Electronic Futures Platform Challenges CME
By Viraf (Willy) Reporter, Senior Consultant, Tabb Group
January 15, 2008
On Friday, December 21, a consortium of liquidity providers and high-frequency traders announced their intention to compete with the Chicago Mercantile Exchange and its parent CME Group Inc, initially in some of its largest futures contracts. The backers include Bank of America, Credit Suisse, Deutsche Bank, JPMorgan, Merrill Lynch and Royal Bank of Scotland from the sell side, along with Citadel, Getco and Peak6 from the buy side.
Lines Were Being Drawn in the Sand for Some Time
The CME's past success is now its future dilemma. As OTC derivatives trading volumes have ballooned, so too have their exchange-traded futures counterparts. The diversity in strategies - from arbs to hedges - necessitates the interaction between the two pools of liquidity, despite their differing regulatory environments. Similar to another OTC behemoth - foreign exchange - the interest rate and credit players from the sell side are the major participants in the related futures contracts, on both the bid and the offer.
Numerous buy-side institutions have earned their place as market-makers in these OTC environments, including those named above. But costs for all such participants have risen despite their contributions and accompanying efficiency trends, thanks in part to the foresight of CME management.
This Isn't Just About Treasury Futures
The CME has been highly successful with its business strategies to date, to the point of getting its largest clients' attention. And their perceived monopoly comes at a great cost to these clients if left unchecked. While previous challenges to the exchange have been inferred in the reasoning for a repeat failure by this consortium, none of those past structures are comparable as strategic or tactical arguments.
This situation and its issues beckon a foreign exchange analogy from 1990 and the creation of the EBS Partnership. That consortium was founded by sell-side liquidity providers whose costs to execute (commoditized) spot trades in major currencies via inter-bank brokers had risen to a point of increasing and needless expense. With the platform's launch in 1993, those clients responded with the re-direction of order flow and associated liquidity, and their costs to transact fell considerably from that point onward.
Technology was the key to their eventual success, but their "mandated" discipline to support their "mutual" platform was a philosophical foundation for their launch.
This situation is starkly similar, with technology playing the role of enabler for such "coopetition" among the founding members. The initial market of interest for this venture is US interest rate futures, namely Treasury and Eurodollar instruments - key components of the US yield curve.
Meanwhile, the CME has directed great effort in penetrating these very OTC markets over the years, with a diversity of products catering to the sell-side's clients. Bite off too much of someone else's sandwich and your own plate is in jeopardy!
Measurement of Success or Repeat Failure
There would likely be little motivation to construct this competing platform if costs to transact at the CME reflected the efficiencies derived from technology and consolidation over the years. And the CME may still respond in kind, but until then, these deep pockets will raise their bets to internalize until free market forces take hold.
While the consortium's founding members have recent history against them, past attempts to the CME's stranglehold are not comparable to this emergence. This consortium did not likely form overnight, but over years! The CME's merger with the CBOT, toward a fully electronic exchange, probably was an awaited tipping point.
Small Precise Footsteps
It is clear that technology will be directed in a robust, expandable manner in any such initiative. But its beginnings will likely be limited to the highest probabilities for initial success - the 10-year and the Eurodollar contracts. Anyone with comprehension of the yield curve in futures-ville will recognize these instruments as anchors of these directed strategies. Their highly-liquid contributions by the sell side make them ideal starting points without much resistance from participants averse to change, since no disadvantage will be discernible by price- and liquidity-conscious trading staff.
An execution or matching platform will take little effort or cost. It is available in many varieties off-the-shelf or in-house through any of the founders' sizable technology efforts. Their fresher collaboration in this regard could prove to be superior. But that's not the eventual selling point to hold onto any launch momentum.
The value-added features to attract tighter spreads and liquidity beyond the launch will require efforts in the direction of clearing and counterparty risk services, an area of great expertise by these very players in other asset classes and instruments. Automation of these middle- and back-office processes is undergoing much change across several complementary instruments, in cross-asset areas. As these requirements from the buy side grew, the sell side has been contemplating next steps for product and business expansion at an appropriate time. That time has arrived, whether voluntarily or by force. Innovation in technology only furthers that cause as the cost to implement necessary hardware, middleware and tools continues to decline.
So, initially, resistance will be mollified by comparable or higher liquidity at lower cost. Additionally, such fees will be partially recouped as future dividends, dependent on shareholder levels of participation. Longer term conviction to grow participants will be borne out by the low- or no-touch features for end-to-end automation. This is key to the consortium's success and they will already have mapped a plan toward that objective prior to announcing last month.
Whether the CME finally responds or not, the ball is in their court - relent and share an appropriate portion, or lose a share of recent gains.
This is going to be about netting efficiency, among those who already net among themselves, in many other asset classes. This is not just another stab at something in the dark looking for opportunity.
This venture will not be allowed to fail because the costs of "not succeeding" are greater than the costs of trying. That's what makes it such an easy call this time. The CME's stock price has begun to reflect these term implications and their PR machine is propping their executives to respond to the challenge in the media.
CME... it's your move! |
