Financials: Value Moving From Investment Banks to Derivative Exchanges

Includes: CME, ICE
by: Harry Long

Where is value migrating to in the world of financial markets? From investment banks to the derivative exchanges.

Unlike the stock exchanges, with fungible equities (you can buy on one exchange and sell on another venue entirely), futures contracts have traditionally been non-fungible. When you combine non-frangibility with rising commodity prices, a legislative push to standardize and move on to exchanges with a variety of previously OTC instruments, and in addition, the rise of OTC instruments cleared by the exchanges, you have multiple forces all pushing in the direction of volume growth at the CME and ICE.

More importantly, whereas investment banks risk capital when trading, the CME and ICE have virtually assured profits on every trade. Unlike physical casinos, they do not need to expand capital expenditures commensurate with growth. Computing power gets cheaper every year, and increasingly, trading floors are a remnant of the past.

If you had to decide where you want to be in the value chain of trading, you essentially have two decisions:

  1. A probability of making money on any given trade (if you're good), with volatility, and finite capacity (trader, investment bank, hedger).

  2. A 100% chance of making money on trades once volume is high enough that fixed costs are covered, and almost limitless capacity (a derivatives exchange).

Clearly, option II is most attractive to the rational mind. What can we conclude from this?

  1. Dominant derivatives exchanges will eventually dwarf the size of investment banks.

  2. Their margins will exceed anything the financial community has become accustomed to.

  3. Unlike investment banks where much of the value is eaten up by star employees, shareholders of the derivatives exchanges will enjoy much of the value generated due to the automated nature of the business model.

What is the risk to this thesis? If regulators and the CFTC allow contracts to become fungible, multiple clearing houses will be created as a back door way for the investment banks to avoid the strict margin requirements of the major derivatives exchanges. If the government is forcing your OTC contracts on to exchanges, and the exchanges' clearing houses are forcing rational margin requirements, why not set up your own exchange and clearing house with lax margin requirements? The government should not allow this. It would bring us full circle to the original problem—multiple pockets of linked risk.

From a regulatory, technological, information, and market-confidence standpoint, it is far easier to manage one or two centralized depositories of risk, rather than dozens of smaller, linked pockets of risk. Huge clearing operations engender market confidence born from the strength of member firms. As we see from reports about what really happened with Lehman's (OTC:LEHMQ) trading positions at the height of the collapse in 2008, it comes down to the strength of clearing houses. The government should oppose anything which diminishes that strength. Unless the government makes futures contracts fungible, the best bet is to own the house in what could become a multi-decade secular trend.

Disclosure: Long ICE and CME