The CME has seen increased volumes in its cash settled Brent contract in the aftermath of its launch of a program that pays rewards to those who trade the contract. This is a standard way to attract volume to a contract competing against an incumbent/dominant contract. Indeed, it’s probably the only way to do it.
Eurex tipped the Bund market away from LIFFE in 1998 after implementing a fee holiday, which LIFFE smugly refused to match, so confident was it of its liquidity advantage. But Eurex had enough organic order flow that it was fairly liquid already, and the fee cut made it cheaper to trade Eurex Bunds, as I document in my paper “Bund for Glory: Or, It’s a Long Way to Tip a Market” (which will be a chapter in a book I’m currently writing). The market tipped within a period of mere months.
Other exchanges didn’t repeat LIFFE’s near fatal mistake, and responded to fee cutting entrants by cutting their own fees to match. This is how CBOT saw off Eurex’s attempt to enter the US Treasury futures market in 2003, and how CME torpedoed EuronextLIFFE’s attempt to enter into the Eurodollar futures market a few years later.
Here’s the deal: incumbents have a huge liquidity advantage that entrants must overcome. How can this be done? The only way, really, is to cut fees, or actively reward volume to attract enough liquidity to compete with the incumbent. And the odds are still long, especially if the incumbent follows the CBOT script, and matches the reduced fees.
But if you want to encourage inter-exchange competition, you have to look favorably on entrants using strategies that reward volume as a way of building liquidity to make themselves into viable competitors.
This basic fact makes this FT article very disappointing. It criticizes the CME initiative, and only quotes those who are critical or dismissive of the endeavor. Yeah, it’s probably true that the only reason why those who participate in the incentive program trade is to collect the rewards. But their order flow can attract order flow from others: other traders see that there is two-way activity, and can be more confident that if they establish a position, it won’t be a Hotel California that they can check into, but can’t leave. Meaning that it’s BS to say, as one anonymous source to the story says, “there is no economic benefit to the trades whatsoever.” The economic benefit is that it can make the entrant a more viable competitor to the incumbent.
And quoting Bart Chilton. Please.
The quote that claims that spread trades-which dominate the activity in the CME Brent contract-”make no loss because they buy and sell at the same price” is just a crock. Yes, spread trades are lower risk, but calendar spreads do move.
The CME is engaging in a penetration pricing strategy. The only real strategy that permits competition against an incumbent. If you like competition, you should like a strategy that harnesses the greed of trading firms to generate liquidity and volume. Because, quite frankly, that’s the only way to compete.
But if you like monopoly, go ahead and denigrate what the CME is doing.
It would also be interesting to see how ICE built market share in its WTI cash settled contract that competes with the CME’s flagship oil contract. It is my recollection that ICE rebated fees for firms that brought volume to the ICE contract. (The structure of the ICE inducement, and Eurex’s in Bunds, were interesting. They basically made it a tournament, with rebates/bonus payment being limited to the top three-if memory serves- order flow providers. That provides a very high powered incentive while controlling the cost of the program.) If my recollection is correct, doesn’t that mean that sauce for the goose is sauce for the gander?
Competition in futures markets, where order flow is not socialized, is highly imperfect. Incumbents have huge advantages. Aggressive price competition-pentration pricing, specifically-is about the only way that an entrant can hope to dent the incumbent monopolist’s huge liquidity advantage, and even that is a highly dicey proposition. The FT story would have been much better had it recognized this reality rather than taking an all too critical view, and containing only quotes that were no doubt music to Jeff Sprecher’s ears.