They Go To Trial

Will Be Interesting

11 years ago, a group of CME/CBOT exchange members filed a lawsuit against CME Group. This week, the judge finally set a trial date for July. It will be an interesting lawsuit to watch.

I don’t know how it will turn out.

I know all the parties personally, but haven’t had contact with them for at least a decade or more. One of them was on the same CME Board I was on at the same time. Another never traded on the floor when I was there, but simply leased their membership out.

For those who are wondering, here is how the class is certified. I don’t agree with that certification. If you bought a B share yesterday, you weren’t harmed like the B shareholders who were members at demutualization when the initial corporate strategic decisions were made on electronic trading and colocation. Because the exchange has an exact record of all seat sales, they know who owned them and for how long. That goes for CME and CBOT.

It is true that the B share has lost a lot of value over the years. There are a lot of reasons for that. Personally, when we went public, I thought that the B share would only have value for fee breaks and access. If you weren’t trading enough volume, there was no need to own or lease a B share. Owning became a math equation.

The CFTC made a ruling that members couldn’t use B shares as collateral for margin, and that also hurt the value of the B share. Now, members had to come up with hard cash to hold larger positions rather than utilize the value embedded in the B share.

Looking backwards almost 20 years now, it would be hard to remember everything exactly to the letter, and because we are all human, harder to be objective.

The Chicago Tribune ran an editorial about it, but I haven’t seen it covered anywhere else except for the details. Amazingly, for a hard-left-wing publication, the Trib did a fair job.

I will preface what I write by saying regular people hear, say, and write words. They have an understanding of what they mean. Lawyers hear, say, and write those same words, but they are construed to be defined diametrically differently. I am a regular person, not a lawyer, and the same goes for traders like me.

I can see both sides of this case. As a member who lost their trading edge when the CME sold out the top step via colocation, I understand exactly why the plaintiffs brought this case.

Anyone could see why CME would try to encourage electronic trading. Roughly 60% or more of CME’s topline revenue flows to the bottom line. Electronic trading volume is exponentially higher than human-traded floor volume.

The Trib makes a point that the NYSE bought out the membership rights of its members when they made the transition from private to public. There are a few important differences between the NYSE and CME/CBOT.

First, one is SEC-regulated and one is CFTC-regulated. It may seem like it isn’t a big difference since they both deal with markets, but it is. We had to deal with the CFTC when we demutualized at CME, but the CFTC is known to have a more principles-based approach to regulation, unlike the SEC. We kept the CFTC informed to a point.

When we were discussing demutualization, the exchange wanted to buy out all the memberships using stock. The IRS ruled against that and would charge capital gains taxes to every member. That ruling significantly affected everything. For some reason, the IRS didn’t do that with the NYSE. CME is stuck with the corporate structure it has today because of that IRS ruling. The CBOT followed CME to the public market and was stuck with the same structure. It took the IRS about a year and a half to come to what I believe is a faulty decision.

Remember, this was the late 90s, early 2000s. There was a virtual worldwide race to change ownership structures of exchanges. Who would be first? The one who was first would get all the spoils. That meant listing publicly and more.

Summing up quickly and looking back, CME listed first. It is the largest exchange in the world. We were right.

Daily, there were articles in all kinds of publications about how exchanges like CME and CBOT were losing the race and would go out of business. I mean daily. I used to get what was called the “clips” of media, and virtually every day, there would be a story about how advanced the Nordic exchanges were and how the German exchange Eurex would take over trading in America. It was hyperbole that was hard to ignore because in our daily lives, we were experiencing the rise of the internet with the internet bubble and all that.

In the 1990s, there was a political fight amongst the members of CME. One faction wanted to modernize. One either didn’t, or wanted to go slowly. The faction that wanted to modernize won that political fight, and the faction that didn’t saw what was happening in the rest of the world and got on board.

CME wouldn’t be where it is if the two factions didn’t find a way to work together. Credit goes to Jimmy Oliff for making that happen. Credit should also go to M. Scott Gordon for doing a lot of blocking and tackling to give Jimmy a field to run in. FILO had a long family history at the exchange and was a member of the “go slow” faction.

Traders are an opinionated and highly competitive bunch. We had 50 hyper Type A people in the board room since it was a member-run exchange with a bureaucratic committee structure and opinionated people on those committees. Many of them were incredibly smart and accomplished people.

