Sep. 14–As they get ready for the arrival of Eurex AG next year, the Chicago Board of Trade and the Chicago Mercantile Exchange are proving the old axiom that the enemy of my enemy is my friend.
The CBOT and the Merc are the two largest futures and options exchanges in the nation, with different cultures and histories. Any efforts at cooperation in the past had always failed, but these days they are working together in ways many thought impossible a year ago.
And they won’t have to wait long to find out when their new competition will begin.
On Tuesday, Eurex Chief Executive Rudolf Ferscha will be in Chicago to announce the date his exchange will begin trading in the U.S. and what it will offer. U.S. Treasury and interest rate futures and options are among the products it is expected to include.
As of Friday, Eurex had not filed a request with the Commodity Futures Trading Commission. Eurex officials have not revealed whether they will open a new exchange or purchase an existing one.
Either way, CBOT Chairman Charles Carey believes his exchange has prepared itself for the competition Eurex will bring.
“At the end of the day, it’s going to be about us offering a product to the marketplace that gives them the most liquidity, the most transparency with the most market integrity,” he said. “That’s how the marketplace is going to decide.”
The Board of Trade, in particular, has been busy making changes, and one of those efforts began to pay off last week.
Tudor Investment Corp., one of the world’s largest hedge funds with nearly $8 billion under management, is the first to take advantage of a new CBOT rule allowing commodity pool operators and other large investment funds to become exchange members. The move means Tudor will be charged the board’s lowest transaction fees, a deal that makes it less likely to shift business to Eurex.
Keeping those with large pools of cash from moving to Eurex is behind a lot of recent decisions at the CBOT.
Perhaps the most telling is its unprecedented move to have the Merc clear its trades instead of going through the Clearing Corp. The new arrangement, which takes effect soon, will free up capital for investors involved with both exchanges because they will not have to deal with two clearinghouses.
Both exchanges also are re-evaluating and changing fee structures. Last week, they reduced the amount brokers have to keep in margin accounts when the Merc begins clearing CBOT trades. Both are also touting the advantages of doing business either electronically or with traders furiously working the pits–a hybrid system that Eurex does not offer.
In his office a half-mile from the CBOT’s offices, Merc Chairman Terry Duffy says he is not making decisions based on Eurex’s expected arrival.
“We haven’t put any steps in place to prepare for Eurex,” Duffy said. “What we’ve done is put our plan in place to prepare for and execute our business plan.”
In a global sense, all the exchanges compete with each other, but the imminent threat to the Merc and CBOT is Frankfurt, Germany-based Eurex, the world’s largest exchange.
The monopoly the Chicago exchanges enjoy on some options and futures, such as U.S. Treasury notes at the Board of Trade and Eurodollars at the Merc, is not the only thing at risk.
Thousands of jobs are tied to the open-outcry system at the exchanges and the support services for that work. And billions of dollars generated by trades at the Merc, the CBOT and the Chicago Board Options Exchange move through Chicago banks at the close of business each day.
Trading on Eurex is nearly all electronic. There is no trading floor, no broker in a pit fighting for the best price. The fees Eurex offers in Europe are also low, sometimes a fraction of what the Merc or Board of Trade offers for a similar transaction.
Eurex makes presence known
Eurex has already proven it can cause headaches for an exchange that relies heavily on open outcry. In 1998 it wrested trading in the German Bund, or government bond, away from the London International Financial Futures Exchange, known as LIFFE. Part of that success came because Eurex was electronic, while LIFFE relied on open outcry. Eurex’s system was cheaper and, ultimately, more popular.
In the U.S., Eurex will have to compete with exchanges that have already embraced electronic trading, in addition to maintaining trading pits.
“They’re coming after an electronic marketplace with the efficiencies that come with an electronic market, with the strong distribution,” Carey said. “We decided four years ago to serve the needs of the marketplace, whether they want to trade electronic or they want to put the orders in the pit where brokers can work them, finesse them.”
Carey said he doesn’t agree with those who deride the pits as a relic. While electronic volume has grown, the number of trades executed via open outcry has remained strong, he said.
“The fact that you’ve got this critical mass of marketmakers in one place trading face to face is certainly a superior solution to a call-around market, where I have to pick up a phone and shop a deal,” Carey said. “From that standpoint, the floors still provide some value to the customer.”
But many question the wisdom of maintaining the open-outcry system. They “have not responded to the economies of scale that are created by electronic trading and other economies of scale created by technological efficiencies,” said Russell Wasendorf, CEO of Chicago-based Peregrine Financial Group Inc. “What they have invested in technology they’ve squandered in the pits.”
Ultimately, if the Chicago exchanges want to match Eurex’s price, it will be difficult for them to maintain open outcry, said Harris Brumfield, CEO of Trading Technologies International and a former CBOT trader.
“If you come to Eurex’s price, I don’t see how you support two venues,” he said. “There’s a bottom-line expense. I’m not saying a lot of people don’t prefer open outcry. I’m saying from an expense point of view, if you’re working and you’ve got two cars instead of one car, it’s more expensive.”
At stake in the battle with Eurex is liquidity, a situation that results from a large number of buyers and sellers working in the same market where trades can easily be executed. That competition ensures the best price for each transaction.
That is why just focusing on the transaction fee is misleading, said Bernard Dan, the Board of Trade’s chief executive. “We focus on the spread [between the bid and asking prices], as well as the transaction fee, because that’s what people pay for,” he said.
“If the transaction fee is lower, but the spread is much wider–guess what, the total cost is much higher,” he said. “And guess what–no one trades there.”
Attempts to take away part of the futures market have been tried before and have failed, said Craig S. Donohue, who takes over as Merc CEO in January. He cited the examples of Cantor Fitzgerald and BrokerTec, both of which had low fees.
“The general proposition is that exchange fees are not a compelling basis for differentiation alone,” Donohue said. “That’s not to say they’re not a factor. But people are focused on how liquid is the market, how efficient is the pricing mechanism, can I get in and out at a very, very cheap price.”
The Board of Trade, long looked upon in some circles as a financial old boy’s club where tradition and members’ self-interest often trumped long-term goals, adopted Rule 100 this summer. The change did away with a restriction that required decisions to be brought before the full membership for a vote. In the past, it could take a month or more to make even a minor policy change.
The move and the board’s agreement with the Merc to clear the CBOT’s trades there were long talked about as moves crucial to operating in a competitive environment, Carey said.
Clearinghouses guarantee trades to both the buyer and the seller before money changes hands. For decades, the Chicago-based Clearing Corp. cleared the CBOT’s trades. This month, Eurex announced it was buying an equity stake in the Clearing Corp.
It is possible that the arrival of Eurex will ultimately result in stronger U.S. exchanges, suggested Joost M.E. Pennings, a professor at the University of Illinois at Urbana-Champaign and a professor in futures markets at Wageningen University in the Netherlands.
“This provides opportunities for the Chicago exchanges,” he said.
Eurex’s arrival in the U.S. could draw more foreign investment with it, he said.
“I’m not pessimistic,” he said. “To be honest, this will provide opportunity.”Tribune file photo by Bill Hogan
Open outcry, as seen in the S&P 500 pit at the Mercantile Exchange, remains an integral part of activity at the Chicago exchanges.
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