The newest US futures exchange, NYSE Liffe, which opened for business on September 8, has a tough challenge ahead of it: attacking CME Group’s 98% market share.

To lead the business, NYSE Euronext has chosen Jim McNulty as chairman and Tom Callahan as executive vice-president and head of the exchange. McNulty is a former CEO of CME Group, while Callahan joined NYSE Liffe in June from Merrill Lynch.

Their job is to build a multi-asset class exchange, starting from the small base of six gold and silver futures and options that NYSE Liffe took over from the Chicago Board of Trade.

But their ambitions go beyond winning market share. McNulty and Callahan want to shake up the market by breaking down barriers and making trading more efficient. And they believe there is huge scope to grow the whole market by creating new products.

They talked to Jim Kharouf at the NYSE Arca headquarters on Wacker Drive in Chicago, in a boardroom with a view of the CME Group building across the street.

McNulty and Callahan explained why they believe NYSE Euronext is well placed for CDS clearing, what NYSE Liffe is doing to reduce latency and how they think volume in the futures market will evolve over the next five years.

Since this interview was conducted, NYSE Euronext has revealed that it plans to sell up to 49% of NYSE Liffe to strategic partners to help it grow.

Why did you both decide to join NYSE Liffe?

Tom Callahan: It was an exciting time to get in the business and things have progressed significantly since then. Out of this whole crisis is going to come some really credible opportunities for exchanges to build new things, new products, new services.

I am a firm believer that the US futures market is a lot more competitive than in the past. And NYSE Euronext is an incredibly dynamic organization.

Jim McNulty: I was on the board of directors of Archipelago, which was a tremendous innovator. It was a firm with a vision for change and efficiency in the US equity market.

When Arca merged with NYSE, I was one of the board members along with Bill Ford from General Atlantic who was asked to join the NYSE Group board.

One of the things that most impressed me about NYSE, pre-Euronext and post-Euronext, was this well defined global vision, where we said ‘we can be more efficient’.

We could really break down some of the artificial barriers, such as those in the US between securities and futures, and globally with cross-border barriers in clearing or in the long run, harmonization of regulation.

If we can do that in the equity exchange space, can we also add value for end users and make new efficiencies in the futures market? I believe we can.

It’s a lot easier to be the incumbent, established futures exchange than a newcomer. How is NYSE Liffe going to be successful?

McNulty: The only way to gain ground is to offer efficiencies that others cannot offer. We’ve been a capital formation house. But as we acquired the American Stock Exchange (Amex) and Arca, we acquired some abilities to go beyond that and become a risk management house with options and also through ETFs. I believe we can build upon that strong position with our futures market.

In mid-October NYSE Liffe announced it would clear through the Options Clearing Corp. Why did you choose OCC?

McNulty: We think we can get the best capital usage for our clients by working with the OCC, marketing together with the OCC both options on securities and then futures.

Did you consider creating your own clearing house?

McNulty: It was certainly considered. We have a futures clearing facility in London and that is the next frontier where we can provide efficiencies across border. If you’re going to find an efficiency to bridge that artificial frontier between futures and securities, working with OCC is the fastest way to cross that.

Callahan: It was an easy decision, actually. We have a great relationship working with OCC on NYSE Arca. And with the Amex acquisition, we own 40% of OCC. To ask our members to connect to a new clearing house in this environment and under the strains they are under didn’t seem to be the smart decision.

CME has a 98% market share in the US and clients are uncomfortable with that. But that alone isn’t going to make a futures exchange succeed.

What people really want is innovation. There isn’t a greater need for innovation than right now in products and services.

That’s what gets our clients and customers excited. They really want to bring in innovative margining structures, more efficient and streamlined rules and even products. That will be the cornerstone of our exchange.

Credit default swaps are in the spotlight now. OCC is clearing your US futures but Liffe’s Bclear system, designed for clearing OTC equity derivatives, is going to provide clearing for CDS. That uses LCH.Clearnet for clearing. What will happen in the US CDS market?

Callahan: Bclear is a Liffe product managed from London, so it’s not part of the exchange Jim and I are working on directly.

But on behalf of Liffe, we think there are a few reasons why we are a very credible player in this space, not only in Europe but also in the US.

