Should Exchanges Own Their Own Commission Merchants?

Vertical Integration

One business item you for sure didn’t notice slipped into the business cycle in October. CME Group which owns several commodity exchanges filed for and received permission from the Commodity Futures Trading Commission to create its own futures commission merchant. It has thrown the brokerage industry into a tizzy.

This might be a big deal to the American and worldwide economy, but you have to understand why in order to connect the dots to see why. It also is a big deal because the structure of the nascent cryptocurrency industry is still being built and evolving. How it is regulated will have a big part in determining how the structure looks in the future.

Let me define.

Traditionally, the universe of brokers that handle customer business is separate from exchanges. Goldman Sachs doesn’t own the NYSE and the NYSE doesn’t own a piece of Goldman Sachs. Hence, if there is a problem at the NYSE, Goldman should be relatively insulated from that problem. The opposite is true. If Goldman does something wrong in its business practices, the NYSE and the other customers at the NYSE should be insulated.

Exchanges ensure that their FCM customers engage in best practices and are run properly and FCM’s ensure their customers are capitalized and aren’t running nefarious scams.

The same goes for the futures markets that CME 0.00%↑ and $ICE run.

This has been the business practice in America since a bunch of capitalists got together under the buttonwood tree in New York City to set up the NYSE. The industry structure is that customers go through an intermediary to access the markets on the exchange.

Customer———>Intermediary———→Exchange

Back in the 1990s when I was on the Strategic Planning Committee of the CME, we were turning the exchange from a non-profit member-run entity to a for-profit publicly listed corporation.

One topic we spent some time on was the structure of how the exchange should interact with customers. Should we “disintermediate” our universe of brokers who fed customer business to the exchange?

We saw the internet for what it was. We understood its transformative power and we saw that it would eliminate layers of distribution putting customers closer to marketplaces. It was more than just electrifying a human marketplace.

Why would we discuss disintermediating our entire futures commission network and going direct?

Because of microeconomic theory. It boils down to consumer and producer surplus. If you don’t know what those are, click the link. In this case, the exchange is the “producer” and the brokerage house is the “consumer”.

In the case of commodity exchange markets, demand is relatively inelastic. There is only one liquid place to hedge risk. Because demand is relatively inelastic, the network that exists to funnel customers to the market and back is organized differently than it would be if demand were elastic. The entire supply chain is captive to the producer.

This graph shows a marketplace with inelastic demand. I pulled this entire piece out of the linked piece to highlight it.

If demand is price inelastic, then there is a bigger gap between the price consumers are willing to pay and the price they actually pay.

The demand curve shows the maximum price that a consumer would have paid. Consumer surplus is the area between the demand curve and the market price.

If the demand curve is inelastic, consumer surplus is likely to be greater

• Monopolies are able to reduce consumer surplus by setting higher prices

• Price Discrimination is an attempt to extract consumer surplus by setting.

Hopefully, now you understand why we had the extended debate about disintermediation. For the exchange, seeing brokers grab more of the surplus than we were getting kind of irked us since we were changing from a non-profit to a for-profit.

It was the exchange that was providing the data, the clearing operation that guaranteed customers would get paid, the marketplace, and the infrastructure that goes with operating and maintaining an efficient marketplace. It was the exchange that innovated and came up with new contracts to trade. It was the exchange, the exchange’s reputation, and how we transparently conducted business that made for a reputable marketplace the entire world trusted.

Brokers merely funneled customers to us. The exchange was indifferent if it came from one broker or another. From the exchanges perspective, the value add of the broker was far less than the value add of the exchange.

If the exchange could set up its own broker, the exchange could significantly increase its profitability. Given what we believed about the internet and how it eliminated layers of distribution, why not disintermediate them?

But, at what cost? This is where “strategy” and “opportunity costs” enter the discussion.

In 1999, the cost to disintermediate was very high. Is it high in 2024?

A lot has changed in the brokerage industry. Consolidation that started in the mid-1990s has continued to happen and there are only a few big massive brokers now. Here is a list of FCMs at CME Group. In 1990, that list would be triple the size of this list. It was cheap to set up an FCM back then compared to the costs today.

