For most of last year, Buck Haworth was telling anyone he could about how CME Group altered his firm’s designation, which effectively ratcheted up his data fees at the end of 2012, and he warned others that they could face the same issue. The problem, he told us back in June, wasn’t so much that they’d raised his fees, but how they did it — first with a multiyear examination into his business practices, and then citing incomprehensible passages in its rules. So, it came as no surprise to him when the exchange boosted its data fees across the board just after Thanksgiving 2013 — and that it did so with a confusing set of rules that industry heavyweight Les Rosenthal derided as a “five-page fee matrix accompanied by three pages of footnotes” (see “Confusion reigns,” below).
Indeed, Rosenthal — a two-time past chairman of the Chicago Board of Trade and co-founder of Rosenthal Collins Group — questioned “CME Group’s actions in implementing these new market data fees without dialogue with market participants” — an act he said was “insensitive, at best, and disingenuous at worst.”
Opinions on the increase may depend on your perspective. End-users don’t like it. From a shareholder perspective, the fee increase is perfectly rational. It is the kind of “growth” the Exchange has been achieving since it shifted from being a nonprofit club working to build markets to being a for-profit service provider.
Ironically, the fee increase came shortly after the CME vigorously defended its end-users against potentially disastrous increases in compliance costs from a new Commodity Futures Trading Commission (CFTC) rule interpretation on residual interest and the on-again/off-again battle over a derivatives transaction tax.
While Haworth was sounding the alarm, the cash-strapped CFTC was expending valuable resources to pursue technical violations from years ago, adding costly compliance rules, re-interpreting its residual interest rule that could possibly double end-user margin requirements and carrying on a costly court battle to defend its position limits rule.
It was, in short, a good year for CME shareholders and a chaotic year for the CFTC — but ultimately a disastrous year for end-users, who seem to be heading into 2014 with the odds stacked against them (see “For profit, for whom?,” here).
London metal mischief
CME Group is hardly the only exchange to be accused of putting shareholders ahead of users, and the accusations don’t stop with fees. In fact, even before the CME imposed its data fees in late 2013, breweries and other aluminum users in the United States were complaining that the London Metal Exchange (LME) maintained rules that extended wait times at warehouses to ratchet up profits for shareholders like Goldman Sachs, which had purchased one of the largest aluminum warehouses in North America.
In a July piece called “A shuffle of aluminum, but to banks, pure gold,” the New York Times explained how a “a merry-go-round of metal” was costing U.S. consumers billions of dollars per year as trucks needlessly shuffled chunks of aluminum between LME warehouses to comply with rules imposed by Goldman Sachs .
Both Goldman and the LME denied any collusion, and the practices finally are being phased out — but only after billions were skimmed from the system. Now Goldman is seeking to unload the warehouse.
The for-profit model pushes exchanges to attempt to create profit centers from what used to be member services.
Pat Kenny, senior vice president of CQG, says the change often favors one participant or type of participant over others, and cites a policy that Eurex imposed in the middle of last year. When his company introduced a simple charting interface for customers, Eurex started charging those customers $75 per month — a fee that customers didn’t face if they went through companies that only had prices but no charts on their screen.
Neither he nor Haworth are averse to competition or profit, but both say the self-regulatory and communal functions of an exchange might best be served with a different governing structure.
“When things were good, they were sometimes cutting exchange fees,” says Kenny. “Everybody was in it together on the basic infrastructure, even though we competed on everything else. But as a for-profit organization, that’s gone right out the window.”
On the regulatory front, reforms designed to incorporate the unregulated world of over-the-counter (OTC) derivatives into the well-functioning and well-regulated futures apparatuses are instead hobbling what works and ignoring the issues that need to be fixed — largely because the major investment banks and housing scammers who created the 2008 crisis have been able to soften the impact of Dodd-Frank on their operations, while less-powerful but better-behaving players are left with a greater regulatory burden.
The futures sector has, of course, suffered two major regulatory failures of its own — namely the coopting of customer funds by CEOs at MF Global and PFG — but instead of addressing these, the CFTC has peppered the sector with regulations many of which will add costs to end-users.
Take the CFTC’s “residual interest rule,” which is really a reinterpretation of an old rule and requires FCMs to deposit money into segregated funds to cover customer margin calls until the customer money arrives. First, it doesn’t really address the issues raised by PFG and MF Global (in fact it could aggravate it), because it might even force FCMs to get more money up-front from hedgers, who in turn are the very people the entire futures industry exists to serve. This and a related rule that requires FCMs to take capital charges for unmet margin calls seem designed to prevent undercapitalization, but they do nothing to keep unscrupulous FCMs from digging around in customer funds.
Instead of preventing future digressions, the CFTC has been reaching back in time to carry out enforcement actions on companies for technical violations of rules involving customer segregation years ago. A cynic might suggest these actions were taken to justify its residual interest reinterpretation or that there is a problem if it takes so long — one enforcement case cited a five-year-old violation — for the regulator to act.
Even National Futures Association (NFA) President and CEO Dan Roth pointed out that the “new” rule would not have prevented either the MF Global or PFG debacles, and one of the panelists at a recent House Agricultural Committee hearing correctly pointed out that it could have doubled the losses of customers of MF Global because they would have had higher margin requirements.
CFTC’s lack of focus
There is the CFTC’s effort to implement position limits — with an estimated cost to the industry of more than $100 million — based on assumptions regarding “over-speculation” not backed by any empirical evidence. Former CFTC commissioner Michael Dunn, who grudgingly cast the critical vote moving the rule forward, famously said, “With such a lack of concrete economic evidence, my fear is that, at best, position limits are a cure for a disease that does not exist or at worst, a placebo for one that does.”
