Rebellionat Themercby MATTHEW LEISING and JOHN
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By MATTHEW LEISING REBELLION at the MERCand JOHN LIPPERT 76 BLOOMBERG MARKETS AUGUST 2008 CME floor traders moved to the Board of Trade building after the merger. CHICAGO HEDGE FUNDS AND NEW YORK BANKS HAVE FOUNDED A NEW EXCHANGE TO BREAK CME’S MONOPOLY ON FINANCIAL FUTURES. THEY’RE UP AGAINST AN INSTITUTION THAT HAS SPENT 160 YEARS STRENGTHENING ITS POSITION. Photograph by Michael Abramson Rubio, center, with Citadel’s Faraz Javaid, left, and Misha Malyshev, want ELX to keep CME in check. HICAGO HEDGE FUND MANAGER TOM RUBIO NEVER considered himself a rebel. He used to stay out of the limelight, quietly developing software to buy and sell interest-rate derivatives and building his 100-person firm, Breakwater Trading LLC. Infatuated with trading technology for 20 years, he once Creprogrammed a scientific calculator to figure out options prices. Rubio, 44, dates his emergence as leader of a revolt to October 2006, when the ON S Chicago Mercantile Exchange, known as the Merc, agreed to buy the Chicago Board of Trade. By combining two rivals that competed for more than a century, the acquisition would put 98 percent of exchange-traded U.S. interest-rate MICHAEL ABRAM 78 BLOOMBERG MARKETS AUGUST 2008 contracts—and 87 percent of all futures— to wrest away from CME are growing fast- from less than 10 cents to more than $1 a under one roof. Rubio’s Breakwater and er than ordinary stock trading. Invest- trade, added up to $1.8 billion, and the funds like it rely on the Merc and CBOT for ment banks and hedge funds are finding company isn’t finished growing. In March, the rapid-fire, low-cost trades that are criti- new uses for the interest-rate, currency CME Group agreed to buy the largest cal to their success. Rubio, whose company and equity index futures the two remaining futures exchange in the U.S., the has $350 million to invest, saw the CBOT exchanges pioneered in the 1970s and New York Mercantile Exchange. If share- takeover as a threat to his livelihood. “I was ’80s—when they were competing to be holder and regulator approval is won for just very frustrated with the problem of a first with each innovation. the Nymex Holdings Inc. deal, valued at movement toward one exchange,” he says. Volume at all U.S. futures exchanges $8.2 billion as of June 6, CME will control His concerns festered for weeks until, rose 94 percent from 2005 to ’07, FIA data 98 percent of all U.S. futures. “Effective on a visit to New York in November, he show; equities trading increased 48 per- monopolies in financial services are rare, decided it was up to him to do something. cent during the same period, according to but the CME is almost certainly one,” Brad As he walked along 55th Street in Manhat- the New York Stock Exchange. Hintz, a bank analyst at Sanford C. Bern- tan, an idea took shape: Why not start a The futures and options traded in a week stein & Co., wrote in a May 22 report. rival exchange to revive some competi- on the CME, now the world’s largest futures CME’s customers are upset, says tion? He was near the offices of ESpeed exchange, have a notional value of $13 tril- Richard Berliand, head of the global cash Inc., operator of an electronic system that lion when you tally the assets underlying the equities business at JPMorgan, one of the trades U.S. government bonds. “I just contracts. That’s equal to 12 times the value ELX backers. “You’ve got a bunch of frus- took a hard right and walked into ESpeed of weekly share trading on the Nasdaq Stock trated people,” he says. “There’s a feeling without an appointment, unannounced,” Market and NYSE combined. of irritation.” Rubio says. The fees CME collected last year, ranging Beneath the surface in the conflict In an impromptu one-hour meeting with Howard Lutnick, chairman of ESpeed’s parent company, Rubio enlisted Lutnick to provide ESpeed’s trading sys- tem for the upstart and to help round up investors. During the next year, their efforts won over a who’s who among the biggest hedge funds and banks that trade on the Chicago exchanges, which together became known as CME Group Inc. after the $11.3 billion merger closed in July 2007. Citadel Investment Group LLC, the $20 billion hedge fund firm run by billion- aire Kenneth Griffin, joined. Getco LLC, which stands for Global Electronic Trad- ing Company, signed up. So did Citigroup Inc., JPMorgan Chase & Co., Merrill Lynch & Co. and five other investment banks. By December 2007, with 12 back- ers, the Electronic Liquidity Exchange was born and Rubio became chairman. The new exchange, known as ELX, held its coming-out party