The importance of the CME’s move to become a Futures Commission Merchant (FCM) is limited only by the imagination of the CME’s management.
This article describes the inadequate service stock exchanges and futures exchanges provide to retail traders. It shows how CME has embarked on a path that could lead CME or competitors to revolutionize the retail trading space. The result would be much reduced retail investor costs and a less risky financial marketplace.
CME’s application comes despite CEO Terrence Duffy’s earlier objection to an application for the same capability by FTX, a much smaller exchange. CME joined a chorus of complaints about the FTX application, saying “The FTX model would significantly increase market risk.” FTX for its part believes its proposal will bring 21st-century technology to U.S. markets, adding that it has safeguards to limit risk.
This article argues that to revolutionize our financial market structure – to enhance market stability and bring retail costs of trading to a bare minimum, the CME should be confronted by a new competitor that truly represents the interests of retail investors.
To assure that this new exchange serves the interests of retail traders it should have a different structure of ownership. This exchange might be owned by its retail customers, like Vanguard’s ownership model. In fact, the cheapest way to get this new exchange up and running would be for the new exchange to be closely affiliated with Vanguard itself.
The CME application
The CME, in a move that received little attention from the media, asked the Commodity Futures Trading Commission (CFTC) for permission to become an FCM. The usually open-minded CFTC is likely to approve.
What is the potential benefit to the retail trading public? The sky is the limit, up to and including replacing the SEC’s securities exchanges as the dominant locus of global trading.
Of course, for the CME to suggest this revolutionary outcome would immediately kill its FCM application. CME claims the application is a defensive response to an application by FTX (largely a cryptocurrency exchange) for the same FCM privilege. Of course, an alternative interpretation is that the CME maneuver is indeed a lamb-like defensive move.
If so, CME must believe there is a possibility that retail investors will understand the value to them of an exchange with an FCM license and that their users might defect to FTX unless FTX’s lower costs are matched by the CME.
For now, there will be more than enough controversy created by the short-run likelihood that the CME will compete directly with its own clearing FCMs, most of which are subsidiaries of holding companies that also house SEC-approved broker-dealers. These bulge bracket players carry heavy weight in Washington and on Wall Street. If they oppose the CME move, CFTC approval will be less likely.
CME self-clearing will plainly reduce the cost to day traders and hedgers of using futures markets. But to truly shake up financial markets, CME need only add one more capability –to become a securities portfolio manager as well.
Can the CME fix our organized financial markets?
The SEC’s National Market System (NMS) is a complete failure. The SEC’s espoused NMS rules are intended to promote:
- Making the best market-wide prices available to retail traders
- A one-penny minimum tick size
- New joint industry plans that allocate revenues to self-regulatory organizations (“SROs,” exchanges, and ATS) for their contributions to public price discovery and promote the wider and more efficient distribution of market data (exchange subsidies) for market-making
What is wrong with the NMS? The NMS has fallen short of these objectives. Instead, the NMS has disastrously reduced retail investors’ direct use of SEC-approved exchanges. These exchanges are now dominated by algorithm-generated computer-initiated transactions, which now constitute up to 70% of all securities exchange transactions.
Retail trades are now mostly executed by Wholesalers (big impersonal trading firms, for example, Citadel’s brokerage servicing sub, Virtu, Jump Trading) that pay retail brokerage firms for their retail orders, bundled by the retailers in a volume sufficient to be profitable to the Wholesalers. This practice is known as Payment for Order Flow (PFOF).
What has ruined the NMS? Several unexpected aspects of electronic trading have inspired the big three exchange management firms (CBOE, NYSE, NASDAQ) to cater to algo traders (traders who program computers to execute transactions that profit from the inefficiencies of the NMS). Algo traders are another aspect of wholesaler activity, known as High-Frequency Trading (HFT). There is a symbiotic relationship between these wholesaler HFTs and exchanges that benefits both but at the expense of retail traders and taxpayers.
