Celebrating Independence and Competition: A Fourth of July Reflection

Image of fireworks in the background with various stock exchanges and trading platforms' abbreviations and names overlaid in white text, including CME, NYSE, CBOT, and others. JLN logo at the bottom right.
John Lothian

John Lothian

Executive Chairman and CEO

Upholding the Values of Openness, Transparency, and Fairness in Markets While Embracing the Power of Competition for a Better Future; FMX Competition with CME, AI Rivalry in the Making

We just celebrated the Fourth of July holiday and JLN continued its annual tradition of publishing the Declaration of Independence. I have always loved the beginning of the second paragraph:

We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness. 

As a writer who advocates for market-based solutions, I believe certain market principles to be self-evident. I hold that markets should be open, transparent, and fair. These were the values that the open outcry futures markets I grew up with strived for every day, in every session and trade. These values produced the critical concept of price, which was the most powerful news imaginable. They gave the markets and their prices integrity, instilling in traders a way of life that transcended the action of the trading pit. From this openness, transparency, fairness, and integrity came a greatness that spread throughout the world as different financial communities embraced derivatives trading.

Over the years, I have struggled to appreciate other variations of market structure, as they often did not share the same open, transparent, and fair values I expect in a market. These variations often involved bilateral trade with limited price transparency and few or restricted counterparties. Alternatively, some of these market structures altered the very essence of the market itself, resembling Las Vegas Boulevard more than Wall Street or LaSalle Street.

However, these market structures reveal another truth that I highly value: the importance of competition. I believe in the power of competition to create a better world. I believe in competition to improve markets and market structures. I believe in competition. Period.

I encourage competition because I believe it makes all parties better. We bring our “A” game when we face competition.

Competition comes in many forms. It can arise from competing market structures, such as the over-the-counter market versus the listed market. It can involve swaps competing with futures, futures competing with options, or options competing with swaptions. It can also see derivatives competing with cash markets, or different markets competing against each other, like corn versus wheat, beans versus bonds, or gold versus silver. Sometimes, competing markets seem complementary, such as S&P 500 futures versus cash equities, or S&P 500 futures versus the E-Mini S&P 500, back in the days when there was a robust S&P pit.

Competition can also mean having a direct competitor who is out to eat your lunch. In the exchange world, sometimes competition must be mandated by regulators. When various options exchanges started up in the 1970s, there was initially multiple listing of options among the early exchanges. However, due to the lack of a linkage mechanism, there were varied customer outcomes for trades on the same options at different exchanges and brokerage firms. The SEC did not like this and instituted a lottery system for the sole listing of options.

That system worked until the Justice Department intervened, ignoring the SEC and forcing them to reverse their decision. Under pressure from both the SEC and the Justice Department, the CBOE initiated a multiple listing war in August 1999 by listing options on Dell Computer, previously solely listed on the Philadelphia Exchange, and Microsoft, previously solely listed on the Pacific Exchange. On September 11, 2000, the options exchanges signed a consent decree with the U.S. Department of Justice, agreeing not to return to their previous practice of solely listing options. The “gentlemen’s agreement” was no more.

It took the Justice Department to light a fire under the lawyers at the SEC, making them appreciate the market truth of competition through multiple listings. As a result, the options markets are incredibly strong today.

The first major challenge to the Chicago Board of Trade in financial futures from an out-of-town exchange came in 1980 when the New York Stock Exchange created the New York Futures Exchange (NYFE) and listed the 30-Year Treasury Bond futures, which had started trading at the Chicago Board of Trade just three years earlier. Traders from the Open Outcry Traders History Project have told me this challenge was taken seriously, with several Chicago traders buying NYFE memberships and coming to New York for the first week of trading.

At the time of the planned launch, the CBOT was trading 13,000 30-Year Bond futures contracts and 9,000 GNMA futures contracts per day. The NYSE hoped that NYFE could capture a 10 percent market share within nine months.

Ultimately, the NYFE did not prove to be much of a challenge to the CBOT and eventually shifted its focus to listing NYSE-related stock indexes. Before long, the NYSE grew weary of the futures industry and, in 1994, offloaded the exchange to the New York Cotton Exchange.

More competition would come from New York, but the rivalry with the “little brother” down the block was a key component of the pre-electronic trading markets in Chicago. The CME and CBOT were always fighting, primarily for new markets. They rarely tried to take each other’s markets, it seemed. When they did compete, echoes of their commodity market past would influence their contract specifications for financial contracts.