Bclear just celebrated its third year of existence in the equity derivative market. We’ve done over 1.5 million transactions, more than $7.5 trillion notional of cleared volume. It’s live and not vapourware, unlike some of the other proposals that are out there. It has 200 users and is very widely distributed and used.

Second, we’ve been working with LCH.Clearnet, which is enormously credible. It managed a $9tr default by Lehman Brothers without dipping into its guarantee fund. In these market conditions, it’s been a remarkable achievement.

Now that LCH is partnered with Depository Trust & Clearing Corp, the case becomes even stronger. We’re still in the early stages, but if you add Bclear with LCH and DTCC as a partner, that is a very credible solution.

We are launching [clearing on Bclear for] iTraxx [European CDS index contracts] on December 22 and we should launch [clearing for] CDX [US CDS index contracts] in the US very shortly thereafter, pending regulatory approval.

It’s probably the only globally cleared solution and this is a global market. To have one solution [offered by NYSE Euronext] that is separate and distinct between the US and Europe is illogical and inefficient.

Can Bclear’s CDS system go live in the US before year end as the Treasury wants?

Callahan: Early January.

As you said, Liffe signed a deal in October with Markit for Bclear to clear credit default swaps based on its iTraxx and CDX indexes. What role will NYSE Liffe have in the US CDS market?

Callahan: This market is evolving so quickly, it’s hard to say with any assurance what the future will be. In terms of the ticket count at any given bank, CDS trades are really disproportionate.

You mentioned Markit, and that’s been our strategy all the way through. We want to work with many of the key vendors, DTCC, Markit, Isda.

Our solution is really a true credit derivative, as opposed to others which are more like a futures central order book. Bclear is not a central order book type of product. Trades are still voice-brokered and then sent to be cleared through Bclear.

But you never know. You could have a market structure for single names and another for indices. They have very different risk properties. I would be shocked if there weren’t different service providers in the US and Europe.

You started the exchange using much of the infrastructure left over from the Chicago Board of Trade, which used Liffe Connect. What have you done with that existing system and what are your plans for it going forward?

Callahan: Technology has to be beyond question and ours will be based on Liffe Connect. The CBOT platform was based on Version 8. But to get us where we need to be, we need to upgrade to Version 10.

That involves a whole new data centre build-out here in Chicago. Two hundred new servers needed to be acquired, and there is a software upgrade as we move our clearing. We’re contractually obliged to clear through CME until March 31 next year. Connecting to a new clearing house and then moving open interest is a lot.

We’re confident that by April 2009, we’ll have the most recent version of Liffe Connect, which trades about 4.5m contracts a day in Europe. Because we will have the latest and greatest software, we will be as fast as or faster than our platform in Europe.

So you’ll probably see a quiet period between now and then. You won’t see new products launched until early second quarter next year.

McNulty: The board realizes that we’re in the applied technology business and there is no point in trying to kick this out really fast.

Will switching to Liffe Connect Version 10 be a big change?

Callahan: The current version cannot support co-location, so that’s the reason for the data centre build-out. We have a latency issue right now. It’s not a capacity issue, it’s a matter of functionality and speed.

Pricing is always an issue for users. What kind of pricing will you offer? Will you engage CME on price?

McNulty: Pricing historically has been way too complicated. One thing we can do is to simplify pricing structures.

Callahan: Competing on price is a losing strategy. That’s not going to be part of our core business plan. Will we be cheaper? We probably will. And we’ll be more efficient. But don’t look to the pricing wars as the business strategy. The business strategy is really about innovation and creating new risk management tools for our customers.

NYSE Liffe started with the old CBOT gold and silver complex. How do you plan to grow that sector and will more commodity futures be added?

Callahan: We plan to both grow gold and silver and add other commodities. This is very important. We are going to be a multi-asset class exchange. This is not a repeat of what other exchanges attempted, where they wrapped their whole identity around one product.

We are making a very substantial investment in infrastructure.

And building on that platform, we will launch more commodities contracts, more equity-based contracts, interest rate futures and we’re going to do it quickly. Some of them are not going to work and that’s OK. That’s the luxury of starting with a sub-1% market share: you can take risks to bring products to market.

Aside from commodities, NYSE Euronext has a strong stable of cash products on which to build financial futures as well. What types of contracts are you looking at and when can the market expect to see them?

McNulty: I’ll be somewhat circumspect. It is clear that ETFs and options have shown tremendous growth. As we bring in futures, we want contracts that allow you to arbitrage between those three arenas and gain unique efficiencies.

