The Innovator’s Dilemma Meets Fertik’s Law

John Lothian

John Lothian

Executive Chairman and CEO

New Start-Up Exchanges Should Help, Not Hurt CME Group

The late author and Harvard professor Clayton Christensen coined the phrase “the innovator’s dilemma” in his popular book by the same name. In the book he describes why some well-run companies lose their dominant market position through the entrance of a competitor with a disruptive technology.

He uses as an example  the personal computer and its smaller, slower disc drives, which  disrupted “big iron” mainframe computers by offering a cheaper solution that was good enough. 

The CME Group’s dominant market position in the U.S. futures market, which some classify as a monopoly, has spawned two separate challengers built on the model of the innovator’s dilemma. The Small Exchange and the Fair Exchange are seeking to disrupt the CME’s dominant position, or at least carve out a place of their own in the U.S. futures market landscape.

It is the latter that is really the truth. The CME Group will most likely benefit from these new exchanges while not sacrificing their higher margins.

(I would also mention the MGEX, which was recently bought by MIAX International Holdings, Inc. as a potential disruptive innovator, but they may be more of an ancillary player in futures and more potentially disruptive in the equity options space.)

While it can be rightly pointed out that the CME Group has a history of offering smaller contracts with the E-mini S&P and even E-micros more than 15 years ago, it was their recent move to expand their micros offering after The Small Exchange was announced that has brought the innovator’s dilemma construct into play.

Both The Small Exchange and FairX are entering the futures market with a page taken right out of the book. While the focus might be on the size of the contracts, that might miss the disruptive point. It is not the size of the contracts that is disruptive, it is the fee structures.

When the CME Group launched Micro E-mini S&P 500 contracts, they quickly became the most successful product launch in industry history. They went small on the micro contracts’ size, but are still big on the fees. Member fees are of course less and complex. For a non-member customer, an E-mini S&P contract costs $1.23 to trade and the one-tenth sized Micro E-mini S&P contract is 25 cents. 

One tenth of $1.23 would be 12.3 cents. The CME Group is charging twice that amount.

One of the key elements of the threat posed by competitors in the innovator’s dilemma is that they come with lower margin offerings. The CME Group is all about maintaining its high profit margins just like the well-run companies written about in “The Innovator’s Dilemma,” which these competitors see as an opportunity.

The fee structure of The Small Exchange includes transaction fees for 7 cents if you pay a one-time subscription fee of $100. There are no market-data fees at The Small Exchange – they are free!

For non-subscribers, the fee is 15 cents and for market makers it is 5 cents. All of these offerings are significantly below the CME’s 25 cents for a micro future.

At FairX, they turn the traditional fee structure upside down. It is the FairX fee structure that has the most potential to be disruptive in the model of the innovator’s dilemma. 

The non-professional customer fees are just 2 to 5 cents at FairX. For professional traders it is just 5 to 10 cents. Market makers however have to pay 35 to 40 cents. And, again as at The Small Exchange, at FairX, “Market Data is free for all market participants.”

FairX is also offering an incentive program that rewards brokers for customers they bring to the exchange. Many if not all exchanges offer some kind of broker incentive program. The programs might be rebates paid based on trades, or co-marketing agreements for advertising campaigns pushing a particular product. FairX’s broker incentive program is meant to be different in the way they are tilting the cost away from the customer and towards the market maker and sharing with the broker.

On the face of it, this paying brokers for bringing clients to the exchange seems to smack of “payment for order flow (PFOF),” the system utilized in the equity markets to reward brokerage firms for routing their customer orders to a particular counterparty. 

However, this is futures, not equities. There are no bilateral relationships. All trades are executed in a central limit order book or CLOB. The trade the customer brings to the market is guaranteed to get the best price because there is only one place to trade. There is no delay, no dark pools or 50 different locations that promise to match the unmatchable National Market System, or NMS, price. 

What FairX gleaned from the equity PFOF experience though is that customer orders are valuable to market makers on a micro market structure basis. There is information in the customer orders that can help market makers in their own trading decision-making.

Thus, futures customers should be rewarded for providing this information and market makers should be charged for using this information. And brokers who do the hard work of soliciting and educating customers should also be rewarded.

But most importantly, while FairX is a for-profit entity, they are willing to accept lower profit margins. That fact alone makes it disruptive.

Another factor that is influencing this move to small contracts is the price appreciation of assets and commodities and the negative impact that has on the profitability of futures commission merchants, or FCMs.

FCMs have an incentive to find active trading customers who trade smaller contracts. The opposite type of customer, one who does not trade that often and trades bigger contracts, costs FCMs a lot of money in regulatory capital. An FCM must hold 8% of the amount of customer risk-based margin funds in regulatory capital, according to CFTC Regulation 1.17(a)(1)(i).

Eight percent of the total risk margin requirement (as defined in § 1.17(b)(8) of this section) for positions carried by the futures commission merchant in customer accounts and non customer accounts.

