The king of US interest rate futures, CME Group, has
faced down a string of pretenders to its crown in recent years.
Now a new array of rivals is arming for battle. As
David Wigan discovers, CME shows no sign of being
worried – but this time the uprising may be a lot more
We all know the story of David and Goliath. Plucky midget
challenges surly giant to a fight, and fells the brute with a
sling shot to the head. It’s the stuff of legends.
We also know that in the real world, plucky midgets get crushed
by giants and then ground into the dust for good
It’s worth bearing in mind these perspectives when
considering the battle being fought between CME Group and
challengers to its dominance of the US interest rate futures
Chicago Board of Trade headquarters, topped by a statue of the
CME Group is master of all it surveys.
Comprising the Chicago Mercantile Exchange, Chicago Board of
Trade and New York Mercantile Exchange, the
world’s biggest derivatives exchange group hosts
98% of US futures trading.
In September, the Group handled the trading of 5.1m interest
rate contracts a day, of which 2.2m were Treasury futures and
1.8m Eurodollar futures. Treasury and Eurodollar options
together accounted for just over 1m contracts.
The business is highly profitable.
In the first half of the year, CME posted revenues of $1.5bn, a
16% rise on the same period in 2009, generating a net income of
$510m. Interest rate products accounted for over 42% of daily
volumes, and Eurodollar contracts for just under
Clearing and trading fees for interest rate products totalled
$344m in the half year, and CME also made $245m from other
services including market data and access and communications
fees – of which a share must be attributable to the
Enter the pretenders
No surprise, then, that there are pretenders to
CME’s throne. Eurex had a go at breaking into the
market in 2004 – now NYSE Liffe is preparing a
"It’s an incredibly exciting, dangerous and
unpredictable time in the futures markets," says Richard
Repetto, principal at
investment bank and broker-dealer
Sandler O’Neill & Partners. "CME is in a
hugely dominant position but with the regulatory changes and
new competitors coming in they will need to be on their mettle
to protect their position."
Behind NYSE is a further group of aspirants who do not pretend
initially to covet dominance, so much as to take crumbs from
the tables of the elite. Chief among these is a small player
with powerful backers, which has made enough noise in recent
months to rattle cages in Chicago.
Electronic Liquidity Exchange, now called ELX Futures, was
conceived in 2007 and launched in July 2009, with the stated
aim of providing "a competitive alternative" in US interest
At the moment the new exchange is as much of a threat to CME as
a flea to a tiger, but ELX’s power lies in its
potential, manifested in the unrivalled calibre of its owners,
which include Goldman Sachs, Bank of America, Barclays Capital,
BGC Partners, Citibank, JP Morgan and Morgan
ELX’s first product was Treasury futures, which it
offered across the curve from the short to the long end. The
exchange has gained a firm toehold, especially in two year
Treasury Notes, where it claimed a 4.7% market share in the
first nine months of 2010, according to FOW’s
proprietary database FOW TRADEdata.
ELX’s five year Treasury futures are its next most
successful product, with a market share of just under 2.5%. In
10 year Treasuries it has 1.17% and in 30 years
It was not long before ELX attacked the Eurodollar market,
launching a contract in June this year, which had won 0.25% of
the market by September.
"We are competing head to head with CME in the interest rate
space," says Neal Wolkoff (pictured), chief executive of ELX,
and former chairman and CEO of American Stock
ELX says that during the 10 trading days between September 27
and October 10, it traded around 45,000 US Treasury futures a
day on average, which it claims was a 2% market share. In the
same period, its ADV of Eurodollar futures was around 10,000,
or 1% of the market.
"We already have 1% market share in Eurodollars, and people are
beginning to take notice. That is because it makes sense to
diversify your risk away from one exchange," says
Central to ELX’s strategy is its attempt to ride a
regulatory wave that appeared as recently as last year to be
leading toward a more open interest rate futures market, and
away from the traditional vertical exchange model, in which
futures trading and clearing are inseparable.
Fungibility – yes, no, maybe?
The buzzword is fungibility, or the
ability to buy a contract on one exchange and sell on another,
equity options. Fungibility would enable investors
to move their open interest between exchanges, which would be
free to compete for business on fees and
The idea is to improve liquidity, and enhance cash management
for netting and margining.
