Tokenization Is Happening

But, Not The Way You Think

A little followed announcement happened last week in finance. CME Group ($CME) will begin tokenizing its clearinghouse using Google ($GOOG) cloud technology. No one is going to be able to speculate on the token like they can with XRP. No one is going to be able to earn profits from holding the token or mining the token.

The article isn’t clear about how things will be tokenized to eliminate friction inside the CME clearinghouse. It’s pretty clear it will not be a public chain but a private chain that CME controls. Google gets a great reference customer, and there might be network effects with banks and brokers. So, no different than clearing seems now, but because it will be cloud-based and tokenized, presumably CME should earn more margin via less friction. In addition, earning more margin also gives them a competitive edge so they can lower costs to customers if a competitor decides to enter.

Clearinghouses move a lot of money around, and they do it with thousands of intermediaries. Banks, brokerages, and broker customers. They have to be secure. Given that they are launching this next year, you assume that the protocol that they will use will be quantum computing type security protocols.

I brought a couple of tokenization ideas to CME back in 2010. I met with my friend Leo Melamed about trading Bitcoin futures. I don’t remember when they finally listed them, but they did and they have been successful for the exchange. They are cash-settled, not physically settled. I have an investment in Bitnomial, where they are physically settled. In 2014, one of the reasons I made the investment in Bitnomial was that no US futures exchange had made a move into crypto. I suspect with the way the Trump administration will instruct the SEC to regulate crypto we will see more embracing going on. That is unless a recalcitrant federal judge says something different.

The other tokenization idea I had wasn’t acted upon, and I think it could have brought CME out of a potential pothole. A lot of this is inside baseball and I will try to explain it the best I can so laymen can understand. If there are members that read this, the laymen would benefit by your knowledge in the comments.

The old exchanges were member-run. Instead of equity, members owned “seats” or memberships. The seats were traded similarly to stock. When we went from a mutually held company to a for-profit corporate entity, the IRS made a poor ruling on the old seats. They said we had to keep them and staple one share of stock to them. Why? Otherwise members would have incurred a massive tax liability. Some members owned their seats for $10,000, and not just a few of them. With demutualization and the seat worth millions, the taxes they would incur would have been extremely high. Demutualization would have been impossible.

Today, if you own a B share at the exchange, you get a dividend from the one share of stock. It’s a pain in the ass for the exchange and for a shareholder.

Prior to demutualization, the membership structure allotted for 6 votes for a B1 (CME), 2 votes for a B2 (IMM), and 1 vote for a B3 (IOM). There were 625 B1, 824 B2, and 1350 IOM. I might be wrong about the IOM number. But, with 6 votes, the CME could dictate on all the big issues that came before the exchange. The CME also had the most representation on the board, and also paid the lowest fees no matter what contract the member traded. In addition, the lower member class was prohibited from physically entering a higher membership class pit and trading. When they did trade those products, they paid a higher fee. In addition, when the exchange had pit and electronic trading, it had to figure out how to charge each. Hence, today’s fee structure represents that old standard. Of course, everything is electronic now too, so having one fee to trade is much more efficient.

To add to the complexity, if you leased your membership instead of owned your membership, you paid a higher fee. There was not only an active membership market for buying and selling, but there was an active membership market for leasing. Many people bought memberships and never traded with them; they leased them out for income.

The exchange wanted to tell the IRS that we would keep seats, but that we wanted all the equity to go to members and no equity stapled to the old seats. That would have resulted in a different corporate structure than they have today.

Instead, there are B shares with B share board members. If you own a B share, check your email and your snail mail this week because you ballot will be in the mail.

In the initial road show, if you read the commentary booklet, one of the risks that was elucidated by CME management was that the B shareholders might be very adverse to actions taken by management. The goals of the B shares were at odds with the A shares.

In fact, there is a class action lawsuit that has been winding its way through the court where the B is suing CME. It’s a multi-billion dollar lawsuit and if the judge rules in the B favor, it’s going to be costly for CME. I don’t have any idea about how it will play out and I don’t own a B. I am not a member of the class either and frankly, I think whomever decided upon the way the class was structured did it incorrectly. But I digress.

The other thing laymen should understand is that the CME fee structure is 100% based on the B share. The IRS decision forced the CME to keep old ideas about fees codified and eliminated CME’s ability to innovate around fees. That fee structure is ossified in a new electronic environment and out of step with the demands of customers along with the ability of CME to supply it. Hence, with supply and demand out of whack, the fee structure is out of whack. CME has no choice but to make up the market dislocation with data fees and customers whine and moan about data fees.

