models have a great deal to offer each other and we should see major developments on this front.


Exchanges were founded by users, and there have been several attempts by users to launch competing platforms to keep existing exchanges in line. So far, none of these efforts have actually made money, but there has been a resurgence of users taking large equity stakes in smaller exchanges. Does this represent efforts to ensure competition — a sort of re-mutualization?

“That’s nonsense,” says Berliand. “Asset managers may be users, but the buyers of exchange shares around the globe are doing so solely with shareholder return interests in mind, not as a means to having a voice in exchange user governance. The only slight exception is on the Chicago exchanges, where you have to invest in membership to receive certain fee reductions.”

Guinan says he’s fine with that — if it’s just an investment. But warns at some point conflicts of interest should be examined. “If Goldman Sachs wholly owned the New York Stock Exchange, is there a potential conflict of interest there? If there is, would the same concern be there if they owned 20%? It’s the policy makers that have to look to see if there’s a conflict of interest there.”

But Sanders, whose company has in fact taken an active investment in OneChicago and subsidiaries of CBOE and ISE, says investments in exchanges can be strategic — and that’s not a bad thing. “We do it because we’re always trying to push the technology envelope,” he says.

Rosenthal focuses more on the competitive threat to existing exchanges. “If you see how much money these exchanges are making, and if you can get to a position where you can internalize order flow as they do in the securities world, then you are in a position as an FCM to make the money that the exchanges are making,” he says. “That is the real threat to these exchanges. I don’t even think that they are paying attention. They know that the threat is out there, but they just don’t think it is going anywhere.”

The reason, he says, is the law: the Commodities Exchange Act explicitly forbids internal crossing of orders, except in exempt energy and currency transactions. “But let’s say I manage to list myself as an exchange,” says Rosenthal. “Then I can match my customer orders. It would be a good thing for me; it would be a bad thing for the exchanges. It depends on whose ox is being gored.”


In Europe, he may theoretically be able to get in some chops in a year or so, depending on how MiFID takes shape, thanks to controversial clauses regarding best execution and the allowance of internalization. Of course, theory and reality often diverge.

Although MiFID comes into effect in November 2007, Berliand doesn’t see a big bang for European FCMs. “First, the rights of internalization are constrained by exchange rules in the derivatives space, which is very different from the cash equities market,” he says. “Second, with consolidation, liquidity pools become more effective, which makes internalization less necessary than is the case in the cash equities market. And finally, you already have some form of internalization with block trades,” he says, adding that the only benefit for users to internalize is doing so when you want to operate outside exchange rules.

“But if that happens, exchanges will change the rules,” he says.

Still, anything that impacts securities will impact derivatives, if only indirectly. “The opening up of competition between execution venues also offers opportunities in the domain of clearing,” says Geert Vanderbeke, executive director of brokerage services for Fortis Bank, which is working with Instinet to build a new pan-European Multi-Lateral Trading Facility/Alternative Trading System (MTF/ATS).

“This integrated offering takes away lots of complexity [and costs] in our clients’ back office operations, while allowing them to continue engaging in financial markets on a MiFID compliant footing at minimal investment cost.”

But MiFID is a political beast — and as such, is subject to a different sort of logic than is the market. Politics may, in fact, ultimately sink the NYSE-Euronext deal, driving Euronext into the waiting arms of Deutsche Boerse. “If we end up with two super exchanges — one on each side of the ocean — obviously you will have less competition. Exchanges will have more pricing power”,” says Blanc.

But that is a story for 2007.

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