CME And Brokerage

CME Files But I Don't Think They Will Move

The CME ($CME) filed the paperwork to establish a brokerage arm for their exchange. This is a response to the upstart exchange, FTX. I noticed ICE ($ICE) hasn’t done this yet but assume they will join the party.

Full disclosure: I own some CME stock, and was part of the group that revolutionized the exchange industry at CME in the late 1990s. I was an early investor in Bitnomial.

To refresh your memory on the steps that big corporates engage in to combat upstart innovation:

1. Ignore it.

2. Encourage regulators to regulate against it and show why its a terrible idea (see George Stigler)

3. Sue the bastards!

4. Compete or die.

CME skipped #3. Who wants to pay legal fees anyway?

However, it’s important to remember all innovation isn’t great and all innovation doesn’t move the ball forward on the path. Some of it sucks and some of it actually can regress progress. If you go on Twitter, you might conclude that social discourse has been hurt by innovation. In electronic markets, several finance professors have concluded that having markets trade in milliseconds offers no advantage on market efficiency compared to trading at the speed of one second. In fact, speed can kill.

I blogged about the FTX idea here. Craig Pirrong blogged about it here.

As I have said before and people like Jack Bouroudjian can confirm, in Strategic Planning we discussed at length the disintermediation of FCMs back in 1996-2001. This is not a new idea. Paraphrasing something my friend Jeff Minch might say, “FTX didn’t invent sex”.

To be clear, being in the futures commission merchant (FCM) business wasn’t that great from 2007-2021. FCMs make a lot of money on the interest they receive from overnight deposits at banks. With 0% rates, FCMs lost a profit center. With higher rates, the business becomes more attractive.

Back when I traded and owned a seat, I remember paying .05 a side to CME and was capped at my FCM at around $25K per year for total fees. Leasees paid more and retail paid the most.

FCMs competed with each other as well. When I started trading, there were scads of FCMs. Today, there has been a big consolidation, or the FCM just went out of business. Retail trading fees have come down a bit, but unlike the SEC-regulated stock market, which has pay-for-order flow and dark pools, they aren’t free.

In many instances, retail has to pay per trade to the National Futures Associaton (NFA) and I could never figure out what their benefit was to the marketplace. The NFA was a good idea when it was established back in the 1960s but I think its time has come and gone.

I prefer the CFTC futures market model over the SEC model because it’s more competitive. Although I think it can certainly be tweaked to make it more competitive and give retail traders a better shot.

Look at CME’s revenue streams. The bulk comes from commissions on trades. They also make a fair bit of cash from selling exchange data. Those are the two big drivers. CME’s profit margin never drops below 50%. They make about .61 on every contract that is traded.

Contrast that with FTX which is a private company. When I searched for data, I found FTX had a 27% profit margin. They expect to do $1.1 billion in top-line revenue for 2022 which is pretty amazing given CME’s top-line was $4.7 billion in 2021. ICE revenue was $7.41 billion. ICE revenue also reflects the fact they own stock exchanges along with their futures exchange. ICE margin is lower, due to stock exchanges at 45%. It will be interesting to see FTX revenue growth, or decline, because of the crypto crash.

Also, remember in the background there is a continual war between Chicago’s LaSalle St and New York’s Wall Street. New York would give several generations of firstborn children up to Satan to get clearinghouses separated from commodity exchanges.

One of the things that new technology does when it enters an industry is get rid of layers of distribution. We see it over and over again. Companies that were pulling profits out of a market get run out of business by software as tech puts consumers closer to producers.

The capital markets transformation we engineered at CME back in 2001 was no different. Floor trading desks and floor brokers were put out of business. Locals in pits were put out of business.

FTX is trying to change the scope of competition by not using the FCM. CME is forced to prepare to compete, but my guess is they hope that regulators see the world from CME’s point of view. Craig Pirrong agrees.

Bitnomial has also filed. I actually didn’t know they filed since I am not a material investor, and I don’t have observation rights or a board seat. Bitnomial’s competitive advantage has been it’s a great platform to trade on and they are still the only exchange in the world that delivers physical crypto to market participants upon contract settlement. Everyone else is cash settled.

It is very hard to predict the actions of a regulatory body when it comes to situations like this.

For sure, existing FCMs will be against it. No one likes change. One can envision several ideas around what the state of play would be if the CFTC allows the FTX idea to be implemented.

Maybe regulators split the baby and tell the exchanges that they can’t own their own clearing if they have their own brokerage. I think I know what would happen in that case.

If you didn’t click over and read the two links to my blog and Craig’s blog I can give you a very short summary. On the run margining every 30 seconds might be destabilizing to the market. Tonight when the Asian markets open if the rumors of three big European banks being insolvent prove to be true, think about how that market would operate with 30-second margining. My guess is it would not be more efficient.

Winston Churchill famously opined that scientific innovation was absolutely necessary to improve human life. At the same time, putting your stock only in science and ignoring the humanism of man will lead to the destruction of society, and man. Just because you can margin every 30 seconds doesn’t make it good. If I were speaking for Mr. Market, I know plenty of times when a human decision overrode a reflexive machine or rules-driven process for the benefit of all market participants. I served on pit committees. I oversaw and chaired the entire exchange pit committee, and believe me there were plenty of hard decisions to make where humans were better than algorithms.

I don’t think this is an innovation that will kill CME or ICE. In fact, implementing it might kill an exchange like FTX. Why wouldn’t CME compete on every single FTX listed contract and use its clearinghouse for cross-margining as an advantage? CME and ICE have largely stayed far away from the crypto futures business and FTX built a nice business there. When a 1000-pound gorilla enters the room, you better be able to go toe to toe with it.

If CME/ICE established their own brokerage, initially it would hurt profit margin as they staffed up and also increased the robustness of their clearinghouse. Once they internalized it, I suspect their profit margin could go up as CME/ICE grabs some of the surpluses that were enjoyed by the FCM community. Additionally, I’d expect to see data revenue increase since a lot of people figure out ways to get data without paying a heavy price for it.

FCMs have different issues. They will have to prove their worth to the users of the market. What can they give market participants that FTX or CME couldn’t in a disintermediated model? What are customers willing to pay for that service?

FCMs wrangle a lot of cats. They have entire networks of introducing brokers, trading advisors, and the like that are similar to small streams that feed into tributaries that feed into big rivers of profit. They won’t go quietly.

CME might have an ace up its sleeve depending on how they use and look at the B share. The B shares are the old memberships. Turning them into commodity crypto tokens and expanding the number of them significantly might be an interesting way to capture and hold market share. There is a lot of innovation that they can do with the B’s if they really think out of the box about them. Of course, they have to negotiate with the existing B shareholders and some of them hold a lot of angst. But, at the end of the day, they are capitalists and are holders for the money. Show them how they can make significantly more money and they will buy in.

I will tell you this. I know Terry Duffy from a long long time ago in the trading pits. When I was a runner, I ran orders to the Hog pit where he was a broker and I traded Hogs from 2003 to 2012. He wears fancier suits and ties now but don’t let that fool you into thinking he is a corporate drone. No one is more competitive than a pit trader. No one. Plus he’s south-side Irish. If you know Chicago, you know what I mean.