"Lack of fungibility makes CME tough to compete with," says Ed
iversified capital markets analyst at Macquarie
Securities in New York. "Because there is currently no
cross-netting between exchanges, it’s a lot more
capital-efficient to use one platform."
Topping described what happened next in an article for
Financial Services Research in the fourth quarter of
January 2008 the Department of Justice called for an overhaul
of vertical clearing. In a letter to the Treasury, the
Department recommended "a thorough review of futures clearing
and its alternatives," including the horizontal utility models
used in equities and options.
a world of fungible financial futures contracts, multiple
exchanges could simultaneously attract liquidity in the same or
similar futures contract, facilitating sustained
head-to-head competition," the DoJ said.
letter argued that incumbent exchanges’ "control
over open interest and clearing have impeded entry and the
development of meaningful competition in execution
The campaign for
fungibility began to gather pace, with some heavyweights
backing a change, including former SEC commissioner Annette
Nazareth and John Damgard, president of the Futures Industry
chairman Gary Gensler called in June 2009 for fungibility in
the clearing of OTC derivatives, many thought it was only a
matter of time before the futures market was forced to follow
surprise when in October last year the SEC and CFTC appeared to
rule out any change.
In their Joint Report on the Harmonization of Regulation of
capital formation and risk management markets, the SEC and CFTC
recognised that "
product fungibility and fair access to clearing services are
necessary for competition in the market for trading
However, they said: "
Products in the futures industry are not treated as fungible
because exchanges expend resources to develop them and
fungibility would enable other trading venues to 'free
ride’ on these product development efforts;
futures exchanges should be able to recoup their investments in
(or, as some economists would term it, enjoy the rents from)
their product development, and that any changes should be
predicated on reform in
following publication of the report, CME chairman Terry Duffy
said it had "lifted a big regulatory cloud from our
As champagne corks popped in Chicago, ELX executives in New
York were already working on another idea. If fungibility was
impossible, they reasoned, why not introduce a rule that
achieved something similar?
Under the new rule,
market participants could privately negotiate two discrete but
integrally related transactions, establishing a futures
position on ELX while concurrently liquidating a position on
another exchange listing identical contracts. Alternatively a
trader could establish a position on another exchange to
replace identical positions liquidated on ELX.
By taking opposing positions in similar products on different
exchanges, the positions could then be migrated between the
respective exchanges’ clearing houses, allowing
investors to switch between markets.
The system, called exchange of futures for futures (EFF), would
tool for firms that were uncomfortable using a new market, but
would do so if they could enter or exit easily,
ELX’s Wolkoff says.
As the harmonisation hearings proceeded in September 2009, ELX
petitioned the CFTC to agree its new rule, and this was duly
CME did not
budge an inch, insisting that EFF
trades contravened its own rules.
War of words
What followed was open war, with both sides unleashing a
bombardment of letters to the regulator.
Based on "false information", ELX was "engaged in fictitious or
wash trades", which "undermined liquidity", CME alleged.
According to ELX, CME was a "monopolist" that was attempting to
"stifle a nascent competitor", having "failed completely to
identify any legitimate business purpose".
And so it went on, until the CFTC in August this year backed
ELX, repeating its earlier assertion that CME had
"mischaracterised" the law by claiming EFF trades were
In response, CME did what any firm with a dominant market share
would do –
absolutely nothing, remarking in a further letter to the CFTC
that an exchange was not "obliged to assist its
The CFTC said in
August that it had launched an antitrust inquiry in respect of
CME’s intransigence, after ELX argued that CME
violated the antitrust core principle in the Commodity Exchange
summarised the CME’s position as contending that
EFFs "would enable ELX to free ride on CBOT’s
investments in exchange facilities, clearing facilities or
CME executives were not impressed. "We’re very
confident in our position on this issue," CFO Jamie Parisi told
journalists in September. The exchange nonetheless fired off a
70 page riposte to CFTC chairman Gary Gensler to ram home its
Even if an antitrust position can be established, there is some
doubt as to how it will be enforced. The Department of
Justice’s antitrust division has held informal
discussions with the CFTC over the matter, but the CFTC is
still reportedly in charge of the inquiry, though it
does not have express authority to police violations of US
"They have been debating this thing back and forth for over a
year and it isn’t clear there is any particular
urgency on the CFTC’s part to force CME to support
EFF trades," Ditmire says.
