EBOT, The Missing Link?
In the rapidly changing realm of global derivatives markets, nothing should surprise us anymore. After all, the Chicago Board of Trade and Eurex—rivals that used to sneer at each other from across the Atlantic—are now best of buddies. And the London International Financial Futures and Options Exchange (Liffe), which had previously practiced technology isolation, has hopped into bed with the CME, happily touting a future in which its electronic trading platform, Liffe Connect, will be interconnected with the CME’s Globex2.
But while those alliances have, in less than 12 months, greatly altered the derivatives landscape, they may represent merely the tip of the evolutionary iceberg. This January—around three months after the CME announced it was converting its member-owned exchange into a for-profit corporation—the CBOT’s board approved a demutualization plan that turned heads worldwide.
Just when you thought you might have heard everything, the 152-year-old CBOT gave the green light to a restructuring plan that calls for the exchange to spin off its electronic trading unit. Tentatively dubbed the EBOT (Electronic Board of Trade), the for-profit entity—upon receiving regulatory and member approval—would have its own management and staff and would compete head-on with the CBOT’s open outcry pits.
Creating a separate electronic trading business could have widespread ramifications—not only for incumbent members of the CBOT but for market participants at the Eurex, CME, Liffe and up-and-coming electronic markets. Most significantly, an EBOT launch could, for the first time, spark the practice of cross-listing at the CBOT, CME and New York Mercantile Exchange (NYMEX).
“This is sort of a first-to-market issue. Whoever is first to market with a viable trading platform in a for-profit environment is going to get their competitors in the crosshairs. For example, the CBOT would go after the Eurodollar contract and the CME would go after the Treasury bond contract,” says a source close to the CBOT’s management. “There will be a feeding frenzy, and I believe there will eventually be no more than two recognizable exchange trading platforms in this country.”
In part, the CBOT’s spin-off strategy was seen as a response to the Cantor Exchange—an all-electronic trading platform that is quickly gaining recognition. Born last March, the CX has yet to take a significant bite out of the CBOT’s U.S. Treasury futures market share. But the wannabe rival just became the first exchange to receive Commodity Futures Trading Commission (CFTC) approval to perform block trades of U.S. Treasury futures, and is constantly dreaming up new strategies—such as cross-margining of cash and futures contracts—to attack the bigger, “badder” CBOT.
“The original Cantor effort, to date, has failed. However, they have reinvented themselves about 10 times in an effort to get market share,” says the source close to the CBOT. The advantage that the CX has over the CBOT, says the source, is that while Cantor can “reinvent itself within 24 hours,” it can take the member-driven CBOT “months” to perform a makeover.
However, while asserting that the exchange takes “all competitive threats” seriously, CBOT chairman David Brennan says the emergence of the CX was only one factor contributing to the CBOT’s for-profit plan. Primarily, he says, the exchange’s board approved the separation strategy to figure out which trading environment its members truly prefer.
Noting that the exchange currently does 98% of its volume in its pits, Brennan says that creating a separate electronic exchange is the only way to give the CBOT’s trading engine—soon-to-be-supplied by Eurex—a fair and equal opportunity to garner volume. “In order to determine whether the future is in open outcry or electronic trading, you’ve got to give those companies a single focus,” he says. “We don’t know which way the customers want to go. Nobody has the crystal ball, but we’re providing the framework that will address that either way.”
That may be true, but the framework Brennan speaks of has left some industry observers scratching their heads, wondering what exactly the CBOT is up to. “Having been through what we’ve been through over the last 18 months or so, I cannot see how you can have the two exchanges competing head to head, co-existing in the same family,” says Hugh Freedberg, chief executive officer of Liffe.
In addition to developing cross-access and cross-margining links with the CME, the London futures market has been very busy porting nearly all of its contracts to full-time electronic trading. But Freedberg says that due to concerns about cannibalization, “stripped liquidity,” and duplicative costs, the Liffe has only run one set of products—its short-term interest rate (STIR) contracts—in parallel with open outcry during its whole conversion process.
Moreover, he says that Liffe only ran its STIR contracts in parallel for three months. “I just think it’s very difficult to ride two horses at the same time,” says Freedberg.
Of course, whether the EBOT would cannibalize open outcry is far from the only hot-button issue at the CBOT. The CBOT’s separation strategy has given rise to a host of other yet-to-be-answered questions, including: What impact will the CBOT’s separation strategy have on the CME’s electronic trading agenda? Where will the CBOT get the money to fund its new electronic entity and how will that affect the value of members’ seats/shares? And exactly how likely is it that the EBOT, if it comes to pass, will engage in cross-listing?
