Given their merger’s rocky beginning, the meshing of the Chicago Mercantile Exchange’s systems with those of its partner, the Chicago Board of Trade, perhaps should have been more complex. Although it was more than nine months between the initial announcement and the shareholders’ final approval, it has taken just over six months to merge the two exchanges’ trading onto a single platform – just in time for the combined group to launch an $11bn takeover bid for Nymex.
The CME-CBOT deal almost never happened, after a very public hijack attempt by the Intercontinental Exchange (ICE) tested shareholders’ nerves. The deal – which created what is, by some stretch, the world’s biggest futures exchange – has been dogged by criticisms that the CME is monopoly-building. However, Arman Falsafi, MD Europe, Middle East and Asia at the CME Group, says its customers will soon realise the operational efficiencies that come with such unparallelled scale.
Single front end
In January, CBOT products were migrated onto the CME’s trading platform, Globex, giving customers who have typically had to operate interfaces to both exchanges access through a single front end.
There is a precedent for such migration returning value to the customers, according to Ms Falsafi, when the two exchanges signed a commercial agreement in 2004 for a common clearing link, which saw the CME settle CBOT contracts. “The consequence of that was we returned about a billion dollars to our customers and intermediaries in performance bond or margin because, all of a sudden, they could fully offset their treasury positions against their Eurodollar positions, DOW positions against S&P positions, because we margin portfolios as a whole,” she says.
“We also returned a couple of hundred million in security deposit that the clearing firms had with us and we provided them immeasurable efficiencies in their own back offices because they didn’t need two sets of staff dealing with two clearing houses.”
With the trading system integration, brokerages who have typically had to build their platforms with two links to the Globex and e-CBOT systems will now only need to maintain one. Maintaining a link to an exchange involves keeping up with upgrades and releases, and this should now be simplified. “The efficiencies of having one interface to one exchange – getting all of the markets – is something we can’t measure, but it’s very significant for anybody who maintains a platform connected to us,” says Ms Falsafi. “We also think that Globex is much better than the current eCBOT platform. It’s faster, it has a higher capacity for transactions – we also think that the functionality is very rich. All of that will contribute to efficiencies in the marketplace.”
Combining the two systems not only adds to the efficiency of trading existing CBOT products, it should allow the exchange to trade intra-commodity spreads. “We have intra-commodity spreads today, so you could trade a front-month Eurodollar against a second month Eurodollar without any leg risk,” Ms Falsafi says. “Over time we will be able to do that between commodities, so you could trade the bonds against a strip of Eurodollars, for example, which also will facilitate people to be able to trade the way they want to trade at a lower risk of execution.”
The combined exchange’s ability to offer scale and an ever-broader product range seems compelling for the CME Group’s shareholders and their end users at least. Nymex, which confirmed on January 28 that it was in talks with the CME, already uses the Globex system, and there seems to be potential for further expansion of the product set and yet more operational synergies.
Direct access
But some in the brokerage community remain to be convinced. As with equity markets, increasingly the larger buy-side traders are seeking direct access to the exchanges, bypassing their traditional execution brokers. When Calyon Financial and Fimat, the French brokers, merged their operations in January this year, Patrice Blanc, CEO of the new entity, Newedge, cited increased competition from the new, merged exchanges as a driver behind the deal.
“It was important for us to gain size to compete with some of the exchanges,” he said. “It is true that as some exchanges have been merging they are disintermediating us in some way.
“If you look today at what kind of products the CME can offer, if you are just a hedge fund trying to trade the US yield curve, you don’t need to have a futures commission merchant (FCM) in the middle. You can become a member and trade all products, from the very short term interest rate products to the US T-note. And the fact that they have all those products within the same exchange, with also the vehicle to clear those products, they can disintermediate the FCM.”
But the CME’s Ms Falsafi says: “People have often said that exchanges are disintermediating the broker. I think that’s a bit naïve.”
