is one-stop shopping coming to US exchanges?
By Jeremy Grant
Published: September 14 2004 03:00 | Last updated: September 14 2004 03:00
Whenever a militant's bomb disrupts the flow of oil from Iraq, or the US government issues monthly unemployment statistics, a forest of hands and arms rises in the trading pits of the big US futures exchanges in Chicago and New York. In so-called "open outcry", traders rush to protect themselves and their clients by buying futures contracts - helping to guard against, or speculate on, future movements in the price of oil or government bonds.
Away from the trading pits, however, many more billions of dollars of futures trades are being carried out electronically, by traders seated at computer screens with no need for a middle man.
The opportunity to trade in this way, opened up by technological change, is doing more than simply highlight the gradual death in the US of the open outcry system. It heralds a deeper revolution for the US exchanges that deal in derivatives products such as futures and options, forcing them to tear up business models that have sustained them for more than a century.
Rapid technological advance is drawing new players into the futures and options markets. These participants - the biggest of them are hedge funds - want to be able to get into and out of markets at the click of a mouse. They are also increasingly indifferent to traditional distinctions between stocks, options and futures. They want exchanges to be able to offer multiple kinds of assets, including products in the vast "over-the-counter" markets where big banks carry out complex trades among themselves.
As a result, exchanges that for decades have relied on trading either futures, options or stocks have started to realise that they must offer more than that - possibly all three types of product, and on electronic trading systems.
Some of the most iconic institutions on the US financial landscape could undergo a radical overhaul. They include the Chicago Mercantile Exchange (CME), the largest of the US futures exchanges; the country's six options exchanges, including the Chicago Board Options Exchange; and stock exchanges, especially the New York Stock Exchange.
James Newsome, president of the New York Mercantile Exchange and until recently chairman of the US futures industry regulatory body, says: "There is certainly a blurring of the lines between equities and commodities markets, as well as between futures and cash and futures and over-the-counter markets, and it is clear that exchanges and clearing houses need to think in terms of diversifying and expanding their services."
Kevin Ashby, chief executive of Patsystems, a UK-based leading provider of software for futures traders, says: "All the ingredients are there for a complete transformation of the way this industry operates [in the US]."
The implications are far-reaching. A wave of consolidation could be imminent as exchanges move to align themselves in a way that allows them to be "one-stop shops".
Meyer "Sandy" Frucher, chief executive of the Philadelphia Stock Exchange, says: "Exchanges are going to have to change. They understand that a single product 'boutique' is not the way forward. I think you'll see a trend towards a multiple product entity: equities, options, futures, traded side-by-side. You are now looking at a bunch of people circling each other figuring out how to make it happen."
Bernard Dan, chief executive of the Chicago Board of Trade, agrees: "I think you're going to find exchanges in the US looking to create the necessary infrastructure to facilitate asset class convergence. You might see that through acquisition, or you might see it through co-operation."
This explains why the NYSE has signalled interest in building a derivatives business, and why the CME earlier this year tried to acquire the International Securities Exchange (ISE), the second-largest US options exchange.
The Chicago Board Options Exchange (CBOE), the largest US options exchange, has made the most progress so far this year towards multi- asset trading with the launch in March of its own futures exchange offering trading in VIX futures. These gauge investors' expectations of future S&P stock index volatility over a 30-day period.
At the CME, meanwhile, Craig Donohue, its chief executive, says: "I very much doubt that we will, over the long run, only offer exchange-traded futures and options on futures contracts. I think we will become a more broadly diversified financial services firm, given the convergence that's happening across products and platforms."
Electronic trading technology has developed rapidly. Complex computer-based algorithms make it possible to carry out trades between types of derivatives products.
Trading Technologies, a Chicago-based software specialist, this year launched Navigator, a screen-based trading system that not only connects a trader to multiple derivatives exchanges but will automatically direct a trade to the exchange that is displaying the best price.
Rudolf Ferscha, chief executive of Eurex, the futures and options exchange owned by the German and Swiss stock exchanges, says: "[Electronic trading] is a great enabler and has allowed this revolution of derivatives and made it much more attractive for pension funds and investors to get active in these markets."
