It's the same old story, same old song and dance, my friend…
Joshua Levine's original trading platform, which became the core of the first high-speed electronic platform, Island, since bought by Nasdaq Inc. (NASDAQ: NDAQ), was an important advance in trading technology. But Levine's true stroke of genius was to make Island's code open source. Freeing a creative concept is, surprisingly, more effective than a patent in protecting and promoting it. Imitation is, indeed, the sincerest form of flattery. So when Island-clone platforms became a dime a dozen, the world sat up and took notice. The value of new platforms rapidly went to zero, their introducers' secondhand creations getting no respect. The respect went to Levine.
In fact, new platforms have become a market disservice. As students of markets are aware, the sine qua non of a quality trading environment is volume. And multiple platforms trading the same instrument split volume into inefficient fragments. These multiple platforms survive only because the instruments and markets traded are so inefficient that traders cannot identify and select the most efficient platform.
So an efficient platform has become necessary for an efficient marketplace but is far from enough.
What does improve market efficiency?
Futures trading methods improve market efficiency substantially, compared to the technology of stock exchanges. There are at least five ways in which futures technology improves on securities trading technology: 1.) intelligent instrument design, 2. instrument standardization, 3.) transactions cost reduction, 4.) risk reduction, and 5.) optional transfer of ownership. To use a dime-a-dozen platform to successfully innovate in market microstructure, a Levine platform must be paired with tools that, at a minimum, include the improvements provided by futures markets.
The futures market is the current paradigm of an efficient market, and as such, shows the World how to accomplish these objectives - through use of a clearinghouse. A clearinghouse introduces several properties absent from New York- and London-based markets. Clearinghouses are the genius of the Chicago-created futures and options markets.
Intelligent instrument design
First, the organization of clearinghouses enables intelligent instrument design. New York- and London-based exchanges have never originated financial instruments. Instead, they have simply provided a place to trade existing instruments. When New York- and London-based firms create new instruments, they prefer to capture creative their value by controlling one side of the marketplace through over-the-counter (OTC) trading - eliminating a secondary market. This strategy has been proven to be short-sighted.
Why OTC instruments fail
Consider the example of the London dollar deposit market. This market began its life under the complete dominance of the major global banks. A short history of LIBOR, the London Interbank Offered Rate, is provided by Ridley and Jones, here. Long story short, the dominance of the deposit-creating banks was short-lived. In the early 1980's the Chicago Mercantile Exchange, now a subsidiary of CME Group (NASDAQ: CME), introduced Eurodollar futures, which captured most of the volume of Eurodollar trading.
These futures are so dominant that the Exchange has created a problem for itself. The Achilles' heel of futures trading is that every futures contract requires a cash market price upon which to base the futures price. In other words, futures contracts derive their value from forecasts of expected cash market prices. But Eurodollar futures have been so successful in capturing volume that the deposit market itself has become bone dry. The futures market may self-destruct as a result.
By intentionally designing inefficiency into the dollar deposit market in order to obtain rents by limiting market access, the London banks opened the door to competition from futures markets, resulting in a slow, scandal-ridden death for the market index, LIBOR.
Second, futures markets are sufficiently self-aware to know that fewer instruments improve trading volume. Futures exchanges minimize the number of instruments traded by standardizing these instruments.
A classic example is crude oil futures. Crude futures are delivered at a single location, Cushing Oklahoma - an otherwise deserted town that hosts a network of pipelines which are at the nexus of several major avenues through which crude oil flows in the United States. The oil industry further enhances the value of the Cushing OK location by identifying the Cushing price of the dominant grade, West Texas Intermediate, as the industry benchmark, against which other grades of crude are priced.
Transactions cost reduction
Futures transactions for a given instrument are all sent through a single platform.
In contrast to regulation of common stock trading, where the SEC has traditionally encouraged competition through regulations designed to ensure that multiple exchanges trade any given share, futures regulations permit the trading of a futures contract only on the exchange that lists it. The result is that futures trading obeys the market's dictate that volume is concentrated in one venue. This brings bid/ask spread to a minimum, assures a seller that she sees the world's best bid, and minimizes the clearing cost of each transaction.
The clearinghouse mechanism reduces risk in several ways. First, the clearinghouse is the counterparty to each buyer and seller. As a result, the clearinghouse is never a net buyer or seller. Thus the clearinghouse cannot gain or lose from changing prices. Second, a settlement on every day save the last is by payment or receipt of the price change during the trading day. Thus there is no question of ownership or custody on any day other than settlement day.
Transfer of ownership is optional
With the introduction of S&P 500 and Eurodollar futures contracts, the Chicago Mercantile Exchange introduced trading in contracts that did not involve the transfer of ownership. These two contracts and many more to follow are settled by the valuation of an index. The S&P 500 futures are settled by a stock index; the Eurodollar futures, by an average of pooled estimates of an interest rate.
What futures are missing
There are limitations inherent in the means by which futures are managed.
First, new contracts are, to date, hostage to a third party valuation. The futures exchanges have no capacity to create their own spot financial instruments. This weakness exposed itself in the past six months as LIBOR, the basis for the CME's most successful contract, began to unravel. Following years of scandal where banks have been exposed for permitting traders and other employees to manipulate LIBOR submissions, banks have shown reluctance to participate in the wholesale London deposit market. Bank regulators around the globe have concluded that a substitute for LIBOR must be found.
But the regulators have had little success. The Fed, through an appointed committee, the Alternative Reference Rates Committee (ARRC), has proposed a version of the overnight repurchase agreement rate, the Secured Overnight Financing Rate (SOFR), explained here. However, although CME Group has listed SOFR for trading, to date volume has been subdued.
The market wants a genuine LIBOR replacement, a term rate on high-quality private debt. Since there are no examples of term debt that could be successfully used to support a futures contract, the exchange would need to create one and establish it as a high volume market before basing a futures contract upon it.
Second, futures markets cannot trade a spot instrument. This is the reason for both the derivative nature of futures and for the inability of futures to trade, much less create, an instrument that is itself a source of value.
What would be better?
The missing ingredient in futures markets is a fund that can introduce its own spot instrument. The model for such a fund is the pass-through or the exchange-traded fund (ETF). By warehousing the appropriate cash financial assets, then issuing liabilities backed by these assets, a marketplace might dramatically improve its capacity to enhance market liquidity.
The combination of a trading platform, a clearinghouse, and an investment fund that manufactures new financial instruments as instructed by the clearing members might be a formidable driver of financial innovation. This new kind of exchange, a combination of a platform, clearinghouse, and investment fund; might, for example, be the source of a viable replacement for LIBOR.
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.