What are the most popular products to trade at CME? Equity futures and interest rate futures. But, because the CME was founded as the Butter and Egg exchange, the livestock contracts have to have a B1 to trade to get the lowest price.

At the CBOT, it is similar. Grain members ran that exchange. However, the most popular contracts to trade are interest rates.

Getting rid of the old tiered fee structure based on B shares, which wouldn’t exist at all except for a bad IRS ruling, is a good idea.

Certainly, CME knows the elasticity of demand for any given product based on the commission fees it charges. Instead of pages and pages of fees with different categories and different types of fees based on membership class or no membership at all, they could simplify it.

What’s an exchange’s incentive? Pump as much volume through and earn a profit on every contract. Fees based on volume are an idea that works with an exchange’s economic incentive.

What is a customer’s incentive as it relates to an exchange? Trade as cheaply as you can so you get the most bang for the buck. Back in the old days, you could do the math about how much volume you traded and whether it made sense to lease or own a membership because there was a fee break for owning. I do not think the broader customer base of CME understands that break now, so the leasing market isn’t very lucrative like it once was. By the way, because of the dormant leasing market, the CME earned itself a lawsuit.

Given those two economic incentives, what’s the best way to charge fees? Volume. Big traders take the most risk, provide the most liquidity, and ought to be rewarded for that by paying the lowest fees no matter what membership class they are in. Small traders benefit from the big traders, so they recognize that benefit by paying a slightly larger fee.

The other thing that would benefit the exchange is having one transparent price rather than a hieroglyphic fee schedule. Because they know the elasticity of demand for a certain product, they can charge fees based on that elasticity. Trading a Hog contract shouldn’t cost the same as trading an S+P. Lowering a fee based on elasticity ought to see a marginal rise in volume and the CME corporate finance department could run the change through a model to understand exactly how much extra profit they would make with a change of fee.

But, it still leaves the B shares out there hanging. That leaves two choices.

Pay the B shareholders and make them go away. You could do a combination of cash/stock, or cash, or just stock. Doing that will involve a negotiation and frankly, you don’t want to negotiate with a lot of the B shareholders because they are unreasonable, which is why in the road show documents the CME management put the risk factor in.

The other thing you could do is to tokenize the memberships. In return, the owners of the B shares would give up their fee preferences and board seats. The sole share of stock attached would become unstapled, and the owner could sell it and pay the corresponding tax. Essentially, those B-shares are a token today. You can use it or lease it. Maybe they could lease it for one session, and CME could divide the 24-hour day up into three sessions. Maybe they could increase the number of memberships they offer through tokenization. Instead of owning a B1 to get the lowest price on Hog trading, maybe you would have to own a certain number of tokens instead. But because there is lower demand for hog trading than the S+P, the S+P would require customers to own more tokens to get the lowest price on the S+P. Opening up flexibility on leasing will increase the opportunity for owners of tokens to monetize them.

It also opens up opportunities to create different classes of clearing membership. If you want to clear CME, the firm needs to own stock plus two membership classes in each class. If it wants to proprietary trade, it needs to own more memberships. Change it to tokens. What if I only want to clear S+P? I could be an S+P clearing member exclusively, holding the requisite shares of stock and the token amount set by the exchange. That puts a floor on the price of the token.

Doing that would allow more competition among brokerage firms and put a check on the consolidation that has happened over the last twenty years.

Big prop firms would trade even more because the fee structure would be more aligned to their business.

Why wouldn’t CME do this? It’s hard. There is a lot of explaining to do and they might be better off concentrating their resources somewhere else. Another reason is they don’t have a huge incentive to do it since they control most of the worldwide futures market. They are the big elephant in the room and if they don’t want to move, they don’t need to.

However, innovation is afoot. Things that are the way they are won’t always be the way they are. If there is one thing people ought to have learned is that even though the SBF fiasco was fraudulent, there is demand out there to do things differently. In the 1990s, there were those of us on the trading floor who saw innovation coming and adapted to it. Turns out, we were right and created the largest exchange in the world.

Innovation never stops. With quantum computing, AI, tokenization, and things we don’t even comprehend yet, you can’t stop innovating. I think that CME’s antique fee system is keeping it from figuring out new ways to innovate. It’s putting upward pressure on data fees, which the entire customer community hates, and gives them a reason to look for alternatives. So far, because of the dominance of the CME clearinghouse, the alternatives haven’t been appealing, but technology can change that. So could a regulatory change.