What that means is that for a customer who has margins of $100,000, the FCM must have $8,000 in regulatory capital. If that margin increases over time to $200,000, then the FCM must put up $16,000. If the FCM is making the same amount of money, but is having to put up twice the amount of regulatory capital, then their profit margins are being cut in half. The price appreciation of financial assets and commodities have exerted this exact kind of pressure on FCM profitability. 

The most egregious issue for FCMs trading the CME’s bitcoin futures is the margin of 45% of the value of the contract. When the contract went to $65,000, the margin was $29,250. The FCM also had to put up $2,340 in regulatory capital for each bitcoin futures contract it had on its books. Compare bitcoin to a 30-year Treasury Bond contract valued at about $160,000, which has a current margin of $3,500. 

In 2003, the margin on the 30-year Treasury bond futures was $3,200 when it was trading at about 105-00, or a $105,000 notional value. For a $160,000 notional value of today’s 30-year Treasury bond, the CME charges $3,500 in margins, which requires the FCMs to have $280 of regulatory capital. That is a long way from the almost $30,000 required for a bitcoin when prices were at their highs.

You can see the problem of bitcoin futures’ 45% margins. Regular or even higher-commission rates can’t compensate the FCM for the cost of the regulatory capital they must put up for bitcoin futures. This may have been a factor in why the open interest of bitcoin futures at the CME has trended down when the price exceeded the old high near $20,000 and exploded to $65,000 this winter and spring. A smart FCM would have hit a bitcoin futures trader with a capital charge to compensate for this margin anomaly. 

Another issue FCMs face is that last year’s volatility in Treasuries around the pandemic,  the Texas freeze, and the price collapse of oil to below zero are still reflected in the margins being charged today. The SPAN margin system takes into account historic volatility of last year when coming up with today’s margins. 

This higher margin level is eating into FCM profitability, as described above. This has FCMs looking for alternatives like The Small Exchange or FairX for ways to improve their profitability. While these start-ups could be considered an afterthought to the bulk of the FCMs’ business on the CME Group and Intercontinental Exchange markets, the moves the FCMs are making to support them are representative of the forces influencing their profitability struggles

While the FCMs are seeing a negative impact from higher margins, the profit margins of the dominant exchanges are staying strong. This has them open to the FairX approach that rebates the FCMs exchange fees for bringing a customer to the exchange and having them trade.

Both exchanges are giving away market data free, which is a sore point with market-data providers who have seen the CME’s market-data fees increase. Free market data will be popular with the retail crowd the two exchanges are aiming at and help attract retail traders to these new markets.

What these two exchanges have seen is that the needs of the retail traders were not being met by CME contracts whose notional values have greatly appreciated over the years, squeezing more and more retail traders out of the market. 

There may be a good reason why CME Executive Chairman and CEO Terrence Duffy says CME’s products are for institutional market participants, not retail traders. The contracts have all appreciated in price so much in recent years as the U.S. Federal Reserve has kept interest rates low and flooded the markets with cash.

However, we have seen a retail trader revolution in the equity and equity options markets in the last few years. Retail traders are empowered by the accessibility of electronic markets, which they can trade from their phones. It was high-priced equities and electronic and algorithmic trading that promoted the use of “odd lots,” the trading of less than 100 shares of stock in a trade. Long thought of as something  uninformed investors traded, odd lots are now used by the most sophisticated traders and investors to make their executions more efficient. And broker commissions on odd-lot trading, long highly priced, are now free at many retail friendly brokerage firms.

It is this idea, though – making trading of all products more affordable to the retail trader – that is at the core of The Small Exchange and FairX value proposition. That is not just commissions or fees, but the size of the trading instrument or contract. FairX not only has micro contracts about the same size as the CME’s micros, FairX also has nano contracts one-tenth the size.

Both exchanges also want their contracts to be simple and easy to trade. There are no worries of deliveries with either exchange as all contracts so far are cash settled.

This nano-micro ecosystem at FairX will bring new traders into futures that were squeezed out by the larger contracts. It will bring in new traders who are used to the concept of bite-sized risk from their experience trading cryptocurrency or equity options, or making odd-lot equity trades. 

The good news for the CME is that this should bring new volume to the exchange  in the form of arbitrage and hedging, without them having to lower their profit margins. In other words, The Innovator’s Dilemma’s concepts may have helped spawn the new competitors, but the CME can prosper rather than perish from the disruption the competitors offer.

To prove this point, I refer you to Fertik’s Law, which Michael Fertik wrote about in my newsletter 20 years ago during the time single-stock futures were being planned and for which I coined the name. 

Fertik’s Law states:

Increasing entropy geometrically increases arbitrage opportunities. In other words: More products and more relationships among products result directly in more arbitrage possibilities, and they do so at a geometric rate, faster than a simple arithmetic increase.

If both exchanges find a niche, FCMs will have found customers who trade more, smaller sized contracts that are not a strain on their capital.

Thus, The Innovator’s Dilemma meets Fertik’s Law. The current futures market version creates the ecosystem for the start-ups to prosper and the CME Group to avoid becoming an addendum chapter in Clayton Christensen’s book.

 

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