Streetwise Professor

I admire  Jeffrey Sprecher. ICE has been an amazing success story, and a lot of that has to do with his rather unique combination of vision and ability to execute.

But he is not above talking his book, and he delivered some self-serving, and in fact anti-competition, remarks in ICE’s earnings call held earlier today:

The head of Intercontinental Exchange, the world’s second-largest exchange group by market value, launched an unusually explicit criticism of its bigger competitor’s business strategy as he touted growth in his flagship oil contract.

Commercial customers such as refineries and airlines propelled this growth “as we see our competitors adopting incentives that attract the type of algorithm . . . trading that typically drives commercial users away,” Mr Sprecher said.

Mr Sprecher said “payment for order flow schemes” such as CME’s expanded the market by “attracting traders that really don’t want to hold the risk of your products but just want . . . to get paid to be there.”

If Mr. Sprecher actually believes that, he should be glad that CME (to speak of competitors plural is rather amusing) is implementing a program that per his telling drives away the paying customers, the commercial users.  That’s doubly true since those commercial users would presumably go to ICE. How is CME supposed to make money giving away trading incentives to traders whose presence those who repel those who pay full fare? If that’s what CME is doing, Mr. Sprecher should remember the old adage about not intervening when your enemy is intent on committing a blunder.

Sprecher was touting the fact that ICE’s Brent contract had now surpassed the older CME WTI contract in open interest. Well, this is good for ICE, certainly, but Sprecher and his exchange really have had very little to do with it: this is further proof that it’s usually better to be lucky, than good. Brent’s relative rise is the result of structural factors, most notably the prolonged logistical bottleneck that isolated WTI from waterborne crudes: that bottleneck is largely gone, replaced instead by a regulatory bottleneck, the US export ban.

ICE should not gloat for too long, though, because it is quite likely that the export ban will go, one way or another. What’s more, the resource base supporting the Brent contract is dwindling, and rapidly, whereas the Midcontinent of the US is experiencing a crisis of abundance, if it is experiencing a crisis at all. Logistical bottlenecks created by such crises tend to be transitory, and even regulatory bottlenecks can be overcome. In a few years, WTI will be deeply connected with the waterborne market, albeit in a non-traditional direction. And Brent will be at the mercy of inexorably declining production, and the ability of Platts and an often fractious community of producers and traders to figure out a contractual fix. (Adding Urals to the Brent basket? Really?) So Brent is riding high now, but over the medium to long term, CME will be one breaking out the shades, because WTI will have the brighter future.

As for incentives offered by upstart markets to unseat incumbents, as CME is attempting to do to ICE in Brent, this is a classic competitive tactic, and almost necessary in futures markets. The network effect of order flow means that (as I say in Gregory Meyer’s FT piece) bigger incumbent contracts have a big competitive advantage. The only way that  a competing contract can possibly build order flow and liquidity is to offer incentives, both to market makers (including HFT and algo traders!) who supply liquidity and to the hedgers and speculators that consume liquidity. (I wrote about this last year. Amusingly, I had forgotten about that post until Greg reminded me of it:-P)

Even that is a dicey proposition. Many have tried, and most have failed. But sometimes the upstart the succeeds, and at other times has forced the incumbent to meet the incentives to keep market share, and that can be expensive for the incumbent. That’s probably what Sprecher really doesn’t like. It’s not that incentives don’t work (as the criticism quoted above suggests): it’s that they just might. And if CME’s incentives work it could be an costly proposition for ICE to respond in kind.

In other words, Sprecher is really criticizing a reasonable competitive tactic, because like any dominant incumbent, he doesn’t like competition. That’s his job, but that kind of criticism cuts no ice with me. Or ICE, either, as much as I admire its achievement.