Fewer FCMs have created some systemic risk to the entire marketplace. Dodd-Frank was a huge driver to change market preferences for FCM consolidation.

The other thing to understand is that the CFTC-structured marketplaces are different than the SEC-regulated marketplaces. CME is not like the NYSE. CME owns its own clearinghouse. Back in 1999, we understood that the most prized asset CME had was its clearinghouse. It was the straw that stirred the drink. No stock or option exchange owns their own clearing and it is a huge difference. CME can charge the rates it does for data and other services because it owns its own clearing. Stock exchanges see clearing as a utility and they make zero money on it.

If you want to get an FCM executive in a lather, ask them about how much their costs are for data and clearing. They will start foaming at the mouth and get very angry at the exchanges.

However, clearing and how you clear does matter to market strategies and function. I have a friend who trades stocks and now that stock clearing has gone from clearing in three days to one day, it’s put a lot of pressure on many of the strategies he employs for his business. Turns out, +1 favors the big guys and not the smaller operators. As a person from the futures industry who cleared on the same day, I never could figure out why stocks were +3. But, I see there might be wisdom in +3 settlement in order to preserve marketplace diversity on the SEC side of the world.

Brokers see CME coming for more of their “surplus” and they are in a tizzy.

The way this entire thing started was when Sam Bankman Fried and FTX wanted to enter the futures market. FTX wanted on-the-run clearing which is a terrible idea in practice. What are traditional exchanges like CME and ICE expected to do if an upstart competitor enters the market? Sit still?

The costs of disintermediation have changed since 1999. CME scans the FCM community post Dodd-Frank and sees more systemic risk to its captive clearinghouse than before. Injecting systemic risk into the clearinghouse is one of the largest fears an exchange like CME has. Customers are consolidated into fewer slots and with the advent of the World Wide Web, it’s far easier to target, find, service, and access those customers directly than it was in 1999.

Here is the rub.

CME holds an account with the Federal Reserve Bank of Chicago. The reason it does is that in times of high financial stress or panic, CME needs direct access to cash without going through a banking intermediary. If the CME clearinghouse were to fail, the entire financial system that ties together international commerce would fail.

From the FT: The CME’s approval is also controversial with customers because the US legal system allows exchanges such as CME Group to have quasi-regulatory powers. They include overseeing FCMs.

You can see there is an inherent conflict of interest brewing if CME operates its own FCM. They could put different standards on their own operation than the other FCMs in order to favor themselves.

What happens if CME doesn’t police itself as hard as it does the existing FCM community? Given that CME has proprietary access to the Federal Reserve, just saying “trust me” isn’t an option.

Given the current regulatory environment and the trendline of that environment, it’s not hard to envision a world where customers went direct to exchanges eliminating brokers.

But, is that the best thing for the safety and security of the marketplace? The marketplace sanctity is more important than corporate profits.

I don’t know the answers to these questions but I agree with the Futures Industry Association’s chairperson Walter Lukken that regulation has to be changed, and changed quickly. The fortunate thing is that the CFTC is pretty responsive to industry. It is a much more adept and better regulator than the SEC.

I started blogging when Dodd-Frank was being debated. Very few people understand the financial industry and shining a light on it was what I wanted to do. I saw the dangers back then of Dodd-Frank. I wasn’t the only one. Craig Pirrong of Streetwise Professor and plenty of other people who truly understood how it all worked sounded the alarm. It was the exact wrong response to the financial crisis of 2008. On a panel I saw in early 2009, Chicago Fed President Charles Evans asked economist and finance expert John Cochrane, “What should we have done, let them all go broke?” Cochrane said, “Yes. That’s exactly what should have happened.”

That financial crisis was government-led, and had its roots in government policy. It was not private industry-led. The industry built a house of cards on top of the incentives the government created. The knee-jerk reaction of Dodd-Frank has instituted a terrible regulatory structure, and perhaps the best first step would be repealing the whole thing and clearing the area.

That’s harder than writing new regulations.

I look forward to the ensuing debate and hope that they can figure out the best way to incentivize the industry to do the best they can for customers while also protecting the sanctity of transparent, free, and competitive marketplaces that absorb economic shocks rather than transmit them to the entire macroeconomy.