Let there be light: Futures leader instructs equity world

Terrence Duffy, who as executive chairman of CME Group Inc. oversees the world’s largest futures exchange, has a solution for those seeking to fix the U.S. stock market: kill dark pools.

While all futures trades happen on exchanges such CME Group (NASDAQ:CME), only about 60 percent of American equity volume does. The rest takes place on venues including dark pools, where orders are hidden until transactions are completed. That hurts investors because it obscures the true price of stocks, Duffy said today during an interview at Bloomberg News headquarters in New York.

“Fix the fragmentation issue, and you’ll fix the problem,” Duffy said. “We need to have 100 percent of that liquidity on exchanges.”

Duffy’s position aligns him with his biggest rival: Jeffrey Sprecher, the chief executive officer of IntercontinentalExchange Group Inc. (NYSE:ICE)Sprecher’s company, which like Chicago-based CME Group has its roots in futures, recently bought the New York Stock Exchange, giving it about 20 percent of the nation’s equities volume. NYSE and its rivals have lobbied the U.S. Securities and Exchange Commission to enact rules limiting the amount of trading on dark pools.

In Duffy’s idealized stock market, even though trades could still be distributed across multiple exchanges, dark pools and other off-exchange platforms would be eliminated. There are currently 13 stock exchanges, and ICE, Nasdaq OMX Group Inc. and Bats Global Markets Inc. are the biggest operators. There are about 45 other alternative trading systems, including dark pools.

More Concentrated

Futures trading is more concentrated. CME Group, where 14 million contracts a day changed hands in February, has its own clearinghouse, setting it apart from stock markets such as the NYSE. The clearinghouse requires investors who buy a contract on CME Group to return to the exchange to sell it. Nasdaq OMX CEO Bob Greifeld in March called that a monopoly.

In contrast, stocks can be bought on one exchange and sold on another because they are all linked to one third-party clearinghouse, Depository Trust & Clearing Corp.

Duffy said the futures market model, known as the vertical silo, is superior because it doesn’t let high-frequency traders use the same arbitrage strategies they deploy in stocks. Given that trading of Standard & Poor’s 500 Index futures, one of CME Group’s biggest revenue generators, takes place in only one place provides investors and traders with constant price signals, he said.

‘Real Value’

“Everybody has to come to the same four walls in order to get it, so in return you don’t have fragmented prices of the S&P basket all over the place and you know what the real value is,” he said. “I’m a proponent of actually knowing what the price is.”

Many broker-dealers own dark pools, and author Michael Lewis’s latest book, “Flash Boys,” argues that they act as a key intersection between high-frequency traders and brokerages’ investor clients. The banks, Lewis says, charge HFT firms for the right to trade against orders placed by their brokerage customers.

About 40 percent of CME Group’s business comes from high- frequency traders, Duffy said.

 

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