That’s interesting, because over the past few years, in many firms the strict differentiations between stocks, futures and options have broken down. Those trading desks are often being melded together now.

McNulty: That happened at O’Connor & Associates in the 1970s. We saw a specific exposure to a specific name as a delta, whether that came as part of an OTC derivative, ETF, future or option. That didn’t matter to us. Those are the artificial barriers I was talking about. We think that in taking the same approach we can create efficiencies.

Callahan: History has shown that as you broaden the liquidity tools around one specific asset, liquidity improves dramatically. So if you have ETFs, options and add futures to that, you broaden the liquidity pool. It’s that virtuous cycle between the three asset classes.

Will you compete directly with CME or ICE on their benchmark commodities or financial contracts?

Callahan: Nothing is off the table at this point.

NYSE Euronext was created as a cross-Atlantic trading and clearing market for stocks, options and futures. How will NYSE Liffe be integrated into that model?

Callahan: This is an area where we can be innovative in terms of clearing. We have arrangements with OCC and Liffe Clear in Europe to harmonize these pools of risk and give capital relief.

Secondly, our universal trading platform will allow us to trade all products and take the friction and headaches out so you can trade globally from one point of entry.

NYSE and Euronext are powerful forces in equities. How can you parlay those customers into traders on NYSE Liffe?

McNulty: We know a big part of our customer base is interested in the equity markets. We’re going to provide a big piece that they haven’t had in the past. They’ve had the stocks, ETFs, options. Now we’re going to add futures and options on futures to address these deltas in a differently leveraged way.

How does the push from OTC to futures exchanges help now?

Callahan: The clients in the OTC space are those who are most actively supporting our exchange. They know regulatory change is coming. If there is going to be a migration from OTC they want that to happen at a place where they see partnership and alignment. That was in the back of people’s minds back in June and July and is now in the front of their minds in November.

The US financial markets are undergoing tremendous change and turmoil. What short term and long term impacts will there be on futures markets in terms of volume, liquidity and participants, especially from the rapid consolidation and contraction of institutional players?

McNulty: It makes it an interesting time to start up a new exchange. I’ve had the opportunity to trade in several different markets, including some that crashed 70%-80% and then made comebacks that exceeded the high water volumes before they crashed.

After the Mexican peso devaluation the market only got bigger. I think we’ll see something similar here. There will be some shrinking in volume over the next 12-18 months and then growth in volume.

A lot will be focused on new markets and there’ll be some development from the trading side and from the product side in Asia in the next three to five years.

Whole new products and categories will spring up and in the next five years there will be a new high water mark in volume. For one thing, technology almost assures that the opportunity is there.

Callahan: One of the untold stories of this crisis is how well some shops are doing because some of these markets have gotten sloppy and liquidity has gotten challenged.

Because their technology is so good, they can move in and out of the market so quickly and manage risk so well, they are having their best years by a factor. This is not just one or two firms but multiple firms and a lot of them are based right here in Chicago.

Earlier this year, treasury secretary Hank Paulson unveiled his Blueprint for reforming regulation of financial markets. Lawmakers largely ignored it and then panicked in the midst of market crises such as the energy price spike this summer, the meltdowns at Bear Stearns, Lehman Brothers and so on. Is this the time to tackle this issue and if so, what would be the best model for a multi-asset class exchange like NYSE Euronext?

McNulty: The end users are global players and it’s more important that strong communication, if not collaboration, on a cross-border regulatory basis is needed. The same can be said of securities and futures, because it’s inevitable that markets will migrate toward greater efficiency.

What will NYSE Liffe look like a year from now in terms of products, participants, volumes and the like?

Callahan: We launched on September 8 with 180 members and four contracts in gold and silver. That’s our starting point. In 12-18 months, we hope to be a multi-asset class exchange with multiple risk platforms.

Beyond that, we want people to look at NYSE Liffe and say: “Those guys took calculated risks, were thoughtful and brought interesting products to market.”

Now we have a new suite of products that provide a way, through the futures market, to exercise new strategies, enter new pools of risk, bring down barriers and create efficiencies.

We’re not just a ‘me too’ exchange but a market that is really creating something new and different to add new volume and liquidity to the marketplace, not just take existing market share from other exchanges.