No more second city

Futures, May 2008 by McMahon, Chris

Chicago has always been the center of futures and derivatives trading, but the exponential growth of the CME, now coupled with the CBOT, has created a financial service's behemoth capable of challenging all comers on the world stage.

Chicagoans jokingly refer to their hometown as America's second city, but that sort of self deprecation is probably more the norm outside the exchange space. For 160 years Chicago has been the center of futures and derivatives trading, but with the consolidation of Chicago's two futures giants into the CME Group, accounting for 85% of U.S. futures volume in 2007, CME Group is now a global player capable of competing in the over-the-counter space on a global basis.

Just for perspective, the nearest competitor was the New York Mercantile Exchange, with 10.85% of the futures volume. The Intercontinental Exchange's piece of the futures pie is less than 2%; and now CME Group and Nymex have announced their plans to merge.

CLEARING THE DECKS

The CME was the first U.S. exchange to restructure itself as a publicly held forprofit corporation from a mutually owned not-for-profit in November of 2000, and on Dec. 6, 2002 it became the first U.S. exchange to have an initial public offering. Converting access to equity proved difficult and was no easier for those that followed, requiring years of debate and legal battles. But those exchanges that have completed the transformation now have a more nimble form of corporate governance; one that is focused on profits and customer service rather than balancing the many competing interests of its members.

The enormity of these changes and the pain and profits associated with them cannot be overstated. Before demutualization, exchange seat holders were more than simply the gate keepers to the trading pits; they literally owned them and made their fortunes by trading and by granting access to those trading floors for a price, either through leasing seats or charging commissions.

But completing that process also removed much of the subjectivity associated with valuing the exchange, creating a common currency that has allowed the wave of consolidation. It also sharpened the exchanges' mission to a single point: increase shareholder value. And the surest way to increase shareholder value, regardless of the industry, is to increase efficiencies, and that meant utilizing clearing as a revenue stream and allowing users to have direct electronic access to the markets on a near 24-hour basis.

SETTING THE STAGE

"The Common Clearing Link's advantages are vast but can be summarized by stressing the one word: single," said CBOT Chairman Charles P. Carey of the historic clearing link between the CBOT and CME in his July 10, 2003 Mid-year Chairman's Report. "The new Common Clearing Link helps assure benefits for CBOT customers, members and member firms via a simplified clearing system that combines a single point of collateral management; a single location for positions; a single risk management platform; a single clearing interface; and a single guarantee fund." And for customers, the CME Group says the savings have been profound.

"We looked at the capital savings of bringing the two markets together, and that figure is north of a billion dollars that we have been able to save our clients from a capital standpoint," says Rick Redding, managing director of products and services for CME Group.

For the exchange, there are two ways to benefit: first by cutting costs, and second by providing increased efficiencies to traders, which increases volume.

"You don't need two people doing accounts payable in two locations. So there are expense synergies related to headcount, IT programs or having two people doing the same functions on the trading floor," Redding says. Post merger, the CME Group says it reduced headcount by 380.

And on the business side, combining CBOT and CME interest rate products onto the same platform allows the exchange to get a better handle on risk in the system and create new trading opportunities by allowing traders to execute more trades faster and harmonizing rules. "It brings easier ways to look at the risk across a firm in the positions that they are carrying," Redding says. "By having those on there, they can execute trades faster and see more trades that could be profitable to them. That's more volume for the exchange. So we pick up the revenue synergies from that trading."

SHOW TIME

Adding the CBOT contracts to Globex took time, money and effort, but apparently less than allotted for. Initially, the CME said that electronic integration would take 12 to 18 months. Then a competitive bid from the Intercontinental Exchange (ICE) stalled the CME/CBOT merger for more than a month. But after the CBOT members voted to approve the CME deal on July 9, 2007, something remarkable happened: CME moved the integration date forward and the commodities and equity indexes went live on Globex on Jan. 13, and interest rates went live on Jan. 27, just seven months from the closing of the merger.