It was Eurex and its rival Euronext-Liffe - Europe's two biggest derivatives exchanges - that this year lit a fuse under the Chicago futures community by launching separate challenges to the CME and CBOT.
Eurex in February launched a US futures exchange based in Chicago's Sears Tower. Its immediate target was the CBOT, whose monopoly on US Treasury bond and note futures it has broken by launching almost identical products of its own. A month later Euronext-Liffe began offering its own, electronically-traded version of the CME's Eurodollar interest rate futures contracts, which were still largely traded in the CME's pits. The CME has since rapidly been shifting trading of its Eurodollar products away from its pits and onto its 12-year old electric trading system, Globex.
In the US options business, electronic competition to the established exchanges has been home-grown but its effect has been no less dramatic. The launch of the ISE in 2000 was a shock to the then four incumbent options exchanges, because it was for the first time offering all-electronic trading. The ISE's rivals have since been developing electronic trading systems of their own.
Linda Bracken, managing director of You Just Trade, a consultancy for trading firms and broker-dealers, says that, with the technology investments made by US exchanges, they have "significant economies of scale" and can now trade, clear and process trades on a much larger scale than when everything was handled manually.
"Diverging into other asset classes is a very logical step because they have the systems in place to be able to process so much more volume. They need to expand and where is that going to come from? That's a question a lot of exchanges are asking," she says.
Hedge funds' growing influence in derivatives markets is also pushing exchanges to develop products that sophisticated traders can use in multi-asset trading strategies.
Arthur Hahn, chairman of the financial services group at law firm Katten Muchin Zavis Rosenman, says: "The advent of the hedge funds is a serious driver in these markets. You used to have the odd sophisticated trader out there but now there are billions of dollars in play in the hands of a generation that is technologically literate. They trade off numerical analysis, they trade relationships between stocks, between asset classes and quantify it all using computers. They are putting serious pressure on the exchanges to provide a product that works for them."
Hedge funds' hunger for derivatives is driven by one over-riding factor: the use of a derivative such as a futures or options contract allows an investor to gain exposure to an asset without actually buying that asset. John Damgard, president of the Futures Industry Association, which represents the interests of banks and brokers, says: "More and more hedge funds are recognising how much more capital-efficient it is to buy a future on something than buy the asset outright."
That helps explain explosive growth in derivatives volume so far this year. According to the Bank for International Settlements, the combined value of trading in interest rate, stock index and currency derivatives contracts rose by 43 per cent in the first half of the year to $304,000bn.
The Options Industry Council, set up by the options exchanges to promote use of options, estimates that institutional investors - including hedge funds - now account for about half of US options trading volume, up from 20 per cent three years ago.
Large brokerages are also seeing clients such as pension funds or other types of institutional investor behaving in a similar fashion to hedge funds.
Thomas Kloet, chief operating officer at Fimat USA, the global brokerage arm of French bank Société Générale, says: "Our end-customers really do not recognise the distinction between products. As products have become closer people have started to arbitrage between them and the customer is less fussed about whether it's a futures product or what exchange the product is listed on."
Banks and their brokerage arms have their own reasons for embracing multi-asset trading. Trading is once again becoming a lucrative source of revenue, after years of drought in merger and acquisition activity.
They also see opportunities for cost cutting. Mr Ashby of Patsystems says: "The big banks want to reduce the cost of maintaining all these vertical [sales and administrative] infrastructures across asset classes that they believe are converging."
Yet there are barriers to exchange consolidation as a way of smoothing the path for multi-asset trading. Chief among them is the regulatory environment. The US has a regulator for futures - the Commodity Futures Trading Commission - and another for equities and options, the Securities and Exchange Commission. The SEC's role has largely been to regulate to protect retail customers, who are not the largest participant in options trading and are virtually absent from futures. The CFTC, meanwhile, deals exclusively with institutional end-users.
Mr Damgard says there are regulatory concerns over multi-asset trading on exchanges "because of the different philosophical points of views on the part of the regulators".
