CME Customers Rebel for Cheap Trades
By Matthew Leising and John Lippert
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June 24 (Bloomberg) -- Chicago hedge fund manager Tom Rubio never considered himself a rebel. He used to stay out of the limelight, quietly developing software to buy and sell interest- rate derivatives and building his 100-person firm, Breakwater Trading LLC. Infatuated with trading technology for 20 years, he once reprogrammed a scientific calculator to figure out options prices.
Rubio, 44, dates his emergence as leader of a revolt to October 2006, when the Chicago Mercantile Exchange, known as the Merc, agreed to buy the Chicago Board of Trade. By combining two rivals that competed for more than a century, the acquisition would put 98 percent of exchange-traded U.S. interest-rate contracts -- and 87 percent of all futures -- under one roof.
Rubio's Breakwater and funds like it rely on the Merc and CBOT for the rapid-fire, low-cost trades that are critical to their success. Rubio, whose company has $350 million to invest, saw the CBOT takeover as a threat to his livelihood. ``I was just very frustrated with the problem of a movement toward one exchange,'' he says.
His concerns festered for weeks until, on a visit to New York in November, he decided it was up to him to do something. As he walked along 55th Street in Manhattan, an idea took shape: Why not start a rival exchange to revive some competition? He was near the offices of ESpeed Inc., operator of an electronic system that trades U.S. government bonds. ``I just took a hard right and walked into ESpeed without an appointment, unannounced,'' Rubio says.
Customer Revolt
In an impromptu one-hour meeting with Howard Lutnick, chairman of ESpeed's parent company, Rubio enlisted Lutnick to provide ESpeed's trading system for the upstart and to help round up investors.
During the next year, their efforts won over a who's who among the biggest hedge funds and banks that trade on the Chicago exchanges, which together became known as CME Group Inc. after the $11.3 billion merger closed in July 2007.
Citadel Investment Group LLC, the $20 billion hedge fund firm run by billionaire Kenneth Griffin, joined. Getco LLC, which stands for Global Electronic Trading Company, signed up. So did Citigroup Inc., JPMorgan Chase & Co., Merrill Lynch & Co. and five other investment banks.
By December 2007, with 12 backers, the Electronic Liquidity Exchange was born and Rubio became chairman. The new exchange, known as ELX, held its coming-out party in Boca Raton, Florida, in March, at the Futures Industry Association's annual conference. In a colonnaded courtyard at the Boca Raton Resort and Club, ELX laid out a lavish spread of crab, oysters, steak and liquor.
Financial Futures
The financial contracts that ELX hopes to wrest away from CME are growing faster than ordinary stock trading. Investment banks and hedge funds are finding new uses for the interest- rate, currency and equity index futures the two exchanges pioneered in the 1970s and '80s -- when they were competing to be first with each innovation.
Volume at all U.S. futures exchanges rose 94 percent from 2005 to '07, FIA data show; equities trading increased 48 percent during the same period, according to the New York Stock Exchange.
The futures and options traded in a week on the CME, now the world's largest futures exchange, have a notional value of $13 trillion when you tally the assets underlying the contracts. That's equal to 12 times the value of weekly share trading on the Nasdaq Stock Market and NYSE combined.
Trading Fees
The fees CME collected last year, ranging from less than 10 cents to more than $1 a trade, added up to $1.8 billion, and the company isn't finished growing. In March, CME Group agreed to buy the largest remaining futures exchange in the U.S., the New York Mercantile Exchange. The purchase of Nymex Holdings Inc., approved earlier this month by federal antitrust regulators, gives CME 98 percent of all U.S. futures. The deal, valued at about $8.7 billion, still needs to be accepted by Nymex shareholders.
``Effective monopolies in financial services are rare, but the CME is almost certainly one,'' Brad Hintz, a bank analyst at Sanford C. Bernstein & Co., wrote in a May 22 report.
CME's customers are upset, says Richard Berliand, head of the global cash equities business at JPMorgan, one of the ELX backers. ``You've got a bunch of frustrated people,'' he says. ``There's a feeling of irritation.''
Beneath the surface in the conflict between CME and ELX, a bigger battle is brewing. This one is for control of derivatives that aren't traded on any exchange. The over-the-counter market, run by banks such as Goldman Sachs Group Inc. and JPMorgan, offers swaps and options based on interest rates, currencies and the creditworthiness of corporate borrowers.
OTC Market
With $596 trillion in outstanding contracts as of the end of last year, the size of the OTC market is more than eight times that of all exchange-traded financial contracts worldwide, according to the Bank for International Settlements in Basel, Switzerland.