Cross-Collision
Today, the two largest U.S. derivatives exchanges do not compete for market share in each other’s flagship products—the CBOT’s U.S. Treasury bond and the CME’s Eurodollar. But many industry observers believe that if the CBOT follows through with its EBOT plan and both Chicago exchanges demutualize, an all-out cross-listings battle could ensue.
“What technology is doing is eliminating the geographic product monopolies that used to exist,” explains Liffe’s Freedberg. “So I think that you are likely to see a scenario where all of these various electronic trading platforms— whether they’re exchanges or quasi-exchanges or whatever—are going to get into the game of trying to list a range of products.”
What’s more, other sources say that cross-listing could eventually lead to consolidation in the U.S. derivatives markets. “To the extent that cross-listing starts to occur, then the exchanges are fungible .... That’s what happens when you are no longer bound to a geographically physical pit,” says a source at an all-electronic derivatives market.
However, there is certainly no guarantee that an exchange will steal market share from a rival exchange simply by listing that exchange’s product. While admitting that there is a “feeling in the market that everybody is going to try” to cross-list competitors’ products, CME chairman emeritus and senior policy advisor Leo Melamed says that there has to be a compelling reason—such as cheaper costs—for market participants to move their order flow from one exchange to another.
Moreover, he says that the CME already has a built-in defense mechanism that will protect the exchange from a would-be poacher: Liffe. The clearing efficiencies that Liffe and CME expect to provide, he says, will make it very difficult for the EBOT to steal market share, should it decide to list the Eurodollar.
On March 31, the Liffe and CME are scheduled to provide cross-margining of the CME’s Eurodollar and the Liffe’s Euribor and Euro Libor contracts. For members who trade both dollar and euro-denominated STIRs, cross-margining is expected to yield margin offsets of up to 60%.
“Where the real money is is in the clearing,” says Liffe’s Freedberg. “It’s all good and well to give customers mutual access, but at the end of the day ... they want capital savings.” Other factors that come into play in a cross-listed environment, says Freedberg, are an exchange’s trading engine, distribution and liquidity.
But CBOT chairman Brennan says that all the present talk about the EBOT cross-listing the products of rival U.S. exchanges is pure speculation. If members approve the restructuring, he says the EBOT will initially list the exchange’s core Treasury products. The CBOT’s other pit-traded products will follow, but Brennan emphasizes that the exchange has yet to discuss cross-listing the Eurodollar or any other non-CBOT product.
Still, if the EBOT eventually dives into the cross-listings game, the CME feels it is up to the challenge. In addition to cross-margining, the CME and Liffe are nearing completion of an electronic interface that links Globex2 with Liffe Connect. That interface will enable members of CME and Liffe to access each exchange’s full complement of electronically traded products via a single terminal.
It’s important for the CME to gain whatever advantages it can, says Melamed, because after the cross-listing of a product begins, only one market will emerge victorious. “Even though two markets compete for that flow for a while, eventually one of them wins out ... and you always end up with one predominant market in a given product,” he says.
Over in Europe, the Eurex and Liffe have already put that theory to the test. Around three years ago, when the German Bund was cross-listed on the Liffe and Eurex, the Liffe accounted for roughly 70% of the Bund’s volume. But in just over a year, Eurex turned the tables on Liffe, wresting away nearly all of the Bund volume. On the flip side, Liffe has maintained its dominant market share position in the Euribor—a European STIR contract that is listed on both Liffe and Eurex. Both Liffe and Eurex—for the record, at least—say they presently have no intentions of cross-listing the products of any other rivals.
Cannibal Conundrum
Regardless of whether the EBOT throws its hat into the cross-listing arena, the electronic exchange is expected to give the CBOT’s open outcry business a run for its money. Today, of course, nearly all of the CBOT’s volume comes from its pits.
But the source close to the CBOT believes that a separate electronic exchange would eradicate open outcry. Financial futures, this source says, would be the first contracts converted to full-time electronic trading, and agricultural contracts would likely be the last removed from the pits.
The exchange’s members, says the source, are aware that the EBOT signals the beginning of the end for their traditional business. “The CBOT membership is very pragmatic and they believe, if we do nothing, we’re going to lose our franchise eventually and come up with nothing in return,” says this source. “But if we bite the bullet and cannibalize ourselves, we have a fighting chance.”
Not surprisingly, those sentiments are not echoed by all of the CBOT’s members. Les Rosenthal—a managing partner at CBOT and CME clearing member firm The Rosenthal-Collins Group—is concerned that the EBOT will take all the volume away from the open outcry pits and leave the CBOT members/shareholders with “nothing left to trade.”
