Market volatility is working in favour of Chicago exchanges in the US. But with an eye on the future, they are holding off any threat from younger competitors by forging new alliances, reports Jim Kharouf.
Every year, the leaders of Chicago’s derivatives exchange send a message to members to the effect that “this is the most important year” in the history of their respective markets. This time, for once, that message is actually true.
By almost all accounts, 2003 is a pivotal year for the Chicago Mercantile Exchange (CME), the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE). At stake is their ability to compete with younger, all-electronic exchanges that are already battling with them for market share, or soon will be. The current and looming threats from exchanges in the US and overseas led to a number of developments that will define each market in the coming years as an innovator or a dinosaur.
Collectively, their choices will also help to determine whether or not Chicago remains a major global financial hub.
Topping the list of important moves was the CBOT’s and CME’s groundbreaking announcement in April that they would process and clear all trades at the CME Clearing House. Starting in January 2004, the clearing link will save firms anywhere from 70% to 90% in performance bond margins in equity and interest rate products.
“It’s always easy for us as exchanges to say this is a win-win,” says Terry Duffy, CME chairman. “But now the customers are seeing the capital efficiencies, the portfolio margining and one pool of liquidity that will drop the margining down. It’s a big saving here.”
That move reshaped the competitive landscape for US futures exchanges, and perhaps the global industry. The historic partnership was the result of a defensive action by the CBOT. It abruptly ended its relationship with the Board of Trade Clearing Corporation (BOTCC) when the latter remained open to working with the German-Swiss derivatives exchange, Eurex, which was preparing for the launch of its new US futures and options exchange in early 2004. The BOTCC also declined CBOT’s subsequent acquisition proposal. Whatever the rationale behind CBOT’s partnership with the CME, it means that Eurex customers will have the choice of clearing in the US or at Eurex Clearing AG.
Eurex pushes change
Without question, Eurex is the most significant challenger and catalyst for change in Chicago. It has been connecting customers to its system since 2000 through a licensing deal with the CBOT to host its electronic trading platform. Already, virtually every major CBOT member has been using Eurex’s trading system for the past three years through the CBOT’s a/c/e platform. Now, with a US clearing house and an established network in place, Eurex promises to offer CBOT and CME benchmark products at a much cheaper rate.
The CBOT had already decided in January this year to end its relationship with Eurex and switch to the Liffe-Connect trading system in January 2004. “As we approach 2004, customers are going to have the best trading engine in Liffe-Connect, which caters far better in terms of options strategies, spread trading and other flexibilities dealing with connectivity that we don’t enjoy today,” says Bernie Dan, president and CEO of the CBOT. “That’s critical in my mind with product development.”
The CME took the greatest leap among US exchanges when it streamlined business operations and launched a successful initial public offering last December, raising $117.5m. The priority now is to expand the distribution of its Globex trading system. One way is by providing firms with “local access hubs” to lower telecommunications costs drastically. CME launched such a hub in London last year and plans to add another in Asia. And in January, it launched a new trading system called Eagle, which allows for complex calendar spread trading on contracts.
Like the CBOT, the CME keeps its open outcry pits in business. But CME executives bristle when critics say they are not committed to electronic trading.
“We dedicate close to half our staff to technology and about 50% of our annual budget is dedicated to technology,” Mr Duffy says. “Trading on Globex went from around 20% of our total volume two-and-a-half years ago to about 50% today. We do believe that electronic trading will continue to enhance our business. We know it opens the markets up to many more people than open outcry. Having said that, we will allow our customers to decide when we are going to be more of an electronic exchange.”
However, there is a groundswell of discontent from firms that use these marketplaces because of their liquidity. They yearn for a cheaper, more customer-friendly market. Many believe that market is Eurex. It has already shown the power of electronic trading, recapturing the majority of Bund trading volumes from London’s Liffe when it launched as an electronic exchange in 1998.
“Liquidity is a function of how many locals, scalpers or traders in the pit are willing to assume risk in those markets,” says Russ Wasendorf, chairman and CEO of Peregrine Financial Group in Chicago. “The Chicago exchanges have performed extremely well in providing liquidity because of this group of people. But once you get into an electronic venue, the liquidity pool changes. Then you have to start counting screens and the liquidity providers there. The CME has done very well there, too, but does Eurex have the same thing? In spades. They can compete on this level.”
Critics say the Chicago exchanges ignore their most important customers – large firms – when it comes to cost and exchange decisions. Cynthia Zeltwanger, president and CEO of Fimat USA in New York, says Eurex could wake them up. “I think customers are getting really fed up with the costs,” Ms Zeltwanger says. “However, the last couple of years have been such a volatile environment that cost was secondary and liquidity was first. In a less volatile market, people will be more willing to give a new exchange a chance.”
Volumes rise
Right now, volumes and volatility are plentiful in Chicago. The CBOT, for example, posted a new daily volume record at the end of May of 3,286,987 contracts traded, with 1,527,160 of them trading electronically. The CME, for its part, posted an average daily volume of 2.22 million contracts in 2002, a 35% rise from 2001 and a close second to Eurex’s 2.24 million average daily volume. In April, the CME averaged 2.35 million contracts a day.
With such liquidity flows and common clearing ahead, many believe the Chicago markets are ready to compete against Eurex and others. “I think the Board of Trade, with its leadership team, is being underestimated,” says Mike Manning, president and CEO of Rand Financial Services in Chicago. “Both the Board of Trade and CME have shown they’re not afraid to make drastic decisions. And only good things can come out of a closer working relationship with the CME and Board of Trade.”
Meanwhile, the options industry is enduring a massive reconstruction as the all-electronic International Securities Exchange (ISE) quickly emerged as the largest options market by stock options listings volume. And it is narrowing the gap on the leader, the CBOE, which boasts the highest overall volume due in large part to its equity index options.
To combat the ISE, the CBOE launched a hybrid trading system in June that uses the floor and its electronic trading platform, CBOE direct. It hopes to contend with ISE and newcomer Boston Options Exchange (BOX) and Eurex.
“It combines the best of what I’ve seen in terms of electronic trading along with the depth and liquidity of the floor,” says Bill Brodsky, CBOE chairman and CEO. “It’ll give users the point-and-click flexibility of seeing our markets, which will be as tight or tighter than any others. And we’ll see the depth of the market and access it as easily on the floor as on the screen system. But you’ll also be able to come to the same place, electronically or otherwise, to do the larger and more complex trades.”
Growth potential
Major market participants think the hybrid system may help the CBOE grab some market share back from the ISE. “The CBOE will grow if this hybrid system makes it more efficient,” says Thomas Peterffy, chairman of Interactive Brokers Group in Greenwich, Connecticut. “Automation will grow in a flexible way and maybe CBOE will find a sweet spot where automation meets open outcry and the advantages of both can be enjoyed in one place.”
But Mr Peterffy also sees a quickly evolving and changing industry, in which new and easier trading platforms will continue to be rolled out. His company is one of the key investors in BOX, and aims to make access to the marketplace cheaper and easier.
Should each exchange’s strategy succeed, Chicago will remain a key player in the global financial markets. But history has proved that liquidity can be shifted and that young pretenders can steal a crown.
“A lot of risk still exists in Chicago,” says Mr Dan. “As long as Chicago continues to innovate, whether it is on product or relationships, technology or clearing and settlement, you’ll find that Chicago will remain formidable and continue to grow. If that innovation stops, there will be cause for concern.”