When you look back, it is pretty amazing what the people in that room did, and it changed worldwide finance.

In the mid-1990s, the London Financial Futures Exchange, or LIFFE, traded almost 100% of Germany’s debt contracts with the Bund down to the BOBL and Schatz. That trade evaporated almost overnight when the open outcry LIFFE exchange saw everything go to the 100% electronic EUREX exchange. Ask someone who traded on the LIFFE floor what it was like. Fortunately for me, I knew Roger Carlsson very well, and he educated me on the finer points.

At the time, I opined that the one thing we saw was the German government putting pressure on German banks to trade German debt on a German exchange. It wasn’t necessarily about humans versus machines. Howard Lutnick ought to pay attention to that first sentence as he continues to try and wrest US Interest rate contracts from CME and clear them in London.

But it sent a shudder up the spines of every exchange in America. In 1994, an exchange membership at CME traded just over $1MM. In 1998, you could have purchased one for $280,000. No one thought we would be in business by 2000. Things were happening quickly.

Blackstone tried to buy CME on the cheap in 1999. IBM even had a bunch of us to their offices trying to figure out a way to buy into CME. I was at that meeting, and the one thing I learned was how internet pipes ran through the country. The physical location of CME between Madison and Monroe put the exchange smack dab in the center of the largest pipes in the US. That’s not important now, but it was important then.

For a while, I would wake up and drive 60 minutes from my house in Geneva, IL to CME in the middle of the night to trade Euribor on the LIFFE. Then I pit traded all day in the Eurodollars from 7:20AM to 2PM. I’d go home, sleep, and do it again. I wanted to see what it was all about. I didn’t make money trading Euribor, but chalked it up to trading at 1 AM, not that I had no edge.

The CBOT panicked. They did a bad deal with Eurex to use their electronic trading system. The CBOT didn’t own its clearinghouse. They cleared their trades at the Board of Trade Clearing Corporation (BOTCC). CME did own its clearinghouse, and we saw it as our number one strategic competitive asset.

In my opinion, instead of thinking critically, the CBOT management acted out of spite for CME. There was a very intense historical rivalry between the two exchanges going back decades. At the time, CME was ahead, and the Eurodollar contract was starting to trade more than its T-Bond contract. Plus, we had equities and currencies. They had the grains, which were a huge worldwide business. CME had the smaller meat contracts.

An aside, legend has it that back in the early 1900s when CME started up, because CBOT was Irish-Catholic, and CME was Jewish, the CBOT board wouldn’t let the CME clear trades at the BOTCC. Hence, the CME guys had to build their own clearinghouse and ironically, it became the most strategic asset CME had.

We told CBOT to make a deal with us, and in the middle of the night, their chairman made a deal with Eurex. We told them they were doomed. Eurex would steal their treasury complex right out from under them.

We were right, and that is why CBOT merged with CME. It wasn’t a merger of equals.

This stuff is important, here is why. Using Grok, I asked what the terms of the merger were. Nowhere did CME purchase any core rights of the CBOT, or at least I cannot find language to support that. In the CME’s demutualization deal with its members, CME members were guaranteed “core rights”.

Core rights as members, defined by them, were priority access to the primary market. That could mean trading pits, or it could mean an electronic market. We had purchased memberships, and those memberships meant we could stand in the pit and trade. Others had to enter orders. That gave pit traders a speed edge. As the Trib says, one B share traded $1.5MM in 2008.

We lost that edge due to the corporate decision-making on colocation. They charged extra fees to colocate. We never had to pay an “extra” fee to go into a pit.

The other thing to remember is that if you owned your membership, you were on the hook if the exchange failed. “Good to the last drop” was a line that talked about the financial stability and health of the clearinghouse. If the clearinghouse failed, the members were liable to come up with the difference. I knew people who would not purchase a membership and leased instead because of the “good to the last drop” provision. They didn’t want the liability.

That is why memberships are NOT taxi medallions. The taxi driver wasn’t liable if the taxi company went out of business. Floor traders and taxi drivers were put out of business by innovation. That’s where the similarity ends. No government official stepped in to protect my membership with regulations and taxes when it happened, like they did with taxi drivers.

Ironically, that liability was one of the driving points to getting rid of the membership structure and turning it into a corporate structure. Here are the big bullet points regarding the merger of the two largest commodity exchanges in the world.