in Boca Raton, Flori- da, in March, at the Futures Industry Association’s annual conference. In a col- CME’s Craig ON onnaded courtyard at the Boca Raton S Donohue seeks a IL G Resort and Club, ELX laid out a lavish piece of the OTC HEW spread of crab, oysters, steak and liquor. derivatives market. TT MA The financial contracts that ELX hopes 79 AUGUST 2008 BLOOMBERG MARKETS used to insure against corporate debt Rising to the Top defaults, more than doubled last year, CME’s purchase of the Chicago Board of Trade made it the world’s largest derivatives for example. exchange. Buying Nymex Holdings would expand its lead. CME Chief Executive Officer Craig Contracts, in millions; 2007 Change from 2006 Donohue, 46, wants a piece of the OTC market and says that’s where the compe- 1 CME Group 2,805 27% tition in his industry will play out. The 2 Korea Exchange 2,709 9 credit crisis of the past year may help 3 Eurex 1,900 24 push business his way. In March, U.S. 4 Lie 949 30 Treasury Secretary Henry Paulson said 5 Chicago Board Options Exchange 946 40 more standardization in the processing of Source: Futures Industry Association trades would make the credit-default- swap market more stable. Donohue says between CME and ELX, a bigger battle is Bank for International Settlements in his clearinghouse, which pools collateral brewing. This one is for control of deriv- Basel, Switzerland. from market participants to make good on atives that aren’t traded on any exchange. The banks’ OTC derivatives, tailored to defaulted trades, fits that bill. “The CME The over-the-counter market, run by clients’ needs, go beyond what’s available is being opportunistic and going on the banks such as Goldman Sachs Group Inc. in the standardized contracts exchanges offensive,” Sandler O’Neill & Partners FILEand JPMorgan,cmeta6 offers swaps and options offer. The exchanges began with futures, analyst Rich Repetto says of Donohue’s SIZEbased on interest26p4 x 11p6rates, currencies and which are agreements to buy or sell an plan to make inroads in OTC trading in NOTESthe creditworthiness of corporate bor- underlying asset at a specific price on a set the aftermath of the credit crunch. rowers. With $596 trillion in outstanding date, and now also trade options. The fast- Donohue says that banks intentionally contracts as of the end of last year, the est growth is in the OTC market, according keep their derivatives dealing opaque to size of the OTC market is more than eight to BIS data, which excludes some com- give their traders more opportunity for times that of all exchange-traded financial modity contracts. The value of credit- profit. It’s a conflict of interest avoided by contracts worldwide, according to the default swaps, which are OTC contracts independent exchanges, he said in a S NEW G CME’s Globex FRANK POVICH/BLOOMBER system has helped the exchange dominate its rivals. 80 BLOOMBERG MARKETS AUGUST 2008 across the middle of the page that reads: “Risk is what you make of it.” Getco, run by Stephen Schuler, with ffective monopolies in financial services offices in the Board of Trade’s landmark Eare rare, but the CME is almost certainly one,’ art deco building, has taken on exchanges Sanford C. Bernstein analyst Brad Hintz says. before. The firm owns a stake in Bats Trading Inc., operator of an electronic system for equity trades that has taken speech at the Federal Reserve Bank of exchanges and investment companies. market share from the Nasdaq and NYSE. Chicago on March 6. “We’re not traders,” This group might move a third of their Jeff Mathis, a Getco spokesman, declined he said. “We don’t have a dog in the hunt.” Treasury futures trading to the new forum to comment. Peak6 Corp., which works in Donohue, who earned $3.9 million in initially, Rubio says. partnership with Rubio’s Breakwater 2007 and this year bought a 2008 Bentley Officials at the banks backing ELX most- Trading, is the other hedge fund that has Continental convertible with a list price ly decline to discuss the initiative. Najib joined ELX. of $210,000, downplays the chance that Lamhaouar, head of global futures capital Firms such as Citadel unleash massive ELX will make a dent in his current trad- markets at Citigroup, had no comment, nor trades in a variety of markets, deploying ing. He cites three failed efforts in the past did Tom Callahan, head of global financial strategies that rely on ever-more-sophis- decade, including one led by ESpeed’s futures and options at Merrill. Jodi Cohen, ticated computer algorithms. Some of Lutnick, to steal away CBOT or CME a director in fixed income at Credit Suisse their programs depend on trading repeat- interest-rate futures.