It is natural that the buy-side wants more dialogue with the trading venues, particularly where they are responsible for large volumes. In the case of a large end user that has 5 per cent market share in a product, “you can safely assume that these entities want a relationship with the exchange,” says Ms Falsafi. “They’re going to come to us. They’re not going to be a passive end user happy to sit behind this wall that an intermediary might want to put up in front of them. They want things from the exchange.”
The increasingly electronic nature of trading has undoubtedly influenced this shift. The CME-CBOT has moved from a floor-based model, and although it maintains some open outcry trading – mainly in US options – between 90 and 95 per cent of its futures business goes through Globex. This has made it far easier for sophisticated buy-side companies to build out their own interfaces to the exchange without the need to go through an executing broker, a role that is in some ways a remnant from the days of phone broking. It has also meant that the exchange can go direct to clients, bypassing the traditional intermediaries.
“I’m not denying that we go to them [the buy-side] as well, but I think the world has moved on from where the exchange was this closed physical space that only so many people could walk into, to this really open community of people who come together day and night and want to trade. And we have to change with that,” Ms Falsafi argues. “We’ve demutualised, we’ve become a for-profit entity and we’ve focused on the end client because we know in an electronic world that’s what the endgame is. It’s not a set of brokers having access into our pits and taking phone calls from end users and executing orders, it’s a lot more than that.”
Ms Falsafi’s message is that brokers need to innovate at the pace of the changing environment, rather than complain about that new world. There is still a place for the brokers, but that place is higher up the value chain than before. “The old model of execution in a self-executing electronic world is not enough,” she says. “We’re all growing up and you can’t do what you did six years ago and expect to be profitable. I think that’s what a lot of the cries about disintermediation are about – that recognition.”
Broker reaction
As expected, brokers have reacted differently to the realisation that their business is changing. Newedge is talking in terms of increasing the size of its prime brokerage operations and offering those high value services, as well as simply creating scale in its merger. It is unlikely, however, to try to launch a competitor, as a consortium of brokers and hedge funds, including JPMorgan and Barclays Capital, did in December 2007.
“There is no specific plan,” Newedge’s Mr Blanc said at his company’s launch. “We have seen in the past some attempts to capture the liquidity from other exchanges. I am sure you remember the Cantor Exchange in the 1990s – it has been a failure. We have seen Eurex US coming to Chicago and trying to capture the US Treasuries market – it has been a failure. It is extremely difficult to capture this liquidity. It is true that Newedge has a lot of liquidity internally, but becoming an exchange – that is another story.”
The consortium, which is yet to release any meaningful details about its model or technology, will surely be looking to the experiences of Cantor and Eurex US, whose bids for market share ended ingloriously.
Kevin McPartland, senior analyst at the Tabb Group, says that the CME-CBOT’s position, including the rights it has to certain indices, could prove too much of a barrier to competition. “The fact that they [the CME] have sole rights to the S&P Futures is going to make it tough for anybody, including for the established players like the ICE, to gain market share. Traders look at liquidity and the CME has it,” he says. “I think what we’re going to see is that where the competitors come in will be the same as the equities market – competitive pricing is going to be the new entrants’ tool to try to pull liquidity off. If they offer rebates for providing liquidity, that could immediately pull liquidity onto a new exchange.”
Ms Falsafi’s argument is that a user should look beyond the simple metric of trading fees. “We like to point out that there is a larger overall cost to trading that isn’t just the 11¢ that you pay for the clearing and trading of a bond future on Globex,” she says. “If you took our fees down – all of the fees we earned last year at CME Group – by 10 per cent, you would be giving our users back $100m. By contrast, if you had just a 1 per cent slippage in the bid-ask spread, that would amount to $12bn of cost. So it’s a bit too simplistic to be talking about exchange fees alone.”
The CME has said on several occasions that it welcomes competition and, if the adage that liquidity attracts liquidity holds true, there might be good reason for that. The new exchange, should it come to fruition, is likely to be all-electronic and may compete more directly with the ICE, taking away its market share and only serving to strengthen the CME’s position. And the ICE, which announced a technology overhaul of its own this month, showed during its own tenacious approach for the CBOT that it has an appetite for a fight.