In the 2007 merger between the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT), a special dividend was issued to CBOT shareholders as part of the revised merger agreement to provide additional value. The terms of the special dividend were as follows:

• Dividend Amount: CBOT declared a one-time cash dividend of $9.14 per share of CBOT Holdings Class A common stock, totaling approximately $485 million across all shares.

• Payment Condition: The dividend was conditioned upon the satisfaction or waiver of all conditions to the merger and was to be paid immediately prior to the closing of the merger.

• Record Date: The dividend was payable to CBOT shareholders of record as of a date prior to the merger's close, specifically tied to the merger vote record date of May 29, 2007.

• Purpose: This special dividend was part of a revised agreement to enhance the value for CBOT shareholders and counter a competing bid from the Intercontinental Exchange (ICE). For a CBOT full member holding the minimum 27,338 shares of CBOT Class A common stock required to exercise Chicago Board Options Exchange (CBOE) exercise right privileges (ERP), the $9.14 per share dividend equated to $250,000 in cash value.

Additionally, the merger agreement included other financial considerations:

• Exchange Ratio: CBOT shareholders received 0.375 shares of CME Holdings common stock for each share of CBOT Holdings Class A common stock, up from the previous offer of 0.35 shares.

• CBOE Exercise Right Privileges (ERP): ERP holders who were also B-1 members on May 29, 2007, could sell their ERP to the Board of Trade of the City of Chicago, Inc. for $250,000 in cash within 45 days of the merger’s closing.

The merger, valued at approximately $11.9 billion including the special dividend, was approved by shareholders on July 9, 2007, and closed on July 12, 2007. These terms were detailed in announcements and SEC filings by CME and CBOT, reflecting efforts to secure shareholder approval amid competitive bidding.

CME also bought the NYMEX. The New York Mercantile Exchange traded energy products in NYC. Interestingly, the NYMEX also owned its clearinghouse. But, it had no electronic way of trading, and other exchanges were rapidly grabbing large chunks of volume away from the exchange. NYMEX was like a boxer staggering about the ring in the waning rounds of a prize fight when CME bought them.

The NYMEX deal happened after the CBOT deal. There were differences.

I thought CME overpaid for NYMEX by quite a bit, and could have competed with them, crushing the entire exchange. CME had the clearing and the best electronic trading system in GLOBEX. With cross-margining and other cash management options, it would be far cheaper to trade at CME than any competitor. Especially after integrating the CBOT.

Here were the terms of that deal:

The acquisition of NYMEX Holdings, Inc. by CME Group Inc. was announced on March 17, 2008, and completed on August 22, 2008. Below are the key terms of the acquisition based on available information:

• Valuation and Payment Structure:

  • The total transaction value was approximately $8.4 billion to $11.2 billion, depending on the source and adjustments during negotiations. The final value was reported as $8.9 billion in cash and CME Group stock by some sources.

• A separate payment of $612 million was made to the 816 NYMEX Class A members to buy out their rights to revenue, with each member receiving approximately $750,000 for their membership rights. Some sources also mention an additional $250,000 per member for core trading rights. CME Group offered 0.1323 CME shares and $36 in cash for each NYMEX share. (This is a huge difference and why NYMEX is not a party to the lawsuit-and could telegraph strategy on settlement going forward)

• Retention of Membership Seats:

  • NYMEX Class A members retained their trading seats and received increased consideration under the revised agreement.

• Approvals and Conditions:

  • The transaction required approvals from regulators, shareholders of both companies, and NYMEX members.

  • At least 75% of NYMEX Class A memberships needed to be repurchased by NYMEX.

  • Amendments to NYMEX’s certificate of incorporation and bylaws were required, subject to member approval.

• • The U.S. Department of Justice provided unconditional clearance on June 16, 2008.

• Strategic and Operational Terms:

  • The acquisition brought NYMEX and its Commodity Exchange, Inc. (COMEX) division under CME Group, creating a combined entity with four Designated Contract Markets (DCMs): CME, Chicago Board of Trade (CBOT), NYMEX, and COMEX.

• NYMEX’s energy, metals, and agricultural contracts were integrated into CME Group’s offerings, diversifying its product portfolio across major asset classes.

• • Trading continued through a hybrid model of open outcry floor trading and electronic trading on CME Globex and NYMEX ClearPort platforms.

• • The deal was expected to generate $60 million in cost synergies and enhance global competitiveness in energy and metals markets.

