US interest rate futures: CME prepares to face challengers

US interest rate futures: CME prepares to face challengers

The king of US interest rate futures, CME Group, has faced down a string of pretenders to its crown in recent years. Now a new array of rivals is arming for battle. As David Wigan discovers, CME shows no sign of being worried – but this time the uprising may be a lot more serious.

We all know the story of David and Goliath. Plucky midget challenges surly giant to a fight, and fells the brute with a sling shot to the head. It’s the stuff of legends. We also know that in the real world, plucky midgets get crushed by giants and then ground into the dust for good measure.

It’s worth bearing in mind these perspectives when considering the battle being fought between CME Group and challengers to its dominance of the US interest rate futures market.

From its beautiful Art Deco Chicago Board of Trade headquarters, topped by a statue of the Roman goddess Ceres, CME Group is master of all it surveys.

Comprising the Chicago Mercantile Exchange, Chicago Board of Trade and New York Mercantile Exchange, the world’s biggest derivatives exchange group hosts 98% of US futures trading.

In September, the Group handled the trading of 5.1m interest rate contracts a day, of which 2.2m were Treasury futures and 1.8m Eurodollar futures. Treasury and Eurodollar options together accounted for just over 1m contracts.

The business is highly profitable. In the first half of the year, CME posted revenues of $1.5bn, a 16% rise on the same period in 2009, generating a net income of $510m. Interest rate products accounted for over 42% of daily volumes, and Eurodollar contracts for just under 20%.

Clearing and trading fees for interest rate products totalled $344m in the half year, and CME also made $245m from other services including market data and access and communications fees – of which a share must be attributable to the rates business.

Enter the pretenders

No surprise, then, that there are pretenders to CME’s throne. Eurex had a go at breaking into the market in 2004 – now NYSE Liffe is preparing a challenge.

“It’s an incredibly exciting, dangerous and unpredictable time in the futures markets,” says Richard Repetto, principal at investment bank and broker-dealer Sandler O’Neill & Partners. “CME is in a hugely dominant position but with the regulatory changes and new competitors coming in they will need to be on their mettle to protect their position.”

Behind NYSE is a further group of aspirants who do not pretend initially to covet dominance, so much as to take crumbs from the tables of the elite. Chief among these is a small player with powerful backers, which has made enough noise in recent months to rattle cages in Chicago.

Electronic Liquidity Exchange, now called ELX Futures, was conceived in 2007 and launched in July 2009, with the stated aim of providing “a competitive alternative” in US interest rate futures.

At the moment the new exchange is as much of a threat to CME as a flea to a tiger, but ELX’s power lies in its potential, manifested in the unrivalled calibre of its owners, which include Goldman Sachs, Bank of America, Barclays Capital, BGC Partners, Citibank, JP Morgan and Morgan Stanley.

ELX’s first product was Treasury futures, which it offered across the curve from the short to the long end. The exchange has gained a firm toehold, especially in two year Treasury Notes, where it claimed a 4.7% market share in the first nine months of 2010, according to FOW’s proprietary database FOW TRADEdata.

ELX’s five year Treasury futures are its next most successful product, with a market share of just under 2.5%. In 10 year Treasuries it has 1.17% and in 30 years 1.54%.

It was not long before ELX attacked the Eurodollar market, launching a contract in June this year, which had won 0.25% of the market by September.

“We are competing head to head with CME in the interest rate space,” says Neal Wolkoff (pictured), chief executive of ELX, and former chairman and CEO of American Stock Exchange.  

ELX says that during the 10 trading days between September 27 and October 10, it traded around 45,000 US Treasury futures a day on average, which it claims was a 2% market share. In the same period, its ADV of Eurodollar futures was around 10,000, or 1% of the market.

“We already have 1% market share in Eurodollars, and people are beginning to take notice. That is because it makes sense to diversify your risk away from one exchange,” says Wolkoff.

Central to ELX’s strategy is its attempt to ride a regulatory wave that appeared as recently as last year to be leading toward a more open interest rate futures market, and away from the traditional vertical exchange model, in which futures trading and clearing are inseparable.

Fungibility – yes, no, maybe?

The buzzword is fungibility, or the ability to buy a contract on one exchange and sell on another, as with equity options. Fungibility would enable investors to move their open interest between exchanges, which would be free to compete for business on fees and services.

The idea is to improve liquidity, and enhance cash management for netting and margining.

