Watching From Afar

CME Trial Offers Insight Into Networks

I am watching the CME trial from afar. I don’t own seats anymore, selling my last one in 2012. I needed the money and saw them dropping in price like a rock. I am not a member of the class. I spent almost my entire career at the exchange, and was on the board and was one of the people who pushed for, and voted for, demutualization.

There has been testimony and ideas floated in the press that the members are very wealthy. First, that doesn’t matter. Second, most members had to sell both their membership and stock because they needed the money. When trading went electronic, 99.9% of floor traders couldn’t make the jump profitably. It was all they had and they needed to sell those assets to survive.

I was one of those people. I had to sell a large chunk of stock in 2003 in order to survive when the Eurodollars went electronic. I didn’t have any income from 2009 until 2017 and lived off stock and savings. Fortunately for me, I redeployed a lot of the capital into startup companies, and I was a very good startup investor.

Many of my peers didn’t have that happen. The ledger of divorces, alcohol and drug problems, suicides, and other life-threatening problems is long. Sometimes when traders see each other, they will say, “I don’t want to hear any bad stories, just good ones.”

If you aren’t familiar with the case, the class action is suing CME Group over “core rights”. What were the core rights of the members prior to demutualization, and what were they after? In the demutualization documents both written and verbally, the CME Board said members would retain core rights.

But what are they? Hence the lawsuit.

I truly wish we had a press corps up to the task of reporting on the case. We don’t. Not only do they not understand the way the exchange worked but they truly don’t understand how businesses work. Instead, they are note takers and repeat talking points.

I have also said I favored a settlement because both sides risk too much in going to a jury. To be honest, the former members risk more. If you sit on the CME corporate side, you assess the damages. It’s an $80B corporation with growing top-line revenue and roughly 60% or more of the top line floats to the bottom line. It has a regulatory moat that keeps it relatively safe from competitors. Any judgment against the exchange is likely to be at a maximum, $3B-$5B. For sure, there will be an appeal, and any settlement after an adverse verdict will be on the low end of that estimate.

On the other side, if the members lose, they lose it all. They can appeal, but the appeal will be tough, and they will have to find a law firm to take it on a contingency basis, cutting any amount they receive further.

There is a pack of people on social media who never traded on the floor that are active in markets today, who wonder what it was like, and love to hear stories about the floor. That’s sort of what this post will be about, not the case. However, if you understand what I write, it will give you insight into how the case happened and how it might progress.

The CME case offers some outstanding business insight into how networks work. I think understanding how they work can help your career.

Networks can be open and closed. Neither is better than the other, though our confirmation bias prefers open because it sounds better. They are usually structured the way they are because it is the best way for the business to attack the market.

Goldman Sachs and investment banks operate like open networks. Food companies operate using closed networks. Goldman benefits from an open network because it gets deal flow and opportunities from being open. Food companies benefit from closed networks because they want to control variance on production since a slip-up could cost them in a big way.

Closed networks usually have a feature of one “star” that everyone knows. In the case of Apple, it was Steve Jobs. When he died, the network reconstituted itself, and now it is Tim Cook. You don’t know other employees, and they aren’t in the news.

There were two broad networks in the exchange. The first was the corpus. It was the exchange itself. There were employees who were “corporate”. It was overseen by a President, and run by the CME Board, who were members. The members were powerful, and the President worked for them.

One phenomenon of networks is that when they break up, they will reconstitute themselves in a similar way after restructuring. A CEO leaves a company that had a closed network, and the existing network might break up. Other execs might leave, or the company might restructure. When the new network comes together, the probability of it being open is very small.

The “exchange” had a closed network. This was historical. You can read about Leo Melamed and the “Young Turks” who took over the exchange in the early 1960s. But, Leo displaced a closed network and reinstituted a closed network he ran to govern the exchange. Leo’s network persisted until demutualization. Only people Leo trusted became a part of that network, like Jack Sandner.

Jack thrived in the closed network, and even after he and Leo broke up, he remained because he had brought in his own people to work inside the closed network of the exchange. When the exchange went through a lot of political strife during the 1990s, it was basically “Jack people” vs “Leo people” at the exchange level and floor level.