• Timeline and Finalization:

  • The agreement was revised on July 18, 2008, maintaining the original exchange ratio and cash consideration but addressing member concerns.

• Shareholders and NYMEX members voted on the transaction on August 18, 2008, with the deal closing in the fourth quarter of 2008.

There are a lot of accusations from both sides in this suit. I don’t know what is true or what is not true. I do know that as a member, once 2003 hit, the ability to earn money trading futures on the floor dried up. Much of that loss rested on the decisions exchange management made regarding colocation and electronic trading.

I only lost money in my career when the Eurodollars went electronic in 2003 and the Hogs in 2009. If the floor still existed, I’d probably be on it trading away. I never made the transition to the screen, and very few people I know did.

The Trib says if you held all your stock, it would be worth $30MM today. The problem is, when you don’t have a job, can’t pay your rent, the only thing you had to “earn money” was selling your membership and stock. The Trib’s supposition is not realistic. It also assumes that you timed the market right.

I went from 2009 to 2016 living off of savings, trying to find a way to earn money. I invested in startups, and fortunately, it worked out for me, but it isn’t exactly a low-risk way to make money after floor trading, which was one of the highest risk occupations one could entertain engaging in.

A small few of my fellow floor traders had enough money that working for a living wasn’t necessary. They might have made it on the floor, or they might have had family money. Many of my compatriots from the floor became realtors, insurance salesmen, and wealth managers. Some drove buses. Some set up contracting operations. Some opened restaurants. Many got divorced when the money ran out. Alcoholism and drug abuse claimed a lot of them. Many committed suicide.

We were round pegs in square holes. 5000 people who couldn’t be employed by anyone suddenly had to figure out a way to become employable by anyone. I had an MBA from Chicago Booth and was continuously told I was unqualified for anything I ever applied for. Any job I applied for was guaranteed rejection. It was laughable like a high school senior’s bong letters from applying to colleges.

It’s also a terrifically hard mental adjustment to wake up every morning and trade for yourself, making a thousand or more per day, to pulling down $100k a year and having to answer to people.

To give you a sense of the money at stake. If you owned what is now known as a B-1, you received 18,000 shares of stock. B-2’s got 12,000. B-3’s got 6,000. B-1s traded for the highest value and still do today. They had the most votes in exchange matters and the most board representation. Voting was valued at 6:2:1 per class, and the shares were divided up based on Post Market Trade (PMT) revenue sharing of 3:2:1. There were 625 B-1, 824 B-2 (thanks, Brian Elliott BEE), and 1350 B-3.

A lot of people owned B shares and leased them. Traditionally, you could earn a decent return on investment. But that ended with electronic trading, and when the money earned from leasing dried up, that was more downward pressure on the value of a B.

The rule of thumb among exchange members was that one-third of the seats were owned for clearing. One-third were owned by members and leased out. One-third were owned by members who actually used the seats to trade or fill orders and operate a business.

CME went public at $35/share which given splits today would be divided by 5x that, or $7 per share.

CME shares were just over $700/share at the end of 2008. They lost over $150 in value in one day, February of 2009, based on a leaked and faulty memo regarding clearinghouse fungability from the US Treasury Department. Here is a chart reflecting splits. Would you have held? Would you have held given everything that was going on in the world?

It doesn’t matter. Nor does it matter that members could have set up their own electronic trading firm. What matters is the deal made with them in 2001 when CME demutualized, and in 2007 when CME bought the CBOT.

All I know is I was told electronic trading was going to be super cheap and every rule or decision made by management made all of my trading costs go up significantly if I wanted to try and compete. Again, that doesn’t matter either.

A couple of data points. NYMEX members were paid $250,000 for their rights back in 2009. Using an inflation calculator, that number is $372,661 today.

I don’t know anything about choosing juries, jury pools, or anything like that. But, I do know that a jury might not be too sympathetic to CME versus small independent traders. I was an investor in a small startup firm called Shuffletech. Shuffletech owned patents and sued Scientific Games over them. A Chicago jury awarded Shuffletech $105MM plus treble damages at the end of the trial.

It will be for lawyers, a judge, and a jury to decide. But if I were CME, I’d offer a meaningful settlement and be done with it. They should have done that years ago, but they are stubborn. They are used to dictating to everyone, and everyone gets in line. If I were the plaintiffs, I know my bottom number. I’d start to listen closely to numbers above it.