“Lack of fungibility makes CME tough to compete with,” says Ed Ditmire, diversified capital markets analyst at Macquarie Securities in New York. “Because there is currently no cross-netting between exchanges, it’s a lot more capital-efficient to use one platform.”

Mike Topping described what happened next in an article for Financial Services Research in the fourth quarter of 2009.

In January 2008 the Department of Justice called for an overhaul of vertical clearing. In a letter to the Treasury, the Department recommended “a thorough review of futures clearing and its alternatives,” including the horizontal utility models used in equities and options.

“In a world of fungible financial futures contracts, multiple exchanges could simultaneously attract liquidity in the same or similar futures contract, facilitating sus­tained head-to-head competition,” the DoJ said.

The letter argued that incumbent exchanges’ “control over open interest and clearing have impeded entry and the development of meaningful competition in execution services”.

The campaign for fungibility began to gather pace, with some heavyweights backing a change, including former SEC commissioner Annette Nazareth and John Damgard, president of the Futures Industry Association.

When CFTC chairman Gary Gensler called in June 2009 for fungibility in the clearing of OTC derivatives, many thought it was only a matter of time before the futures market was forced to follow suit.

Imagine their surprise when in October last year the SEC and CFTC appeared to rule out any change.

In their Joint Report on the Harmonization of Regulation of capital formation and risk management markets, the SEC and CFTC recognised that “product fungibility and fair access to clearing services are necessary for competition in the market for trading services”.

However, they said: “Products in the futures industry are not treated as fungible because exchanges expend resources to develop them and fungibility would enable other trading venues to ‘free ride’ on these product development efforts; futures exchanges should be able to recoup their investments in (or, as some economists would term it, enjoy the rents from) their product development, and that any changes should be predicated on reform in foreign jurisdictions.”

Unsurprisingly, following publication of the report, CME chairman Terry Duffy said it had “lifted a big regulatory cloud from our world”.

The EFF workaround

As champagne corks popped in Chicago, ELX executives in New York were already working on another idea. If fungibility was impossible, they reasoned, why not introduce a rule that achieved something similar?

Under the new rule, market participants could privately negotiate two discrete but integrally related transactions, establishing a futures position on ELX while concurrently liquidating a position on another exchange listing identical contracts. Alternatively a trader could establish a position on another exchange to replace identical positions liquidated on ELX.

By taking opposing positions in similar products on different exchanges, the positions could then be migrated between the respective exchanges’ clearing houses, allowing investors to switch between markets.

The system, called exchange of futures for futures (EFF), would be a tool for firms that were uncomfortable using a new market, but would do so if they could enter or exit easily, ELX’s Wolkoff says.

As the harmonisation hearings proceeded in September 2009, ELX petitioned the CFTC to agree its new rule, and this was duly approved.

CME did not budge an inch, insisting that EFF trades contravened its own rules.

War of words

What followed was open war, with both sides unleashing a bombardment of letters to the regulator.

Based on “false information”, ELX was “engaged in fictitious or wash trades”, which “undermined liquidity”, CME alleged. According to ELX, CME was a “monopolist” that was attempting to “stifle a nascent competitor”, having “failed completely to identify any legitimate business purpose”.

And so it went on, until the CFTC in August this year backed ELX, repeating its earlier assertion that CME had “mischaracterised” the law by claiming EFF trades were illegal.

In response, CME did what any firm with a dominant market share would do absolutely nothing, remarking in a further letter to the CFTC that an exchange was not “obliged to assist its competitors”.

The CFTC said in August that it had launched an antitrust inquiry in respect of CME’s intransigence, after ELX argued that CME violated the antitrust core principle in the Commodity Exchange Act.

The agency summarised the CME’s position as contending that EFFs “would enable ELX to free ride on CBOT’s investments in exchange facilities, clearing facilities or product development”.

CME executives were not impressed. “We’re very confident in our position on this issue,” CFO Jamie Parisi told journalists in September. The exchange nonetheless fired off a 70 page riposte to CFTC chairman Gary Gensler to ram home its point.

Even if an antitrust position can be established, there is some doubt as to how it will be enforced. The Department of Justice’s antitrust division has held informal discussions with the CFTC over the matter, but the CFTC is still reportedly in charge of the inquiry, though it does not have express authority to police violations of US competition law.

“They have been debating this thing back and forth for over a year and it isn’t clear there is any particular urgency on the CFTC’s part to force CME to support EFF trades,” Ditmire says.