Moreover, he fears that members may have to absorb the costs of hiring new staff and implementing technology at the electronic exchange. In such a scenario, Rosenthal says, the CBOT’s auction market would revert from a “self-funding” business to a cash-strapped business that “probably” would have to tax its members. “And all of this would be very depressing on the price of memberships,” he says.
Unlike the CBOT, the CME will not spin off its Globex2 electronic trading business as part of its demutualization strategy—but Melamed says that the Merc’s strategic planning committee did indeed evaluate that option. The committee, he says, considered “every possible iteration of how to restructure.”
After nearly a year of deliberations, the committee suggested a plan that will cut the Merc’s board in half and bestow two classes of stock upon exchange Members—Class A and Class B. Class A shares will represent pure equity in the exchange; Class B will represent a combination of equity and members’ trading rights.
Melamed says the committee rejected a Globex2 spin-off idea, primarily because such a move would have been prohibitively expensive—from both a technology and staffing point of view. Moreover, he says that the committee did not want to have to raid the staff of the Merc’s open outcry business. “We couldn’t duplicate our staff because that would have been very costly.... And we thought, if we had divided our staff, who gets the best staff?” Melamed asks rhetorically.
Still, in spite of the skepticism expressed by Melamed and Rosenthal, the source close to the CBOT says that if the exchange’s restructuring plan was voted on today, “it would be a slam dunk.” Brennan agrees, noting that the member response to the plan has, thus far, been “overwhelmingly” positive. “They tell me it’s bold and aggressive and they like it,” he says.
Eurex, the Distribution Equalizer?
One key component of the CBOT’s “aggressive” plan is Eurex. Since the CBOT began side-by-side trading of its U.S. Treasury contract in September 1998, open outcry has totally dominated the exchange’s incumbent electronic trading platform, known as Project A. However, if and when the EBOT is launched, the Eurex trading engine will replace Project A.
Eurex—which has deployed thousands of electronic trading terminals across several countries in the U.S. and Europe—has “much more widespread distribution” than Project A, says the source close to the CBOT. Therefore, he says, the EBOT will be much better positioned to grab users and volume than the CBOT’s current electronic trading business. “It’s a true statement that Project A is not being used often intra-day, but it simply does not have broad distribution … and distribution is the key,” explains the source.
CBOT’s Brennan concedes that Eurex has a broader distribution network than Project A, but says it’s a bit like comparing apples to oranges because Eurex has no internal open outcry business to compete with. That said, he says that the CBOT definitely expects to pump up the volume with Eurex. “I would expect that with their distribution network and the network that’s going to be deployed here in the U.S. ... electronic trading volume will go up,” says Brennan.
The CBOT will port from Project A to Eurex’s trading engine in mid-2000, adds Brennan, regardless of whether it gets regulatory and member approval for the EBOT. Last summer, when the CBOT signed its pact with Eurex, it said that it expected to spend $50 million over the course of 18 months to convert to the German exchange’s technology.
Some sources, however, question where that $50 million is going to come from. “They may have allotted that money, but do they have it? It’s one thing to say that this is what it will cost us. But who’s going to pay for it? ... That’s still an open question, as far as I can see,” says an official at a CBOT member firm.
The CBOT, in one instance prior to allying with Eurex, talked with the CME about adopting Globex2. Those talks eventually fell through, but the Merc, like the CBOT, yearns to know what exactly the future holds for electronic trading.
To date, side-by-side trading of the CME’s flagship contract has produced pretty much the same results as the CBOT’s experiment. Open outcry has dominated Globex2, in terms of intra-day trading of the Eurodollar.
But if the EBOT gets approval and proves to be a success, one question remains: Will the CME feel pressured to expedite its push into all-electronic trading? The answer, says Melamed, is a resounding no. The Merc, he says, is confident that its current restructuring plan—combined with its partnership with Liffe—will yield great results.
However, with the EBOT and cross-listing potentially on the horizon, whispers of a merger of the Chicago derivatives markets are starting to heat up once again.
A CBOT spokesperson dismisses the rumors. Noting that the CBOT/Eurex alliance accounts for “almost 40% of the volume of global derivatives trading,” he says that the exchange is committed exclusively to that partnership.
But the source close to the CBOT says that once the Chicago exchanges become demutualized, something’s got to give. “One way or another, you will see one exchange in Chicago,” he predicts. “Either one’s going to eat the other one for lunch or they will combine.”
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