Streetwise Professor

August 19, 2013

Penetration Pricing in the Futures Markets: This is a Bad Thing?

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges,Regulation — The Professor @ 4:43 pm

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.

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  1. it is an interesting way to try and steal a contract. Combine that reward with cross margining savings. the big question is what is the tipping point where you can remove the stimulus? What happens when the drug addict can’t get drugs?

    I was never a fan of creating a contract and having zero fees. Didn’t make people trade it. Contracts have to create economic value. If they do, people will trade it.

    As you point out, stealing is different. To be truthful on the Bund however, German govt wanted German bonds traded on a German exchange and put pressure on German banks to do it.

    Comment by Jeff — August 20, 2013 @ 8:23 am

  2. The largest market in the world, FX does not have any fees for liquidity providers or takers. Nor is it centralized on an exchange. So it this the end point of all markets? No transaction fees (only bid/ask) and a large number of liquidity pools?

    Or is the end point for commodities something different?

    Comment by scott — August 20, 2013 @ 2:37 pm

  3. ICE started its WTI contract before Nymex was bought by CME. ICE was able to grab market share mostly by giving traders the electronic market that Nymex was loath to offer. There was also the issue of looser regulation in London. The same story played out in gold where the CBOT almost stole Comex’s flagship contract simply by offering an electronic marketplace.

    Comment by ACS — August 20, 2013 @ 2:47 pm

  4. FX – counterparty risk – cash settlement sometimes across time zones, bid ask spread not inconsiderable – a cash not a futures market. The more direct comparison would be on forward markets vs. futures and there a lot of games are played and term counterparty risk is a real consideration. And there they do have margin.

    Comment by sotos — August 20, 2013 @ 2:55 pm

  5. It could be that the burst in volume is simply some prearranged cross trades that are scratches. Pit traders used to get fined for that.

    Comment by Jeff — August 21, 2013 @ 5:54 am

  6. Hi Craig,

    Really interesting points on the piece, but I’d have to take issue with this:

    “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”

    Surely if a significant portion of trading is in a very specific forward spread contract and only lasts a few minutes, the impression of two-way activity and order flow is misleading?

    Not questioning right of exchanges to use incentives to break into contracts that would otherwise be monopolies, but isn’t it worth highlighting if those programmes create misleading impressions of liquidity?

    Be great to continue the conversation anyway.

    Comment by Ajay Makan — August 21, 2013 @ 7:45 am

  7. The Brent/WTI spread approaching zero

    I have been watching the ‘Brent’ vs ‘WTI’ crude trade for quite some time. Now
    that the bottleneck in Cushing (Oklahoma) is being resolved and the fracking
    revolution is causing an explosion in U.S. oil production, the benchmark WTI contract
    will become the global pricing market for crude. Remember, Brent production is
    declining. Volume should begin leaking from the Brent contract to the WTI contract.
    This is a big plus for the CME group, where I believe WTI is prominent.

    Comment by Peter M. Todebush — August 21, 2013 @ 9:52 am

  8. @Peter. Spot on. I wrote posts predicting that a couple of years ago when people were throwing dirt (and other stuff) on CL because it was “landlocked”. The way I put it was that the disconnect was temporary. It’s easier to build infrastructure (pipelines, refineries) to eliminate bottlenecks, than it is to overcome the secular decline of an oilfield like Brent. It was inevitable that the oil boom in the US would eventually redound to the benefit of WTI once the infrastructure caught up. And once the inexorable decline in Brent had its affect on prices. Both of those things happened in relatively short order.

    Ironically, it is conceivable that the biggest threat to disconnect WTI from the seaborne crude market in the medium-to-long term is US government policy. If oil production in the US grows sufficiently to make export a viable option absent government restrictions, those restrictions will drive a wedge between domestic prices and international prices.

    Those who predicted the demise of WTI and the enduring dominance of Brent were extraordinarily short-sighted in their analyses. It was kind of a joke, actually.

    The ProfessorComment by The Professor — August 21, 2013 @ 2:16 pm

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