The significance of CME’s decision to become a Futures Commission Merchant (FCM) is limited only by the imagination of CME management.
This article describes the inadequate services that exchanges and futures markets provide to retail traders. This shows how CME has embarked on a path that could lead CME or its competitors to revolutionize the retail space. The result would be a considerable reduction in the costs of retail investors and a less risky financial market.
CME’s bid comes despite CEO Terrence Duffy’s earlier objection to a bid for the same capacity by FTX, a much smaller exchange. CME joined a chorus of complaints about the FTX app, saying “the FTX model would significantly increase market risk.” FTX, for its part, believes its proposal will bring 21st century technology to US markets, adding that it has safeguards in place to limit risk.
This article argues that to revolutionize the structure of our financial market – to improve market stability and bring retail transaction costs to a bare minimum, the CME should face a new competitor that genuinely represents the interests of retail investors.
To ensure that this new exchange serves the interests of retail traders, it should have a different ownership structure. This exchange could be owned by its retail customers, like Vanguard’s ownership model. In fact, the cheapest way to set up this new exchange would be for the new exchange to be closely affiliated with Vanguard itself.
The CME app
The CME, in a low-profile move, applied to the Commodity Futures Trading Commission (CFTC) for permission to become an FCM. The generally open-minded CFTC should approve.
What is the potential benefit to the retail audience? The sky is the limit, up to and including the replacement of SEC securities exchanges as the dominant venue for global commerce.
Of course, for the CME to suggest this breakthrough result would immediately kill its FCM application. CME claims that the application is a defensive response to an application by FTX (largely a cryptocurrency exchange) for the same FCM privilege. Of course, an alternative interpretation is that the CME maneuver is indeed a lamb-like defensive move.
If so, CME must believe that there is a possibility that retail investors will understand the value to them of an exchange with an FCM license and that their users can switch to FTX unless the lower costs of FTX are compensated by the CME.
For now, there will be more than enough controversy created by the near-term likelihood of the CME directly competing with its own clearing FCMs, most of which are subsidiaries of holding companies that also host SEC-approved brokers. . These bulge bracket players weigh heavily in Washington and Wall Street. If they oppose the CME’s decision, CFTC approval will be less likely.
The CME’s self-compensation will clearly reduce the cost to day traders and hedgers of using futures markets. But to really shake up the financial markets, CME only needs to add one more capability: to also become a securities portfolio manager.
Can the CME fix our organized financial markets?
The SEC’s National Market System (NMS) is a complete failure. The NMS rules adopted by the SEC are intended to promote:
- Making the best market-wide prices available to retail traders
- A minimum tick size of one penny
- New joint industry plans that allocate revenue to self-regulatory organizations (“SROs”, exchanges and ATS) for their contributions to public price discovery and promote wider and more effective distribution of market data (exchange grants) for market making
What’s wrong with the NMS? The NMS did not achieve these goals. Instead, the NMS disastrously curtailed retail investors’ direct use of SEC-approved exchanges. These exchanges are now dominated by computer-initiated transactions generated by algorithms, which now constitute up to 70% of all exchange transactions.
Retail trades are now primarily executed by wholesalers (large impersonal trading firms, e.g., Citadel’s brokerage services subsidiary, Virtu, Jump Trading) who pay retail brokerage firms for their retail orders, aggregated by retailers in sufficient volume to be profitable for the Wholesalers. This practice is known as Payment for Order Flow (PFOF).
What ruined the NMS? Several unexpected aspects of e-commerce have inspired the big three exchange management firms (CBOE, NYSE, NASDAQ) to reach out to algo traders (traders who program computers to execute trades that take advantage of NMS inefficiencies). Algo traders are another aspect of the wholesale business, known as high frequency trading (HFT). There is a symbiotic relationship between these HFT wholesalers and exchanges that benefits both, but at the expense of retail traders and taxpayers.
