Streetwise Professor

January 5, 2008

The CME Competitor: The Definition of Insanity

Filed under: Commodities,Derivatives,Economics,Exchanges — The Professor @ 4:05 am

I was quoted in this article in the Chicago Tribune about the just announced competitor to the CME.

A couple of points. First, as I’ve pointed out in my academic research, an entrant exchange has a chance against an incumbent if it (or its owners) control enough order flow to generate sufficient liquidity to narrow the incumbent’s execution cost advantage. The owners of the CME’s new competitor do control a decent fraction of order flow in Treasuries and Eurodollars, so this exchange has a leg up as compared to earlier would-be competitors. Nonetheless, I am skeptical that this is sufficient to allow the upstart to prevail. It is a necessary condition, but not a sufficient one.

Indeed, previous attempts to compete in the US Treasury complex have failed miserably despite the direct involvement of large banks. BrokerTec Futures (BTEX) was formed in 2001 by a consortium of 14 big banks, investment banks, and brokerages (including some involved in the latest venture) . Although BrokerTec was very successful in trading cash Treasuries, it failed miserably in Treasury futures in competition with the CBOT, and the banks pulled the plug a couple of years later. BTEX was sold to Eurex US shortly before Eurex entered the US market. The major bank/owners of BTEX were given an equity stake in Eurex US, and they had incentives to direct additional order flow to Eurex US; Eurex would boost each bank’s equity stake based on how much revenue (and hence trading volume) that bank threw Eurex US’s way. That didn’t work either.

A couple of lessons: (1) Although big players do have a lot of order flow, they haven’t had enough to “tip” the Treasury futures market in their direction, and (2) the definition of insanity is doing the same thing repeatedly, and expecting a different outcome. Here we have essentially the same players implementing essentially the same business model based on the same economic theory (re control of order flow)–but we’re supposed to believe that the outcome will be different this time. If you think so.

Indeed, the CME is in a better position than CBOT was when Cantor and then BrokerTec and then Eurex made a run at the Treasuries. CBOT was still largely floor based when each of the electronic competitors entered. Thus, the entrants arguably had a technology differentiator that appealed to a large potential set of market participants (although Cantor’s setup was stupid–users couldn’t enter orders into the electronic system directly, but had to phone it in to a Cantor clerk who entered it. Gee, I wonder why that didn’t work?) Moreover, at the time its earlier competitors surfaced, CBOT was going through managerial turmoil and intense internecine conflict over strategic direction regarding the fate of the floor, and was not renowned for its managerial nimbleness and foresight; the political battling often hamstrung management. Furthermore, entrants were not at a disadvantage in attracting traders participating in other interest rate products, especially Eurodollars, and especially Treasury-Eurodollar spreaders. Spreaders, for instance, had to trade multiple platforms regardless of whether they traded the Treasury leg at the CBT or elsewhere.

In contrast, CME is fully electronic, with a robust and proven trading platform–so no technological differentiator. Moreover, CME management is very good, and CME is not beset by the political infighting that often paralyzed CBOT around the turn of the millennium. And perhaps most importantly, spreaders and others trading both Eurodollar futures and Treasuries can execute on a single platform–CME Globex. Somebody who wants to trade the Treasury leg on the CME’s new competitor still has to trade the Eurodollar leg on CME. If the entrant decides to list Eurodollar futures too in order to overcome this disadvantage, it will be faced with the task of building two liquidity pools and wresting two complexes from an incumbent. Won’t say it can’t be done. Will say it has never been done before.

Second, this is a case of back to the future–a return of exchanges to the customer-owner mutualized model. The question arises : who will benefit if this new mutual succeeds? Even if the CME is charging supercompetitive fees for its services, the entrant’s success does not mean that fee levels in the industry will become competitive. Given the tippiness of order flow, if the entrant succeeds it will likely gain a near monopoly position. In the event, the monopoly rents will just move from the CME to the new exchange–and its big bank owners.

So, this should be viewed as a battle over rents. The efficiency effects of this entry are likely to be negative because real resources will be expended in this contest in which either (a) the incumbent monopoly will survive, or (b) it will be replaced by a new monopoly. This rent dissipation is wasteful. Indeed, if the bank-backed exchange prevails, efficiency may suffer because this outcome could dampen competition in the OTC space where the CME is endeavoring to encroach on the big banks’ turf.

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