The CME focused on trading short-term interest rates, such as T-Bills and Eurodollars. Meanwhile, the CBOT concentrated on long-term interest rates, including 30-Year Treasury Bonds, 10-Year Treasury Notes, 5-Year Treasury Notes, and Municipal Bonds.

The anomaly in this competition arose when the CBOT chose to list the Dow Jones Industrials, which comprises 30 stocks, while the CME opted for the S&P 500, which includes 500 equity names.

Despite losing the bid for the Dow Jones index after it was auctioned, the competition proved to be a powerful win for the CME. The intense rivalry with the CBOT prompted the CME to split the S&P 500 multiplier from $500 to $250 and then create the E-Mini S&P, which would be 1/10 the size, or $25 per point. The E-Mini was designed to be traded mostly electronically. There was intense competition between open outcry and electronic trading interests, and the original E-Mini market structure required orders for more than 30 contracts to be sent to an open outcry pit. I recall that the open outcry pit only accepted Fill or Kill order types. Needless to say, no one I knew used this method; instead, they simply broke larger orders into smaller parts. In May 2001, the CME dropped the 30-contract rule, and volume soared.

Amidst the competition between the CME and CBOT in stock index futures, a subtler competition was taking place in interest rate futures. As open interest in Eurodollars grew, it became the largest futures contract in the world by open contracts. Since 1988, Eurodollars had been the largest contract at the CME by both volume and open interest. A shift in the yield-curve favored the short-end of the curve and the CME’s 10-years of listed Eurodollar contracts. 

Another challenge for the CBOT arose in the Treasury complex after it attempted to take on Cantor Fitzgerald in cash Treasuries. This was done through its Chicago Board Brokerage (CBB) electronic trading joint venture with one of Cantor’s biggest rivals.

The CBB conflict was messy, as it involved the CBOT, through its Ceres LLP partnership, contracting with Market Data Corporation, a company in which Bernie Cantor’s widow Iris held a 66 percent ownership stake. Because she was a partner with Cantor Fitzgerald, she was sued by Howard Lutnick and Cantor Fitzgerald for breaching her obligations under the firm’s partnership agreement.

The CBB was a failure. I remember evaluating the value proposition as an electronic trading broker and finding the $5,000 per month cost per screen to be absurd for a futures broker without any cash Treasuries business.

However, the competition between the CBOT and Cantor Fitzgerald sparked a rivalry that continues to this day. Cantor Fitzgerald went on to launch the Cantor Exchange in a deal with the New York Board of Trade. Joe O’Neill, a senior vice president at NYBOT, served as the Cantor Exchange president.

The initial offering from the Cantor Exchange wasn’t a threat to the CBOT, as it was a “call-in” market rather than electronic trading. The rules for a call-in market are completely different from those of a futures market; once your bid is off the market, it is canceled. As someone who traded a lot of Treasury futures at the time for various Commodity Trading Advisors, this approach seemed to assume an awful lot of risk for no apparent reason.

The electronic version of the Cantor Exchange, which operated on the eSpeed platform, was severely impacted by the September 11 attacks on the World Trade Center. These attacks tragically killed 658 Cantor employees in the north tower, amounting to 68.5% of Cantor Fitzgerald’s total New York workforce.

Another factor in exchange competition during this era was the Wagner Patent. Susan Wagner, a former executive director of the Commodity Futures Trading Commission, received a patent in 1990 for online futures trading after a seven-year application process. The patent, which included methods for regulatory record-keeping and simultaneous order matching, was transferred to Electronic Trading Systems Corp. (ETS) by 1999, The Wall Street Journal reported. ETS then filed lawsuits against various exchanges and trading firms, including Cantor. In April of 1999, eSpeed acquired the patent for $1.75 million and took over the ongoing litigation against the CME, CBOT and NYMEX as the plaintiff.

The CME and CBOT ended up settling with Cantor in August of 2002 for $15 million a piece, paid over three years, so the CME could move forward with its IPO. NYMEX settled with Cantor for $8 million for the Wagner patent in December of 2003. 

A competitor to Cantor Fitzgerald emerged in the cash Treasuries market that also featured a futures exchange to compete with the CBOT. BrokerTec was designed to offer competition in the bond market on both fronts, though its primary focus was on the cash side. The futures exchange, backed by a consortium of banks, aimed to force the CBOT to lower its prices. As a result, the banks saved millions in reduced fees due to the nominally competitive BrokerTec Futures Exchange.

The challenge from Eurex, with its Eurex US offering, posed a serious competitive threat to the CBOT. Eurex US used the same a/c/e Alliance connectivity that the CBOT had previously used. After Eurex US faltered, I broke the story of the great trade it made: buying the exchange licenses from BrokerTec for $1 in return for millions of dollars in guarantees for volumes or revenues.

