By MATTHEW LEISING REBELLION at the MERC and 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 Li e 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. Group’s U.S. investment bank, which is also edly to gain advantage from narrow and ELX is the response of the banks to the part of ELX, declined to comment. fleeting price fluctuations. For these threat CME Group poses to their OTC While ELX gets a leg up from its roster derivatives, says Leo Melamed, who intro- of banks and hedge funds, it also gets an duced the first financial contracts when advantage by having Lutnick’s ESpeed on Grand Prize he was chairman of the Merc in the 1970s. board. New York–based ESpeed is the sec- CME Group is targeting the derivatives banks trade over the counter. “I don’t blame the banks for saying, ‘These ond-biggest electronic market for Trea- guys are trying to get into our turf in the sury notes and bonds after ICAP Plc’s DEC. 2007: $676.6 TRILLION OTC market, and we’ve got to protect BrokerTec. It’s part of BGC Partners Inc., 12% ourselves by creating a counterweight in a publicly traded brokerage with a market Exchanges the form of a new exchange,’” says value of about $1.5 billion. Cantor Melamed, 76, who chairs a strategic plan- Fitzgerald LP, a privately held investment ning committee of CME directors. “I bank that Lutnick runs, is the biggest don’t think they’re going to succeed, but I shareholder of BGC. don’t blame them.” Startup costs for ELX can be kept to a 88% OTC The first target for ELX, Rubio says, is minimum because ESpeed terminals are CME’s $435 billion–a-day market for already on traders’ desks at most banks Treasury futures. Banks, hedge funds and and investment firms that deal in U.S. corporations use these contracts to pro- government debt, says Berliand, whose GLOBAL OTC DERIVATIVES, $596.0 IN TRILLIONS tect against or speculate on changes in responsibilities include oversight of $516.4 U.S. interest rates. Trading Treasury JPMorgan’s global futures business. He $414.3 futures and the government debt they are refers to the ESpeed system as “Lutnick’s $369.5 based on is a specialty of Rubio’s firm and exchange-in-a-box.” $297.7 a vital activity for all of the banks and The Chicago hedge funds backing ELX hedge funds in ELX. are closely associated with the city’s DEC. JUNE DEC. JUNE DEC. Combined, the ELX backers do as exchanges. The biggest by far is Citadel. ’05 ’06 ’06 ’07 ’07 much as half of the Treasury futures Griffin has been featured this year in Figures are notional amounts outstanding, including foreign trades on CME, says Don Fandetti, a Citi- CME Group advertisements in financial exchange, interest rate, equity and credit derivatives. Source: Bank for International Settlements group analyst who covers brokerages, magazines and newspapers, with a quote
FILE cmegro8 SIZE 12p8 x 25p6 NOTES DECORATIVE 81 August 2008 Bloomberg Markets banks worse, says Benn Steill, an economist at the Council on Foreign Relations in New York, who follows trading institutions. “I don’t think it’s a good strategy to insult your major customers,” Steill says. Donohue says he takes the ELX initia- tive seriously, while pointing out the previ- ous challengers that failed. Eurex AG, the largest futures exchange in Europe, opened a U.S. affiliate in 2004 and captured less than 1 percent of CBOT’s Treasury futures market before giving up. BrokerTec made an attempt in 2001. Lutnick’s prior run at Treasury contracts came in 1998, when Cantor Fitzgerald laid plans to offer round- the-clock electronic trading of Treasury Customers have futures. The CBOT had been trying to pro- confidence in trades on the CME, tect the live trading in its pits by allowing Chairman Terrence electronic transactions only when the floor Duffy says. was closed. It responded to Cantor by expanding its electronic trading hours, and strategies, low transaction costs are vital. what ELX expects to charge. The range Lutnick’s effort fizzled. A small increase in trading costs might might be 5 cents to 10 cents per trade, Three years later, Cantor Fitzgerald make a strategy unprofitable. according to two people familiar with the and ESpeed lost 658 employees on Sept. Citadel, Getco, Peak6 and Breakwater planning for the exchange who asked not 11. The companies had their offices on the all get one of the lowest per-trade fees to be identified. top floors of the north tower of the World that CME offers: 11 cents for each Trea- At the FIA conference, on the day ELX Trade Center. Lutnick became a media sury contract, far below the average of hosted its party, Donohue was dismissive fixture after the terrorist attacks as he 63.6 cents that the exchange collected of the upstart. “Ex-Lax, or whatever the set about rebuilding his business. He across all of its product and customer cat- thing