The banks' OTC derivatives, tailored to clients' needs, go beyond what's available in the standardized contracts exchanges offer. The exchanges began with futures, which are agreements to buy or sell an underlying asset at a specific price on a set date, and now also trade options.
The fastest growth is in the OTC market, according to BIS data, which excludes some commodity contracts. The value of credit-default swaps, which are OTC contracts used to insure against corporate debt defaults, more than doubled last year, for example.
CME Chief Executive Officer Craig Donohue, 46, wants a piece of the OTC market and says that's where the competition in his industry will play out. The credit crisis of the past year may help push business his way.
'Opportunistic'
In March, U.S. Treasury Secretary Henry Paulson said more standardization in the processing of trades would make the credit-default-swap market more stable. Donohue says his clearinghouse, which pools collateral from market participants to make good on defaulted trades, fits that bill.
``The CME is being opportunistic and going on the offensive,'' Sandler O'Neill & Partners analyst Rich Repetto says of Donohue's plan to make inroads in OTC trading in the aftermath of the credit crunch.
Donohue says that banks intentionally keep their derivatives dealing opaque to give their traders more opportunity for profit. It's a conflict of interest avoided by independent exchanges, he said in a speech at the Federal Reserve Bank of Chicago on March 6.
Turf Battle
``We're not traders,'' he said. ``We don't have a dog in the hunt.'' Donohue, who earned $3.9 million in 2007 and this year bought a 2008 Bentley Continental convertible with a list price of $210,000, downplays the chance that ELX will make a dent in his current trading. He cites three failed efforts in the past decade, including one led by ESpeed's Lutnick, to steal away CBOT or CME interest-rate futures.
ELX is the response of the banks to the threat CME Group poses to their OTC derivatives, says Leo Melamed, who introduced the first financial contracts when he was chairman of the Merc in the 1970s.
``I don't blame the banks for saying, `These guys are trying to get into our turf in the OTC market, and we've got to protect ourselves by creating a counterweight in the form of a new exchange,''' says Melamed, 76, who chairs a strategic planning committee of CME directors. ``I don't think they're going to succeed, but I don't blame them.''
The first target for ELX, Rubio says, is CME's $435 billion-a-day market for Treasury futures. Banks, hedge funds and corporations use these contracts to protect against or speculate on changes in U.S. interest rates.
Treasury Futures
Trading Treasury futures and the government debt they are based on is a specialty of Rubio's firm and a vital activity for all of the banks and hedge funds in ELX. Combined, the ELX backers do as much as half of the Treasury futures trades on CME, says Don Fandetti, a Citigroup analyst who covers brokerages, exchanges and investment companies.
This group might move a third of their Treasury futures trading to the new forum initially, Rubio says.
Officials at the banks backing ELX mostly decline to discuss the initiative. Najib Lamhaouar, head of global futures capital markets at Citigroup, had no comment. Jodi Cohen, a director in fixed income at Credit Suisse Group's U.S. investment bank, which is also part of ELX, declined to comment.
'Exchange-in-a-box'
While ELX gets a leg up from its roster of banks and hedge funds, it also gets an advantage by having Lutnick's ESpeed on board. New York-based ESpeed is the second-biggest electronic market for Treasury notes and bonds after ICAP Plc's BrokerTec. It's part of BGC Partners Inc., a publicly traded brokerage with a market value of about $1.5 billion. Cantor Fitzgerald LP, a privately held investment bank that Lutnick runs, is the biggest shareholder of BGC.
Startup costs for ELX can be kept to a minimum because ESpeed terminals are already on traders' desks at most banks and investment firms that deal in U.S. government debt, says Berliand, whose responsibilities include oversight of JPMorgan's global futures business. He refers to the ESpeed system as ``Lutnick's exchange-in-a-box.''
The Chicago hedge funds backing ELX are closely associated with the city's exchanges. The biggest by far is Citadel. Griffin has been featured this year in CME Group advertisements in financial magazines and newspapers, with a quote across the middle of the page that reads: ``Risk is what you make of it.''
Market Share
Getco, run by Stephen Schuler, with offices in the Board of Trade's landmark art deco building, has taken on exchanges before. The firm owns a stake in Bats Trading Inc., operator of an electronic system for equity trades that has taken market share from the Nasdaq and NYSE.
Jeff Mathis, a Getco spokesman, declined to comment. Peak6 Corp., which works in partnership with Rubio's Breakwater Trading, is the other hedge fund that has joined ELX.
Firms such as Citadel unleash massive trades in a variety of markets, deploying strategies that rely on ever-more- sophisticated computer algorithms. Some of their programs depend on trading repeatedly to gain advantage from narrow and fleeting price fluctuations. For these strategies, low transaction costs are vital. A small increase in trading costs might make a strategy unprofitable.