NMS fixable inefficiencies
- Exchange transaction engines in different places. The movement of commerce from human execution of commerce to electronic execution was accomplished by what must have seemed like a sensible decision to locate exchange transaction engines in New Jersey warehouses. Each exchange purchased its own warehouse. Due to the spatial separation of exchanges, an algorithm-friendly trade-off is created due to the well-known fact based on the theory of relativity that there is no meaningful way to identify a consistent meaning of the NMS notion of ” National Best Deal and Deal (NBBO)” in separate locations when orders are placed at close to the speed of light.
- Flatsharing. To capture a slice of the profitability of algorithm-based inter-exchange arbitrage, exchanges sell brokers space adjacent to their trading engines. It immediately became clear to the dealers that they had to co-locate with all trades to compete successfully for customers.
- Maker-taker fees. The SEC subsidizes bids and offers that are used in the SEC’s National Best Bid and Offer (NBBO). This has created a joint exchange/wholesaler strategy where wholesalers offer tighter spreads when customers cannot access them, thus collecting SEC subsidies for exchanges and arbitrage profits for wholesalers.
- Proliferation of exchanges. Exchange management has not escaped the fact that every exchange has generated these revenues, whether retail traders have used them or not. The result has been an explosion of new exchanges, all collecting the same revenue from NMS-inspired fees.
A company that combines a securities portfolio manager with a futures clearing house and a broker directly deals with the shortcomings of securities exchanges and futures exchanges.
How CME’s Decision Leads to an NMS Fix
One of the reasons the CME is empowered to fix the NMS mess is that it is not part of the NMS. Additionally, the futures trading rules eliminate the problems the SEC has created for itself with the NMS.
Advantages of futures exchanges over stock exchanges
- No inter-exchange arbitration trading. CME issues all the futures contracts it trades. Additionally, trading the instrument without using the exchange clearinghouse violates the rules of the exchange. This eliminates the exchange proliferation problem that the SEC has created for itself.
- No regulation Q 50% margin requirement. The exchange may manage the level of clients and clearing member margin payments in accordance with the exchange’s perception of the current risk in each market. Historically, clearing houses could set client margins above those set by the exchange, but perhaps the advent of exchange-traded trading by the CME will eliminate this unnecessary cost.
- No proliferation of exchanges. There is no regulatory reason why two exchanges cannot trade the same instrument. But there is no way to offset a long position on one exchange with a short position on another, so trading in every instrument has always gravitated to one exchange or another. Thus, CME has come to dominate the futures trading space.
- No Maker-Taker fees. Because competition between exchanges has always been settled by superior liquidity generation, the CME never pays one type of trader to take orders from another.
Disadvantages of Futures vs Exchanges
- No control of delivery or cash payment. The key problem with futures exchanges, laid bare by the demise of LIBOR, is that futures are dependent on developments that kill contracts in the deliverable instrument’s spot market.
- A futures contract cannot pay dividends or interest. The greatest weakness of futures trading is that there is no possibility of payment of securities income to buyers. Adding an exchange wallet manager would make these payments possible at a fraction of the cost of receiving these payments in the NMS.
Capitalize on CME’s brokerage capacity
If the CME settles for the FCM designation without exploiting the opportunities created by the capability, not much will come of it.
But if the bulge range FCMs lose their clearing member privileges, I believe they will open up competition in the new futures or similar futures markets created by the FCM. These new exchanges if they simply clone the CME model will achieve nothing. CME’s liquidity advantage will blow up any de novo futures exchange that does nothing but mimic the standard futures exchange model.
The path to market dominance will depend on a de novo exchange initiative to combine the benefits of futures trading with the ability of stock exchanges to create their own securities.
I doubt CME sees the huge opportunity of adding FCM capability that I see. On the other hand, as this Wall Street Journal article reports, Craig Pirrong, professor of finance at the University of Houston, points out that “by creating its own FCM, the company may be laying the groundwork for a decision regulation that disrupts the traditional relationship between futures exchanges and brokerage houses. This result is the minimum possible when companies like FTX induce established companies like CME to grudgingly consider an improvement to the status quo.