When Eurex came to town to take on the CBOT, its offices were just one floor away from mine in the CBOT Building. I was asked to moderate the big kick-off event panel discussion, one of several such invitations I accepted to help narrate the story of market competition and Chicago’s trading scene. Eurex US eventually became U.S. Futures Exchange after Eurex sold most of its interest to Man Financial. Although it eventually shut its doors, the garish orange paint of its offices remained for years.

Then-new CBOT CEO Bernie Dan turned the CBOT-Cantor relationship from red to green when he announced an agreement with eSpeed in 2002. My comments at the time in this newsletter were quoted by then CBOT Chairman Nickolas Neubauer in his annual report to the CBOT. In the deal, Espeed, Cantor Fitzgerald’s electronic trading subsidiary, partnered with the CBOT to distribute CBOT products through the eSpeed system. This agreement allowed customers to trade both cash and futures in real-time on eSpeed’s platform. CBOT’s electronic futures markets were available alongside eSpeed’s cash marketplaces for government securities globally via eSpeed’s new SuperQuad 5.0 technology.

Liffe came to Chicago in the early 2000s and relaunched its Eurodollar offerings, which prompted the CME to increase the trading of Eurodollars on the screen. Competition was beneficial, assuming you could adapt to the times. For those who clung to open outcry trading until the end, competition had its moments, but the outcome was not favorable.

Liffe also invited me to moderate a panel at its launch event in Chicago for Eurodollar trading. I love competition, and I was right in the middle of it.

It was my story about the acceptance of electronic trading by traders in the Eurodollar pit at the CME, after being invited over and escorted around from trader to broker by then CME board Treasurer Pat Lynch, that caused me to take a breath.

My story about the CME Eurodollars’ move to the screen triggered a significant investment by a Kansas City mutual fund advisor, who added substantially to his position in CME shares. This action pushed the price up by approximately $30. At the time, CME shares were trading at around $190, and they rallied in a day to about $220.

The analyst was a reader of my newsletter, but more importantly, he had been shown the famous “hockey stick” chart of CME revenues. This chart highlighted the inflection point of sharp growth when Eurodollars moved to Globex. It was one of the key charts that the Jim McNulty-led CME team presented to investors during their presentations.

This was an example of external competition being beneficial for the CME’s profits. It also demonstrated how profitability and opportunities were draining from the trading floor due to competition from Globex. Like death and taxes, the triumph of electronic trading over open outcry was inevitable.

Amidst all this, another exchange emerged: ELX, backed by BGC Partners and a consortium of banks and market players. Led by former AMEX CEO Neal Wolkoff, ELX, which was once a MarketsWiki sponsor, had a decent run trying to take on the CBOT and CME. However, it eventually faded from the competitive landscape. I still regularly use my ELX coffee mug from the FIA Boca conference on trips.

There is far too much history for me to recall all the competition and drama in the cash bond markets of the 2000s, including the interdealer broker space after the financial crisis and the rise of MarketAxess, TradeWeb, and other players. Thus, I will save that for another day.

The latest challenge for the CBOT’s Treasury complex comes from FMX, backed by BGC Partners and a consortium of market players. FMX is actually the former Cantor Futures Exchange L.P., and according to the CFTC, FMX is a division of the exchange.

This effort benefits from lessons learned from past mistakes, including the importance of finding a value-added partner for a clearinghouse. In the case of FMX, it has struck a deal with LCH, owned by the London Stock Exchange Group. LCH offers a valuable assortment of customer interest rate swaps to margin against FMX futures.

The real challenge for FMX will be to define itself and not be overshadowed by the 800-pound gorilla it is attempting to wrest the Treasury complex away from. Howard Lutnick enjoys a good fight, and while this is a competition, it is also something much more subtle.

It is a competition between two exchanges of vastly different sizes during a time when artificial intelligence tools are transforming the world around them. This competition will be decided by who leverages AI most effectively, particularly when engaging with the trading community.

Perhaps this competition will end like the others, with the CME on top. It might end up being more about banks and proprietary trading firms saving on fees at the CME rather than earning discounts at FMX for their trading volumes. However, this time, FMX might figure out how tools like AI can make a significant enough difference to disrupt the CME’s monopoly power.

I am not discounting FMX and Howard Lutnick at all. Lutnick and his team are motivated, have proven they can learn from the past, and are operating in the most dynamic market and broader cultural era of disruption since the introduction of electronic trading and the personal computer.

This competition between CME Group and FMX might just be the most interesting exchange rivalry yet.

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