is called,” he said during a panel dis- declined to be interviewed for this story. egories last year, according to CME. A 28 cussion that included JPMorgan’s Berli- Donohue says the ELX team is wrong percent jump in the number of contracts and on the dais two chairs away. “I would to consider CME a monopoly. The alter- the Merc and CBOT handled last year have found a trade name that can’t be natives to exchange-traded contracts are failed to yield lower per-trade costs for found in the diuretic or laxative section of OTC derivatives or other financial instru- customers as the average fee CME the pharmacy,” he said. A hush fell over ments such as index funds, individual charged went up 1 cent. the crowd of about 500 conference goers, stocks or bonds. Competition among The ELX initiative is all about keeping followed by nervous laughter. those choices keeps fees in check, he says. fees in check. Faraz Javaid is director of Berliand was chairman of the industry Antitrust regulators in the U.S. Justice business development for high-frequency group for a two-year term that ended in Department last year sided with Donohue trading at Citadel, charged with making March—a period when FIA’s relations when they approved his acquisition of sure Griffin’s traders have the ability to with CME soured because it opposed the CBOT. The FIA, on behalf of the New execute their transactions quickly and at purchase of CBOT. In a speech the day York banks among its members, had low cost. He says it’s hard to know what a after Donohue’s Ex-Lax jab, Berliand said argued unsuccessfully that competition fair price is for an electronic trade on an there will always be disagreements would be harmed. exchange if there’s no competition to between banks and exchanges. “What Terrence Duffy, CME Group’s chair- force the issue. Stocks can be traded in the matters is that the conflict is managed in a man, says customers habitually complain
U.S. markets for less than a penny a share, mature and in an adult way,” he said. In an about trading costs. “In the hog pit, they ON S IL he says. “Is 11 cents fair for Treasuries?” interview, he declined to comment on the used to say anything above zero was too G
He shrugs. Griffin declined to comment. back-and-forth at the conference. much,” says Duffy, 49, who got his start as a HEW TT
Rubio says it would be premature to say CME is making the tension with the runner in the section of the CME trading MA 82 Bloomberg Markets august 2008 Caronia Waller in New York. and the ELX backers have several prece- Off Their Peak Globex helped CME reel in Nymex, dents they can point to as they try to break After a 17-fold increase from their IPO Sandler O’Neill’s Repetto says. In Febru- the grip CME holds on financial futures. price, shares of CME have fallen this year. ary 2006, Atlanta-based Intercontinental “This group has the potential to $800 CME stock price Exchange Inc. introduced an electronical- become very successful,” says Interconti- ly traded contract to compete with the nental CEO Jeffrey Sprecher, who tried to U.S. benchmark crude oil futures Nymex break up the Merc’s purchase of CBOT 600 controlled. The move was reminiscent of last year with a competing offer. Sprech- Lutnick’s attempt to break CBOT’s grip er’s company has kept about a quarter of on Treasury futures, though more suc- the trading in U.S. crude oil futures, crack- 400 cessful. Faced with the weaknesses of its ing Nymex’s monopoly. own computer trading system, Nymex Sprecher says the mix of hedge funds 200 struck a deal to list its energy futures con- and banks backing ELX will help jump- 12/6/02 6/6 tracts on Globex, giving CME a slice of its start the new exchange. Intercontinental, profits and a foot in the door. founded in 2000 as an OTC market for nat- ’03 ’04 ’05 ’06 ’07 ’08 CME Group shares have been a signal of ural gas and power, had companies that Source: Bloomberg the company’s success, and they are up 11- traded energy among its initial investors, fold since they were first offered in Decem- including BP Plc, Goldman and Morgan floor where pork belly prices were set by ber 2002. The company carries a stock mar- Stanley. This helped Sprecher address the traders shouting and flashing hand signals. ket value of about $21 billion, 34 percent chicken-and-egg problem any new market- While such open-outcry trading survives, greater than NYSE Euronext, which owns place faces: A critical mass of buyers and the traders in color-coded jackets—sym- exchanges in the U.S. and Europe, and more sellers is needed to make a liquid market— bols of the Chicago exchanges—are dwin- than twice the size of Nymex. Still, this year where a trade can always get done at a good dlingFILE in number.cmestk5 The pits or rings for CME the shares have plunged to $387.60 on June price—yet until