Yet the cash-strapped agency had a laser focus on limits while MF Global imploded on their watch and then was more than happy to let the Securities Investor Protection Corporation (SIPC) do the heavy lifting in attempting to claw back customer money illegally diverted. Later it engaged in a costly appeal after the rule was rejected in court.
Then you have the cumbersome reporting requirements developed under Rule 1.35 that state, “…FCMs, certain IBs and RFEDs are required to keep a record of (and therefore tape record) all oral communications provided or received concerning quotes, solicitations, bids, offers, instructions, trading and prices that lead to the execution of a transaction in a commodity interest and related cash or forward transaction, whether communicated by telephone, voicemail, mobile device or other digital or electronic media for a period of one year.”
Participants at the 5th annual conference on Futures and Derivatives at the Chicago-Kent College of Law of the Illinois Institute of Technology were concerned that new rules will force smaller FCMs out of the business, which will leave the retail customers nowhere to go. “We want a diveristy of FCMs,” said CME Group’s Dale Michaels. “Not every [FCM] is going to clear the dairy farmer in Iowa.”
There was a consensus from the event, which catered to futures industry legal and compliance professionals, that the current (outgoing) regulatory regime isn’t in touch with the industry, isn’t particularly concerned with knowing the impact of its rules and is incapable of looking inward to see that many of the recent problems were the result of poor enforcement of existing rules and not a failure of having proper rules in place.
The wrap-up panel on hot topics in compliance revealed a troublesome trend of the CFTC demanding more information from FCMs without a thought to its impact on those firms. According to Mary Beth Rooney of Citigroup Global Markets, FCMs are expected to have a specific policy and procedure for every new rule. She noted that industry participants were unclear on the extent and detail needed of these policies and procedures, yet the CFTC has not provided further guidance despite a looming deadline.
One professional attending the event stated the attitude of the CFTC was simply that these are the rules and they did not particularly care what burdens it would place on the industry.
So a regulatory overhaul made necessary to a great extent by the creation and marketing of dubious investment products by large investment banks will end up causing more consolidation, forcing more business to the larger bank-run FCMs.
In the end, the victims of the MF Global and PFG debacles are facing another hurdle, and higher costs are falling on those least able to fight back.
The CFTC leadership is going through wholesale changes and the new regime may be more responsive to industry concerns and pay more attention to the cost/benefit side of regulations. And if exchanges press their advantage, brought on by demutualization and consolidation, new competition invariably will rise.
Hilary Till (see “Chicago’s futures industry: A story of crisis and opportunity,” page 14) points out that it often has been in periods of extreme difficulty, like the industry is currently going through now, when the seeds of innovation emerge. That pattern can repeat itself and Chicago’s risk management community is a likely place for it to happen.
Daniel P. Collins contributed to this article.
For profit, for whom?
Buck Haworth’s family runs technology provider Born Capital, and he’s just one of several market veterans who say CME Group’s mandate to serve shareholders leaves users in the lurch. It’s a debate that arguably began when Olof Stenhammar founded OM Sweden as the first for-profit electronic options exchange in the 1980s – although for Stenhammar himself, the for-profit vs. non-profit debate was always wrong-headed.
“Everyone is saying that demutualization drove down the cost of trading,” said Stenhammar in 2001, “but the reduced fees have nothing to do with whether an exchange is non-profit or for-profit and everything to do with technology.”
That new technology removed costly floor brokers and their support needs and replaced them with relatively inexpensive trade-matching engines. The shift from a non-profit model to a for-profit model may have speeded the transition, but it was technology that drove down costs. Haworth agrees.
“Before the floors started winding down, the customers paid all of the costs of the floor brokers and the floors themselves,” said Haworth in June. “When the markets went electronic, all of that money shifted over to the exchange. It was ‘found money.’ Now, it isn’t enough, so they want market data fees.”
It’s a quest that he says the Exchange began in 2010, when the CME data distribution department started peppering him and his staff with questions about their customers and their business plan. It seemed at first like a minor annoyance, because Born only deals with active traders who rack up considerable execution fees and traditionally have been exempt from data charges. But in November 2012, the Exchange told Haworth that, based on their answers to CME’s inquiries, Born Capital was now classified as a data distributor, and that meant they had to pay new licensing fees. When Futures asked the Exchange to explain the 2012 fee increase, CME Group sent us a 53-page market license agreement and directed us to Schedule 4, which implied that people who used APIs to analyze historical data – which is almost anyone who develops trading systems – could be charged a data fee. While the charge nominally refers to people who are distributing data, the criteria are vague and subjective and include this caveat: “CME reserves all rights to determine whether any compilation of data represents historical information in accordance with this definition.”
By that definition, anyone who uses Excel or FIX (Financial Information eXchange protocol) should be subject to the 2012 fee.
A former CME board member, Haworth stopped answering questions and started demanding answers — and warning everyone he saw that massive hikes were afoot.
When the hikes came, they were not only massive, but camouflaged to such an extent that it took weeks for traders to realize what had hit them. It imposes fees on every trading screen, and it extends the definition of a “professional” trader to include anyone who is registered with the SEC or CFTC, any state securities agency, anyone defined as an investment advisor and anyone employed by a bank. It captures many smaller traders who are classified as LLCs. Now they are classified as professionals and subject to the data fees, which can top $670 per month, per exchange. It adds up quickly. While the Exchange has grandfathered some fee increases on established traders, those aren’t the ones Haworth is worried about.
“The lifeblood of any industry is the new people coming in with new ideas and new energy and new enthusiasm,” he says. “At the beginning, they need all the help they can get — especially in this business, where they usually lose money until they figure it out.”