CME's Price
Citadel, Getco, Peak6 and Breakwater all get one of the lowest per-trade fees that CME offers: 11 cents for each Treasury contract, far below the average of 63.6 cents that the exchange collected across all of its product and customer categories last year, according to CME.
A 28 percent jump in the number of contracts the Merc and CBOT handled last year failed to yield lower per-trade costs for customers as the average fee CME charged went up 1 cent.
The ELX initiative is all about keeping fees in check. Faraz Javaid is director of business development for high- frequency trading at Citadel, charged with making sure Griffin's traders have the ability to execute their transactions quickly and at low cost. He says it's hard to know what a fair price is for an electronic trade on an exchange if there's no competition to force the issue.
Stocks can be traded in the U.S. markets for less than a penny a share, he says. ``Is 11 cents fair for Treasuries?'' He shrugs. Griffin declined to comment.
Rubio says it would be premature to say what ELX expects to charge. The range might be 5 cents to 10 cents per trade, according to two people familiar with the planning for the exchange who asked not to be identified.
Ex-Lax
At the FIA conference, on the day ELX hosted its party, Donohue was dismissive of the upstart. ``Ex-Lax, or whatever the thing is called,'' he said during a panel discussion that included JPMorgan's Berliand on the dais two chairs away. ``I would have found a trade name that can't be found in the diuretic or laxative section of the pharmacy,'' he said.
A hush fell over the crowd of about 500 conference goers, followed by nervous laughter.
Berliand was chairman of the industry group for a two-year term that ended in March -- a period when FIA's relations with CME soured because it opposed the purchase of CBOT.
In a speech the day after Donohue's Ex-Lax jab, Berliand said there will always be disagreements between banks and exchanges. ``What matters is that the conflict is managed in a mature and in an adult way,'' he said.
In an interview, he declined to comment on the back-and- forth at the conference.
CME is making the tension with the banks worse, says Benn Steill, an economist at the Council on Foreign Relations in New York, who follows trading institutions. ``I don't think it's a good strategy to insult your major customers''
Past Failures
Donohue says he takes the ELX initiative seriously, while pointing out the previous challengers that failed. Eurex AG, the largest futures exchange in Europe, opened a U.S. affiliate in 2004 and captured less than 1 percent of CBOT's Treasury futures market before giving up. BrokerTec made an attempt in 2001.
Lutnick's prior run at Treasury contracts came in 1998, when Cantor Fitzgerald laid plans to offer round-the-clock electronic trading of Treasury futures. The CBOT had been trying to protect the live trading in its pits by allowing electronic transactions only when the floor was closed. It responded to Cantor by expanding its electronic trading hours, and Lutnick's effort fizzled.
Three years later, Cantor Fitzgerald and ESpeed lost 658 employees on Sept. 11. The companies had their offices on the top floors of the north tower of the World Trade Center. Lutnick became a media fixture after the terrorist attacks as he set about rebuilding his business. He declined to be interviewed for this story.
Antitrust Approval
Donohue says the ELX team is wrong to consider CME a monopoly. The alternatives to exchange-traded contracts are OTC derivatives or other financial instruments such as index funds, individual stocks or bonds. Competition among those choices keeps fees in check, he says.
Antitrust regulators in the U.S. Justice Department last year sided with Donohue when they approved his acquisition of CBOT. The FIA, on behalf of the New York banks among its members, had argued unsuccessfully that competition would be harmed.
Terrence Duffy, CME Group's chairman, says customers habitually complain about trading costs. ``In the hog pit, they used to say anything above zero was too much,'' says Duffy, 49, who got his start as a runner in the section of the CME trading floor where pork belly prices were set by traders shouting and flashing hand signals.
Floor Trading
While such open-outcry trading survives, the traders in color-coded jackets -- symbols of the Chicago exchanges -- are dwindling in number. The pits or rings for CME Group have been consolidated in the Board of Trade building. In the first quarter, just 17 percent of its contracts traded on the floor. In 2000, 85 percent did.
Donohue, who never traded on the floor, has a law degree from the John Marshall Law School in Chicago and a Master of Business Administration from Northwestern University's Kellogg School of Management, which he earned while working at the Merc.
Donohue is proud of the successes that have made CME into the world's biggest futures exchange. He says the commitment over two decades to develop the company's Globex electronic trading system, for example, was a smart move -- especially since few imagined early on that electronic transactions would displace open outcry.
Today, Globex is used in 86 countries and can process a trade in about 15 milliseconds -- or about 17 trades in the time it takes to blink your eye.
Globex
``It's one of the most powerful computing systems on the planet of any type,'' says Ed Ditmire, an analyst at Fox-Pitt Kelton Cochran Caronia Waller in New York. Globex helped CME reel in Nymex, Sandler O'Neill's Repetto says.
