Time is on my side. Yes it is.
- The Rolling Stones
Recently, here, I discussed the distinguished history of CME Group (NASDAQ:CME), up to the Exchange's ground-breaking shift to electronic trading circa 2000. The remaining important chapter of CME's development to date is its consolidation of other US futures exchanges. But that chapter is unfinished. CME acquisitions have come to a screeching halt.
What is the future of the CME? How will the competition between the CME and ICE (NYSE:ICE), the other acquisition-minded clearing manager, play out? The answer will depend largely on the parallel competition between the Commodity Futures Trading Commission and the SEC. Why? Because ICE has become a creature of the controlling New York-London dealer oligopoly and its captive regulator, the SEC. The CME remains a creature of the wild and wooly competitive marketplace.
Everything is not well at CME Group. The juggernaut is stalled. There are two things holding the CME back:
- The regulation of spot market trading.
- Futures culture and the contrast to the culture of the New York-London dealing community and its Washington clients.
These apparently different things have a common thread. And to understand the forces impacting the CME, it is useful to understand that thread.
The CME has a new leader, Terrence Duffy. Mr. Duffy receives credit in the press for shepherding the Exchange through its transition to electronic trading, its mergers with other exchanges, and the introduction of a meld of futures with certain over-the-counter trades through ClearPort, (a way of transitioning an over-the-counter (OTC) trade to a futures trade, as well as a way of Clearing OTC trades). One can expect Terrence Duffy to be open to change and aggressive. His roots are the CME floor community, also significant in predicting his future decisions.
Consolidation of futures trading. First, to bring futures exchange trading up-to-date. Probably due to its lead in electronic trading and its greater trading volume, CME Group bought The Chicago Board of Trade, later mopping up the two remaining major futures exchanges in New York, The New York Mercantile Exchange and COMEX.
The acquisitions consolidated the electronic trading and clearing of futures within CME's Globex system. Arguably the consolidation was simply an acknowledgement of the economies of scale of a single electronic clearing system that replaces several. The consolidation might have raised antitrust issues, but the fact that the various markets traded different instruments seems to have dampened any public or regulatory concern over the issue.
From an economist's point of view, there are three benefits:
- The common mark-to-market-in-cash transaction clearing system.
- Margins based on price volatility of the underlying cash market.
- Multiple separate commodities.
These factors all increase the efficiency of exchange resources available to protect against pressure on the clearing house due to a single large price change.
In short, the likelihood of an exchange failure, or of a recurrence of the kind of pressure brought by a small powerful group of clearing members upon the CME clearing house, when the CME auctioned off Lehman's positions, is reduced by consolidation.
The new face of exchange competition, the rise of ICE. Competition in futures trading is not over, however. Probably because of poor decision-making by the management of the New York Mercantile Exchange, once the sole trader of energy futures, today there is hot competition for the energy forward and futures trading business between Intercontinental Exchange, an upstart headquartered in Georgia, and CME Group. History teaches us that competition between two markets in a single time zone is ultimately won by a single market. See, for example, my discussion of the competition between CME and COMEX for the gold market, here. That competition was ultimately won by COMEX.
The floor traders at New York Merc unwisely fought the tide of history, attempting to force the energy trading business through the floor long after electronic technology had bypassed floor-trading technology. The result: electronic-only ICE was an instant success in energy futures trading. The purchase of the New York Merc by CME Group was too late to save the Merc's energy dominance. Thus, the world is being treated to competition between the two dominant exchange management firms, CME Group and ICE, in energy markets.
The outcome of this battle is pivotal. If, as I expect, CME dominates, ICE will become less a US-based futures clearing firm; more an internationally-based data management firm, further increasing the gulf between the business philosophies of CME and ICE.
Over time, it has become apparent that ICE is slowly being co-opted by the New York-London big dealer community. ICE is a serial exploiter of various Washington regulation-created monopolies. For example, ICE has successfully sought to be the source of the various OTC indexes such as LIBOR that cement the dealer bank control of these London-based OTC markets. And ICE's willingness to cede dealers control of credit default swap (CDS) clearing may have helped ICE to dominate CDS trading. But ICE's purchase of the New York Stock Exchange is most likely the strongest tie that married ICE to the dealers. The CME, with its competition-drenched, floor-trading roots, has avoided that trap.
How spot market trading presents problems for CME Group. As electronic trading opens futures and securities markets to a common set of retail customers, the split between securities markets and futures markets makes less and less sense. But electronic trading also bares the significance of the distinct mechanisms by which futures and securities markets control risk.
The opening of competition among trading technologies between futures exchanges and securities exchanges would, in a world driven by competition, open spot markets to invasion by the CME.
But the spot securities markets are not competition-driven. They are regulation-driven and oligopoly-bound, due to the big dealers' regulatory capture of the SEC. The effect is extreme exchange inefficiency, a result of anachronistic SEC rules.
The Commodity Futures Trading Commission (CFTC) by contrast, born of the market forces that created financial futures and carried by the winds of Congress' decision to award all derivatives markets to the CFTC, has shown a light touch and an openness to change that the SEC has not.
Perhaps more importantly, the SEC has managed, perhaps with good intentions, to introduce a system of market practice - the National Market System - that, by ignoring a rather important law of physics (that light has a speed) has thrown securities markets into utter chaos. The result is a system of twelve parasitic, redundant, stock exchanges that serve no market purpose other than self-enrichment. The myth that these exchanges compete is belied by the reality that ten of them are owned by three firms.
It is apparent that the CME is not interested in pursuing competition with this opposition [ICE, Nasdaq (NASDAQ:NDAQ) and CBOE Holdings (NASDAQ:CBOE)] outside the CFTC umbrella in the United States. The CME has passed on several chances to buy one of the securities exchange cash cows - most recently, the blatantly parasitic BATS (BATS), which has been acquired by CME's cross-town competitor, CBOE.
The history of the futures market struggle with the New York-London-Washington Axis. Chicago was presented with a hostile atmosphere when financial futures became important, circa 1980, for a variety of reasons. The stock exchanges of New York, The New York Stock Exchange and the AMEX, fully expected to dominate financial futures trading as well as securities trading. With domination in mind, they created new futures exchange subsidiaries. The stock exchanges were supremely confident, in part because of under-the-table support from Washington. Thus, it came as quite a surprise to the New York trading community when both New York-based securities exchange-owned futures-trading subsidiaries, listing me-too interest rate and foreign exchange contracts, fell flat on their faces.
This development bared the superior market efficiency of futures trading in any given commodity or securities market - and foreshadowed the acquisition of the two major stock market firms: NYSE, by ICE; BATS, by CBOE. Are the world's spot markets to be divided among ICE, CBOE and Nasdaq, or does CME have a role in spot market trading? The answer will depend on the coming struggle for domination in Washington between the CFTC and the SEC. More of this Washington battle to come.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.