Fixable inefficiencies of the NMS
- Exchange transaction engines in different locations. The movement of trading from human trade execution to electronic execution was accomplished by what must have seemed a sensible decision to locate exchange transaction engines in New Jersey warehouses. Each exchange bought its own warehouse. As a result of the spatial separation of exchanges, an algo-friendly arbitrage is created because of the well-known relativity-theory-based fact that there is no meaningful way to identify a consistent meaning of the NMS notion of “National Best Bid and Offer (NBBO)” at separate locations when orders are placed at close to the speed of light.
- Co-location. To capture a share of the algo-driven profitability of inter-exchange arbitrage, the exchanges sell broker-dealers space adjacent to their transaction engines. It immediately became clear to the dealers that they had to co-locate with all exchanges to compete successfully for customers.
- Maker-taker fees. The SEC subsidizes bids and offers that are used in the SEC’s National Best Bid and Offer (NBBO). This created a joint exchange/wholesaler strategy where wholesalers quote tighter spreads when customers are unable to access them, thereby collecting SEC subsidies for exchanges and arbitrage profits for wholesalers.
- Exchange proliferation. It was not lost on exchange management that every exchange earned these revenues, whether retail traders used them or not. The result was an explosion of new exchanges, all collecting the same NMS-inspired fee income.
A firm that combines a securities portfolio manager with a futures clearinghouse and a broker-dealer directly addresses the shortcomings of both securities exchanges and futures exchanges.
How CME’s move leads to an NMS Fix
One reason the CME is empowered to fix the NMS mess is that it is not part of the NMS. Moreover, the rules of futures trading eliminate the problems the SEC created for itself with the NMS.
Advantages of futures exchanges over stock exchanges
- No interexchange arbitrage trading. CME originates all futures contracts it trades. Moreover, to trade the instrument without using the exchange clearinghouse violates exchange rules. This gets rid of the exchange proliferation problem that the SEC has created for itself.
- No regulation Q 50% margin requirement. The exchange can manage the level of customers and clearing member margin payments consistent with the exchange perception of current risk in each market. Historically the clearing firms could set customer margins above those set by the exchange, but perhaps the advent of CME exchange-brokered trading will eliminate that unnecessary cost.
- No exchange proliferation. There is no regulatory reason that two exchanges cannot trade the same instrument. But there is no way to offset a long position on one exchange with a short position on another, so trading in each instrument has always gravitated to one exchange or another. Thus, CME has come to dominate the futures trading space.
- No Maker-Taker fees. Because the competition among exchanges has always been settled through superior liquidity generation, the CME never pays one sort of trader to take the orders of another.
Disadvantages of futures exchanges over stock exchanges
- No control of spot delivery or settlement. The key problem of futures exchanges, bared by the demise of LIBOR, is that futures contracts depend on contract-killing developments in the deliverable instrument’s spot market.
- A futures contract cannot pay dividends or interest income. The single biggest weakness of futures trading is that there is no facility for payment of securities’ income to buyers. Adding an exchange portfolio manager would make these payments possible at a fraction of the cost of receiving these payments in the NMS.
Capitalizing on CME’s broker-dealer capability
If the CME settles for FCM designation without exploiting the opportunities that capability creates, little will come of it.
But if the bulge bracket FCMs lose their clearing member privileges, I believe they will open competition in FCM-created new futures or futures-like exchanges. These new exchanges if they simply clone the CME model will come to nothing. CME’s liquidity advantage will blow away any de novo futures exchange that does nothing other than imitating the standard futures exchange model.
The path to marketplace domination will depend upon a de novo exchange initiative to combine the advantages of futures trading with the security exchanges’ ability to originate their own securities.
I doubt that CME is seeing the enormous opportunity in the addition of an FCM capability that I see. On the other hand as this Wall Street Journal article reports, Craig Pirrong, a finance professor at the University of Houston, points out that “By setting up its own FCM, the company may be laying the groundwork for a regulatory decision that shakes up the traditional relationship between futures exchanges and brokerages.” That outcome is the minimum that is possible when firms like FTX goad established firms like CME to reluctantly consider an improvement in the status quo.