In February 2006, Atlanta-based Intercontinental Exchange Inc. introduced an electronically traded contract to compete with the U.S. benchmark crude oil futures Nymex controlled. The move was reminiscent of Lutnick's attempt to break CBOT's grip on Treasury futures, though more successful.
Faced with the weaknesses of its own computer trading system, Nymex struck a deal to list its energy futures contracts on Globex, giving CME a slice of its profits and a foot in the door.
CME Group shares have been a signal of the company's success, and they are up 12-fold since they were first offered in December 2002. The company carries a stock market value of about $21 billion, 58 percent greater than NYSE Euronext, which owns exchanges in the U.S. and Europe, and more than twice the size of Nymex. Still, this year the shares have plunged to $436.95 yesterday from a peak of more than $700.
Expansion Plan
Donohue says that expanding in OTC derivatives might have a similar strategic importance to CME in the future as Globex has had in the recent past. He's taking steps to make his clearinghouse a venue for guaranteeing credit-default swaps.
Goldman Sachs, Morgan Stanley and 14 other banks and brokerages are backing an alternative. They reorganized Clearing Corp., which used to clear the CBOT's trades, and announced in June that they would be ready to guarantee credit market trades in the third quarter.
While Donohue looks beyond any immediate threat that ELX poses to existing business, Rubio and the ELX backers have several precedents they can point to as they try to break the grip CME holds on financial futures.
``This group has the potential to become very successful,'' says Intercontinental CEO Jeffrey Sprecher, who tried to break up the Merc's purchase of CBOT last year with a competing offer. Sprecher's company has kept about a quarter of the trading in U.S. crude oil futures, cracking Nymex's monopoly.
Liquidity
Sprecher says the mix of hedge funds and banks backing ELX will help jump-start the new exchange. Intercontinental, founded in 2000 as an OTC market for natural gas and power, had companies that traded energy among its initial investors, including BP Plc, Goldman and Morgan Stanley.
This helped Sprecher address the chicken-and-egg problem any new marketplace faces: A critical mass of buyers and sellers is needed to make a liquid market -- where a trade can always get done at a good price -- yet until there's enough liquidity, it's hard to attract buyers and sellers.
For ELX, the test of its ability to create and sustain liquidity is still months away. As of early June, the ELX board had yet to name a CEO. Rubio had no comment on when they would announce their top executive and no schedule for the start of trading. The exchange will need at least three months to gain approval from the U.S. Commodity Futures Trading Commission once it files its application to start the new exchange.
'Shift of Power'
``I would say ELX has its work cut out,'' says Leslie Rosenthal, a managing partner of Chicago-based futures broker Rosenthal Collins Group. ``It's always difficult to move the liquidity.''
Nobody predicts that putting a dent in CME's market share will be easy. The liquidity of CME Group's financial contracts is well established. Its agricultural contracts date to the mid- 1800s, when the Board of Trade grain futures helped transform American agriculture.
The financial derivatives have grown steadily and now generate seven times the revenue. CME's Eurodollar contracts are the most-traded interest-rate futures in the world.
``We've seen the power going to the exchanges over the last three to five years,'' says Misha Malyshev, head of high- frequency trading at Citadel. ``Now, there is a little shift of power to the market participants.''
Ice Sculpture
In Boca Raton in March, at least, ELX made good on its promise to displace CME. Following FIA's opposition to the acquisition of the Board of Trade, CME declined to host any events at the March conference. It was a departure from previous years, when the dominant exchange threw the biggest party. It was an opening for ELX to woo CME customers.
The backdrop for ELX's spare-no-expense bash included a golf course, palm trees and the hotel's Mediterranean architecture. Chefs stationed around a courtyard offered up duck Marsala and steak grilled with thyme and garlic. The centerpiece was an ice sculpture of a pagoda, 8 feet (2.4 meters) tall and decked out with cold-bar seafood. Shrimp, crab legs, oysters and clams on the half shell were there for the taking.
As the party wound down and darkness fell, the melting ice pagoda collapsed with a crash. Broken glass, ice, dipping sauces and stray shrimp skidded across the floor. Guests jumped out of the way. Waiters rushed over to push the wreckage out of sight.
The Chicago exchanges, with their history spanning three centuries, have beaten back competitors before, and Donohue is confident he knows the right strategy to keep CME Group growing for decades to come. Unless the banks and hedge funds are ready for a long fight, ELX may melt away like past challengers.
To contact the reporter on this story: Matthew Leising in New York at mleising@bloomberg.net; John Lippert in Chicago at jlippert@bloomberg.net.
Last Updated: June 24, 2008 00:11 EDT |