CME, meanwhile, has thrown the ELX antitrust accusation back in its face, saying the EFF rule is itself anti-competitive.

Fundamental to the CME’s argument is its belief that futures are inherently different from securities like equities. Futures are risk management products rather than instruments designed to raise capital, the exchange claims, and are therefore unsuitable to be regulated under a similar regime.

“Futures contracts are different animals,” says Robin Ross (pictured), managing director of interest rate products at CME. “To assume that futures will go the way of securities markets disregards the intellectual property involved in creating new and innovative contracts. While we believe competition is good for our business, why would we want to make it easier for someone to mimic and leverage our ideas, our resources and our technology?”  

A trail of defeated rivals

CME is a past master at seeing off the attentions of rivals. As early as 1984, amid concern over competition from outside US time zones, it set up a link with the Singapore International Monetary Exchange called Mutual Offset System, which allowed the CME Eurodollar contract to be traded on the Simex floor, moved to the CME Clearing House in Chicago and offset on the CME trading floor. Any similarity with EFF is purely accidental.

In 1999 Cantor Fitzgerald launched Cantor Exchange, its electronic exchange for US Treasury futures, and in 2001 BrokerTec, now part of Icap, launched an online futures trading outfit, aimed at taking market share from CME.

Both closed soon after launch, amid disappointing trading volumes. Cantor’s spin-off BGC Partners now owns a 25% stake in ELX, which operates on Cantor’s eSpeed technology.

In 2004, Eurex launched an electronic trading exchange in Chicago, aimed directly at grabbing market share from CBOT’s floor-based offering. #

The reaction of CBOT and CME was described in the book Electronic Exchanges by Michael Gorman and Nidhi Singh: “The first thing they did was throw up every regulatory barrier they could. For example, they ensured that Congressional hearings were held... They also did everything to slow down the approval process... by questioning every single aspect of the application made by Eurex.”

While Eurex was dealing with the regulatory hurdles, CBOT and CME upgraded their systems, so that by the time Eurex launched in early 2004, it failed to win any substantial share of the futures market.

So CME has seen it all before. However, the difference this time may be that it is fighting competition on more than one front. While ELX engages in the public battle, an arguably more dangerous competitor is readying itself in the shadows.

Enter David?

NYSE Liffe US, a NYSE Euronext subsidiary launched in 2008, announced plans in April for a complete suite of interest rate futures from three month Eurodollars to 30 year Treasury bonds.
The key differentiator in NYSE Liffe’s offering lies in a company called New York Portfolio Clearing, a joint venture between NYSE Euronext and The Depository Trust & Clearing Corporation, which will clear trades for the new venture.

All cash Treasuries are cleared through the Fixed Income Clearing Corporation, a subsidiary of DTCC. Uniquely, the NYPC will be a single pot clearing house for cash and futures, with a cross-margining agreement between FICC and NYPC, enabling exchange users to pay a single margin across positions.

“What we are calling one-pot margining is a huge competitive advantage in this marketplace,” says Ira Krulik, chief operating officer at NYPC. “Clearing members will settle with only one counterparty, whereas at the CME they need to settle futures on the exchange and cash elsewhere.”

In stark contrast to the vertical clearing model at the CME, NYPC is designed to operate horizontally, allowing open access to clear trades from other exchanges. This will come “as soon as it is operationally practicable to do so,” Krulik says.

Cross-margining and netting of cash against derivatives, and the delivery advantages afforded by the one-pot model, together comprise what NYSE Liffe US chief executive Tom Callahan calls “a dramatic shift in the market situation”, and would make NYSE a very serious contender indeed.

Some feel that the ELX battle is something of a red herring, perhaps motivated by Wall Street’s desire to keep pressure on CME in respect of fees, with the greater challenge coming from NYSE.

“CME will need to bring out their best game to defend against NYSE,” says John Lothian, editor of The John Lothian Newsletter. “This is not a Eurex or an ELX situation NYSE Liffe is a global company with headquarters in New York they are a very recognisable name from a branding point of view, with strong technology and good relationships in the market. CME will give them respect.”

A final showdown between NYSE Euronext and CME Group has been on the cards for some years, Lothian says. “What prompted CME to merge with CBOT in 2007 was the coming together of NYSE and Euronext this is the real battle and this has been the play all along.”

NYSE is in final discussions with regulators and expects to launch its new product suite in the first quarter of next year, Callahan told FOW. Might it be that Goliath has met his match?