CME, meanwhile, has thrown the ELX antitrust accusation back
in its face, saying the EFF rule is itself
Fundamental to the CME’s argument is its belief
that futures are inherently different from securities like
equities. Futures are risk management products rather than
instruments designed to raise capital, the exchange claims, and
are therefore unsuitable to be regulated under a similar
"Futures contracts are different animals," says Robin Ross
(pictured), managing director of interest rate products at CME.
"To assume that futures will go the way of securities markets
disregards the intellectual property involved in creating new
and innovative contracts. While we believe competition is good
for our business, why would we want to make it easier for
someone to mimic and leverage our ideas, our resources and our
A trail of defeated rivals
CME is a past master at seeing off the attentions of rivals.
As early as 1984, amid concern over competition from outside US
time zones, it set up a link with the Singapore International
Monetary Exchange called Mutual Offset System, which allowed
the CME Eurodollar contract to be traded on the Simex floor,
moved to the CME Clearing House in Chicago and offset on the
CME trading floor. Any similarity with EFF is purely
In 1999 Cantor Fitzgerald
launched Cantor Exchange, its electronic exchange for US Treasury futures, and
in 2001 BrokerTec, now part of Icap, launched an online futures trading outfit, aimed at
taking market share from CME.
Both closed soon after launch, amid disappointing trading
volumes. Cantor’s spin-off BGC Partners now owns a
25% stake in ELX, which operates on Cantor’s
In 2004, Eurex launched an
electronic trading exchange in Chicago, aimed directly at grabbing market share
from CBOT’s floor-based offering. #
The reaction of CBOT and CME was described in the book
Electronic Exchanges by Michael Gorman and Nidhi
Singh: "The first thing they did was throw up every regulatory
barrier they could. For example, they ensured that
Congressional hearings were held... They also did everything to
slow down the approval process... by questioning every single
aspect of the application made by Eurex."
While Eurex was dealing with the regulatory hurdles, CBOT
and CME upgraded their systems, so that by the time Eurex
launched in early 2004, it failed to win any substantial share
of the futures market.
So CME has seen it all before. However, the difference this
time may be that it is fighting competition on more than one
front. While ELX engages in the public battle, an arguably more
dangerous competitor is readying itself in the shadows.
NYSE Liffe US, a NYSE Euronext subsidiary launched in 2008,
announced plans in April for a complete suite of interest rate
futures from three month Eurodollars to 30 year Treasury
The key differentiator in NYSE Liffe’s offering
lies in a company called New York Portfolio Clearing, a joint
venture between NYSE Euronext and The Depository Trust &
Clearing Corporation, which will clear trades for the new
All cash Treasuries are cleared through the Fixed Income
Clearing Corporation, a subsidiary of DTCC. Uniquely, the NYPC
will be a single pot clearing house for cash and futures, with
a cross-margining agreement between FICC and NYPC, enabling
exchange users to pay a single margin across positions.
"What we are calling one-pot margining is a huge competitive
advantage in this marketplace," says Ira Krulik, chief
operating officer at NYPC. "Clearing members will settle with
only one counterparty, whereas at the CME they need to settle
futures on the exchange and cash elsewhere."
In stark contrast to the vertical clearing model at the CME,
NYPC is designed to operate horizontally, allowing open access
to clear trades from other exchanges. This will come "as soon
as it is operationally practicable to do so," Krulik
Cross-margining and netting of cash against derivatives, and
the delivery advantages afforded by the
one-pot model, together comprise what NYSE Liffe US chief
executive Tom Callahan calls "a dramatic shift in the market
situation", and would make NYSE a very serious contender
Some feel that
the ELX battle is something of a red herring, perhaps motivated
by Wall Street’s desire to keep pressure on CME in
respect of fees, with
the greater challenge coming from NYSE.
"CME will need to bring out their
best game to defend against NYSE," says John Lothian, editor of
The John Lothian Newsletter. "This is not a Eurex or
an ELX situation – NYSE Liffe is a global company with
headquarters in New York – they are a very recognisable name from a
branding point of view, with strong technology and good
relationships in the market. CME will give them
A final showdown between NYSE
Euronext and CME Group has been on the cards for some years,
Lothian says. "What prompted CME to merge with CBOT in 2007 was
the coming together of NYSE and Euronext –
this is the real battle and this has
been the play all along."
NYSE is in final discussions with
regulators and expects to launch its new product suite in the
first quarter of next year, Callahan told FOW. Might
it be that Goliath has met his match?