Not only do both agencies have their own powerful constituencies in Washington DC, but it makes no sense to try to combine institutions with separate expertise, he argues. "The CFTC frankly has done an excellent job over the years providing an environment in which the futures industry has grown. It doesn't make any more sense than combining the State Department and the Defense Department. The fear in our industry has always been that if, all of a sudden in the name of convergence we combined the SEC and CFTC, we would have people making judgments about our business who know very little about it," he says.
However, some draw encouragement from the collaboration between the two agencies in devising a regulatory environment for "single stock futures" - futures on individual stocks, launched last year in the US.
Alden Adkins, senior vice-president of regulatory policy at the San Francisco-based Pacific Exchange - one of the six US options exchanges - believes that a second Bush administration might favour re-examining the issue of a two-pronged regulatory structure. "If the current administration is re-elected one of the things they are likely to do is remove those barriers because the business community is keen to do it [consolidate]."
Whether the regulatory environment ultimately does prove problematic, the exchanges are already moving to change their corporate governance structures from member-owned entities to for-profit status.
Yesterday, an Illinois judge said he would rule later this month on whether to uphold or dismiss a four-year-old lawsuit that has held up a demutualisation plan by the CBOT. Charlie Carey, CBOT chairman, says he wants to demutualise to make possible "business combinations".
The CME has gone furthest, and last year became the first US futures exchange to become listed on a stock exchange. It has made no secret of its intention to lead consolidation in the industry - but has refused to identify targets publicly.
Mr Newsome at Nymex says his exchange recognises the rapidly-changing environment. "Any exchange that hopes to expand must take into account the integration and consolidation of the marketplace," he says. "It cannot expect to flourish in a vacuum."
New York and Chicago have long enjoyed a healthy rivalry, but for some in the Midwest's largest metropolis the label "second city" grates. Some involved in marketing Chicago are considering a new slogan: "Second to none."
If the trend towards multi-asset trading of derivatives and other financial instruments gathers pace, the two cities will battle for the title of "risk management capital of the US".
One early sign of increased friction between the two financial centres came in August, when the Chicago Board of Trade said it would next month launch full-sized gold and silver futures contracts, electronically traded, that would compete head-on with the New York Mercantile Exchange (Nymex)'s own gold and silver futures, traded in its pits.
Chicago has a head start over New York in the futures industry. According to World Business Chicago, a non-profit economic development organisation, Chicago accounted for 63 per cent of all volume in exchange-traded futures, and options on futures, in the US last year. New York trailed with 16 per cent.
New York, home to the New York Stock Exchange and Nasdaq and powerful Wall Street banks, dominates in equities and energy futures trading. But derivatives of all types are growing faster. It is no wonder that John Thain, the New York Stock Exchange's chief executive, said earlier this year that he wanted to develop a derivatives business.
Rudolf Ferscha, chief executive of Eurex, the Frankfurt-based derivatives exchange, says: "You need to have the right derivatives products to be competitive in every arena. Whether you have stocks or energy products on top of that is not so critical. That's not going to change the face of the competitive landscape.
"Derivatives have proved to be the door to globalisation of trading opportunities," he says.
The Chicago Mercantile Exchange has this year moved into new product areas and has multi-asset ambitions. Leo Melamed, a former Chicago Mercantile Exchange chairman and now senior policy adviser, says the CME is likely to be transformed into a broad-based financial services business. "We don't want to be the old version of a futures exchange. We have to find ways in which to service the market not just by virtue of being a 'transaction forum' but in every aspect of the ancillary consequences of transactions: banking and asset management. The ideas that emanate from that will make us a very interesting place in the next decade."
In New York, Nymex has made progress in expanding beyond its traditional energy futures portfolio. It was the first US exchange to offer clearing of over-the-counter energy trades. James Newsome, recently installed as president, says the exchange is "taking a fresh look at which business model we will pursue".
The NYSE has revealed plans to expand its electronic trading system, which only accounts for 10 per cent of exchange volume. At the CME the figure is 62 per cent.
Chicago is ahead in another important aspect: demutualisation. Moving away from a member-owned structure has proved critical in helping the CME to change rapidly. The NYSE is still grappling with its complex system of specialist traders. |
