Scott Early, a partner with Foley & Lardner LLP, is a member of the firm’s securities, commodities and exchange regulation and transactional and securities practices. Early also is general counsel to the Kansas City Board of Trade and provides counsel to numerous other financial industry entities including exchanges and clearing houses. For 10 years prior to joining Foley, Early was general counsel to the Chicago Board of Trade (CBOT). Early recently talked with MarketsWiki senior editor/producer Christine Nielsen and discussed his views on an exchange for futures (EFF) block-trade mechanism offered by ELX Futures that allows traders to move their Treasury futures positions from one exchange to the other. CME Group has claimed ELX’s EFF violates CME’s rules. Both exchanges have petitioned the Commodity Futures Trading Commission (CFTC) to decide the issue.
SE: None of the public discourse on this [subject] addresses the real issue…The real issue, in economic terms, is a natural entry barrier issue. If somebody is starting a new exchange and they want to come in and try to compete with an existing product at an existing exchange, they are at, as economists would call, a natural entry barrier disadvantage. That being said, traders need liquidity in order to be confident in trading. Liquidity means not just the ability to put on a trade, but more importantly the ability to get it off at a reasonable price – at a time of crisis, so to speak, when blood is running in The Street.
BrokerTec would be a decade-ago model for what ELX is doing now. BrokerTec also tried to make inroads into what was then the CBOT Treasury complex. The owners of BrokerTec were the Wall Street firms who comprised the majority of the primary government dealers in the cash side of government bonds.
Yet, they couldn’t really make inroads into the established Board of Trade contract positions, because even their own traders who reported to different people didn’t have the confidence that they could put a trade on at BrokerTec and get out of it at the price they needed to in times of crises, because of liquidity.
So what ELX is doing is…going after the Merc’s market and trying to take it. Let’s start with that premise. Not that they are just starting as an exchange and coming in with a new product.
What they are saying is that we know from prior experience about this natural entry barrier; but if we could figure out a way we could say to traders, you are perfectly free to put trades on with us, and if you’re concerned about taking them off from us, we will give you a means by which you can take them off at the Merc. Now, that’s a very unique situation in the context of economic regulation in what is otherwise a free market.
Because the analogy would be… well, Microsoft has the dominant share of the marketplace. A new market entrant says that if something goes wrong, Microsoft will substitute our product for it. If Microsoft refuses to do that, we are going to claim that they being are anticompetitive.
The superficial battle is not reflective of what the real battle is. What ELX is trying to do is to piggyback on the liquidity that the Merc has built up, most particularly, in its clearing house, which is proprietary.
To me, having said all that, when you talk about the difficulty in their rules in the context of the Commodity Exchange Act/ antitrust principles and anticompetitive principles, the discussion is 180 degrees from the reality. The reality is, why should ELX be allowed to have free access to the proprietary development of the Merc in their contract and their clearinghouse? And that’s the question nobody is addressing publicly and upfront.
Now, it could be that somebody in Congress would say they think that’s a good idea. They think that’s it’s pro competitive…These are public markets. They are regulated by Congress, by the Commodity Exchange Act, by the 1934 Act, whatever it is. So they think that should be permitted. But until Congress actually takes that kind of action you don’t have a mandate in the Commodity Exchange Act that would permit [something to that effect].
Look at the model. I just gave you BrokerTec as a historical example and said that ELX is trying to do in essence [the same thing]… but you look at the only successful market entrant in the last 20 years – ICE – and they have been a very successful market entrant, and competitor. How did they do it?
ICE’s CEO Jeffrey Sprecher came in, some would say by the back door. I would say he came in the side window. He came in with products that were basically just a little off of regulated futures. Today we would call them standardized swaps. They were non-regulated futures…Gradually he got himself into the position where he got those products to be listed universally.
He became – and has become – the only viable competitor to the CME as a result. The reason I mention this is that it’s an example of how you can overcome this natural entry barrier that exists in the futures world. He’s done it by taking himself kind of around the side and coming into the house that way. ELX is trying to come through the front door with a free pass.
Q: Even though the ICE has been successful, the CME continues to be, of course, very strong. Why is the CME so afraid of ELX?
A: I don’t know that they’re afraid, as much as they are offended…I use the word offended, because I think they view it as why, in the regulatory context, should just anybody be able to free ride on what we’ve taken 50 years of hard labor and investment to create.
Those are the issues that people are talking about that are really at issue in this rule-following context. Of course lawyers are going to address the rule-approval context on the basis of the regulations…
The Commodity Exchange Act says the Commission shall take the least anticompetitive means in administrating these markets and approving the rules. That’s a very weak antitrust/anticompetitive mandate. The good news is that means the Commission has a good deal of latitude…
Futures are very different animals, and the risk taken in futures is unique. Price discovery is crucial to that… Go back to the early 80s and the creation of the energy markets, again this is ancient history, but it’s still instructive… The NYMEX was a very small New York exchange. The dominant competitors were the Board of Trade and CME. All three exchanges tried to bring up energy contracts – virtually the same products – at the same time. NYMEX won. The least of the three competitors. If you were taking bets in Las Vegas, they would have been a far distant third in that race, but they gave the market participants what they wanted.
Q: So this is probably fresh in the CME’s mind that they shouldn’t underestimate their opponents?
A: They know. If I remember, you can bet they have people who remember.
Q: The CME is perceived as having strong ties in Washington. Any thoughts on what they may have up their sleeve in terms of lobbying in Washington? How they may try to keep ELX at bay?
A: I’m sure the Merc loves having that image, but…nobody has that kind of absolute influence…. It’s chaos [currently in Washington]. I spent a lot of time in Washington in the 80s and I can tell you it’s totally changed, including in the entire way the nation is being run right now. So I would say that the rumors of the Merc’s extensive influence in Washington are overrated. But right now in particular you have a very strong agency in the CFTC and you have a chairman in Gensler who is not afraid to use all of these powers…It’s a strong chairman agency – by law – the way it’s structured. So when people say The Commission, first and foremost that means the chairman. He will have the first say.
Q: If there would be a Merc lawsuit, could that take awhile? Would that slow things down?
A: Yes and yes.
Q: So how do you see all of this playing out?
A: I would say it’s a major league chess game right now. I don’t know that I could predict the resolution of it….I have a…bias. I came up on the exchange side. I’m somewhat sympathetic to the CME’s position if somebody wants to come in and say we want to take full advantage of 50 years of your proprietary investment in these products. There’s something about that that just does not seem right to me.
Q: What about on the ELX side? Do you think they that have any legal or regulatory avenues that they haven’t pursued yet?
A: I think they are doing the right thing for them.
Q: Are any other parts of this issue that are being missed?
A: I would like to see more from the major users of these products – including pension funds. We’re talking about people who have huge investments in United States government debt with futures contracts. I’m not so sure they’d be in favor of it. A great many of these people say they are very well served by the current…system. What would they think about having a bifurcated market? I’m not sure they’d be in favor of it. I think a great many people would say they are very well served by the current system.
Q: So you don’t think they’d benefit from any cost savings?
A: I’m not sure there is cost savings these days. I think costs have been shaved down pretty low. It’s computerized trading these days, and 78 percent of volume is on the computer. Some say there is potential savings on the clearing side… I would worry about that. Clearing is the only thing that stands between systemic failure and isolated failure. That clearing system is vital and critical to the entire economy.