there’s enough liquidity, GroupSIZE have12p8 been x consolidated 17p0 in the Board 6 from a peak of more than $700. it’s hard to attract buyers and sellers. ofNOTES Trade building. In the first quarter, just Donohue says that expanding in OTC For ELX, the test of its ability to create 17 percent of its contracts traded on the derivatives might have a similar strategic and sustain liquidity is still months away. floor. In 2000, 85 percent did. importance to CME in the future as Glo- As of early June, the ELX board had yet to Donohue, who never traded on the bex has had in the recent past. He’s taking name a CEO. Rubio had no comment on floor, has a law degree from the John Mar- steps to make his clearinghouse a venue when they would announce their top exec- shall Law School in Chicago and a Master for guaranteeing credit-default swaps. utive and no schedule for the start of trad- of Business Administration from North- Goldman Sachs, Morgan Stanley and 14 ing. The exchange will need at least three western University’s Kellogg School of other banks and brokerages are backing months to gain approval from the U.S. Management, which he earned while an alternative. They reorganized Clearing Commodity Futures Trading Commission working at the Merc. Corp., which used to clear the CBOT’s once it files its application to start the new Donohue is proud of the successes that trades, and announced in June that they exchange. “I would say ELX has its work have made CME into the world’s biggest would be ready to guarantee credit market cut out,” says Leslie Rosenthal, a managing futures exchange. He says the commit- trades in the third quarter. partner of Chicago-based futures broker ment over two decades to develop the While Donohue looks beyond any imme- Rosenthal Collins Group. “It’s always diffi- company’s Globex electronic trading sys- diate threat that ELX poses cult to move the liquidity.” tem, for example, was a smart move— to existing business, Rubio Nobody predicts that putting a dent in especially since few imagined early on that electronic transactions would displace open outcry. Today, Globex is used in 86 countries and can process a trade in about 15 milliseconds—or about 17 trades in the LX has the potential to become very successful’ time it takes to blink your eye. “It’s one of Ebecause of its bank and hedge fund backing, says the most powerful computing systems on Intercontinental Exchange CEO Jeffrey Sprecher. the planet of any type,” says Ed Ditmire, an analyst at Fox-Pitt Kelton Cochran 83 august 2008 Bloomberg Markets centerpiece was an ice sculpture of a pago- da, 8 feet (2.4 meters) tall and decked out with cold-bar seafood. Shrimp, crab legs, oysters and clams on the half shell were Leo Melamed says there for the taking. banks know their OTC As the party wound down and dark- derivatives trading ness fell, the melting ice pagoda col- is threatened. lapsed with a crash. Broken glass, ice, dipping sauces and stray shrimp skidded CME’s market share will be easy. The In Boca Raton in March, at least, ELX across the floor. Guests jumped out of liquidity of CME Group’s financial con- made good on its promise to displace the way. Waiters rushed over to push the tracts is well established. Its agricultural CME. Following FIA’s opposition to the wreckage out of sight. contracts date to the mid-1800s, when the acquisition of the Board of Trade, CME The Chicago exchanges, with their his- Board of Trade grain futures helped trans- declined to host any events at the March tory spanning three centuries, have beat- form American agriculture. The financial conference. It was a departure from previ- en back competitors before, and Donohue derivatives have grown steadily and now ous years, when the dominant exchange is confident he knows the right strategy to generate seven times the revenue. CME’s threw the biggest party. It was an opening keep CME Group growing for decades to Eurodollar contracts are the most-traded for ELX to woo CME customers. come. Unless the banks and hedge funds interest-rate futures in the world. The backdrop for ELX’s spare-no- are ready for a long fight, ELX may melt “We’ve seen the power going to the expense bash included a golf course, away like past challengers. ≤ exchanges over the last three to five years,” palm trees and the hotel’s Mediterranean says Misha Malyshev, head of high-frequen- architecture. Chefs stationed around a Matthew Leising covers derivatives exchanges at Bloomberg News in New York. mleising@ cy trading at Citadel. “Now, there is a little courtyard offered up duck Marsala and bloomberg.net John Lippert is a senior writer shift of power to the market participants.” steak grilled with thyme and garlic. The in Chicago. [email protected] Tallying the Trading
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