Having a closed network benefited the exchange. It was in the money-moving and transparent market business that a high degree of trust was needed in order to sustain the business. The closed network helped it work closely with regulators and other large institutional entities. One point of contact, clarity on how decisions were made, with clear responsibility.

The trading floor was always described as an insular club by the press. But it was an open network. The closed network of the exchange put in place clear rites of passage for someone to enter the open network.

Hence, once you were in the open network of the trading floor, there were clear rules delineated in rule books and by culture. This is where there is some confusion that caused the lawsuit.

On the floor, “your word was your bond”. Traders had too much on the line, and the floor wouldn’t have worked if that culture didn’t exist. If every time I traded with you, I had a problem, what happened? The person who didn’t live up to their word was run out of the pit by the entire population. Do it in another pit, that person would find themself running off the floor. They wouldn’t get trades.

The floor was populated by people from all over the world. This was especially true among locals who traded their own money. Brokers who handled customer orders were more homogeneous. Families, of course, brought their kin down, and you’d see brothers, sisters, cousins, uncles, sons, daughters, nieces, and nephews. That led to the idea that the floor was closed, but it wasn’t because there were clear rites of passage established by the exchange. Go through them, and you have your stamp of approval to enter the network.

The floor was a human place. Each and every different pit had its own network, with its own culture. It was hard to enter a pit, leading people to think it was closed. However, it was generally possible, and if you were a good trader, you’d survive and become a part of the network.

The floor was open because it was about the best bid or offer. It was about the person willing to assume risk. It was about competition. Heated competition made the best markets, and advantaged customers, increasing the amount of order flow and business. That created more opportunity, and lather, rinse, repeat.

Because the exchange board was elected by peers, and made up primarily of peers, the membership implicitly trusted the board. When demutualization happened, if a board member said something, their word was their bond, and they were trusted.

But, as we know, words are words. Interpretation of those words can be wildly different.

For example, I wrongly assumed that with electronic trading, the order flow allocation would be “fairer”. In pits, if you stood next to a large order filler, you were able to get more opportunities to trade. On the screen, where you stood didn’t matter.

In practice, what CME did was sell out the pit space to entities that put servers next to the order flow in a data center.

Is that fair? It all depends on your perspective. From my perspective, it certainly wasn’t. I went from making a lot of money to losing a lot of money. What does the market think? By any measure, the “market” thinks it is fairer since volume has exploded.

I always assumed the board members would turn over. I assumed that the carve out for the B share board members would be taken by market participants who truly understood electronic trading, or options, or untaken opportunities that the exchange should pursue. Innovation in the closed network of the exchange generally didn’t germinate in the corporate. Innovation happened on the open network of the floor and flowed into the corporate world to be reformulated with member oversight so it could be digested by regulators and institutions. That hasn’t happened.

If you look at some of board members (not the B’s since they actually stand for a competitive election), there have been some who have been there for decades. They have no expertise, but are there because they are “yes men” or for some other aspect, like diversity or something like that. Some don’t even have expertise in how to manage a global company or in legislative matters. They aren’t experts in any part of the business or CPAs for an audit committee. They are puppets, but excellent political animals. Recall how NASDAQ tried to tell its listed companies who they should have on their boards and the makeup of them. CME isn’t immune to that. These “yes men” are insulators, not accretive to the advantage and operation of the exchange.

Because I have been gone for so long, it is impossible for me to talk about the culture of the exchange as it exists today. However, if Professor Ron Burt’s lessons are correct, the closed network that historically existed continues to persist today.

One way to see if that is correct, ask how many names from the exchange are in the news. Do you know any other names other than one?

Again, that’s not a “bad” thing or “good” thing. It is a function of how the exchange works to propel its business forward. It is in the money moving, transparent market making, and risk transfer business. It has to have trust to operate. It has to handle and negotiate with large government forces both nationally and internationally, along with global and national private institutions in a competitive marketplace. A closed network is probably still the best way to manage that.