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2013-05-16 10:52:05
The biggest financial exchange you have never heard of
May 11th 2013 | CHICAGO |From the print edition
IN THE competition for most inauspicious introduction to finance, Terrence
Duffy, the executive chairman of CME Group, must surely be the winner. Soon
after convincing his mother in 1981 to borrow $50,000 so he could buy a seat to
trade futures on what was then known as the Chicago Mercantile Exchange, he
lost $150,000 because of a misheard order.
The anecdote holds a number of lessons: how quickly money can evaporate in the
futures market; how trivial the cause can be; and how important it is to honour
an agreement (at least in this area of finance). But the most important lesson
became apparent only belatedly: a disastrous trade can be offset by a big bet
gone right. In Mr Duffy s case that was joining an institution which has become
one of the finance industry s brightest stars.
It did so largely unnoticed by the public. Tourists continue to line up outside
the historic building of the New York Stock Exchange on Wall Street, hoping to
see the inner workings of capitalism even as the NYSE is becoming increasingly
irrelevant.
The magnitude of CME s success is easy to miss. Its quarterly earnings,
reported on May 2nd, were mixed. Profits dipped. The fear that prompts firms to
purchase futures (the contracts traded on the CME to protect firms against
changes, for instance, in the level of a currency and the price of energy) was
less acute. A little more havoc would have been good for business.
Yet CME s growth in recent years has been nothing short of spectacular (see
chart). It now boasts a market valuation of more than $20 billion, nearly twice
as much as Intercontinental Exchange (ICE), another rising star in the
financial firmament. The NYSE is, meanwhile, now worth less than $10 billion.
When Mr Duffy joined the Chicago Merc, relationships with key companies were
considered a financial firm s most important asset. That was certainly true for
J.P. Morgan, Dillon Read and Morgan Stanley, then among the leading banks, and
for the NYSE. But the fate of these firms shows that such relationships may not
help much: two of the banks were absorbed in semi-distress sales; the NYSE will
soon be swallowed by ICE. Morgan Stanley survives, but is in search of a viable
strategy.
In contrast, the Chicago Merc s business was tied to products, not customers.
At first, it was eggs and butter, then cattle and pork bellies. The Chicago
Board of Trade across town, once the more successful exchange, dominated trades
in wheat and corn. The two did not really compete because product-oriented
exchanges in particular benefit from strong network effects . These mean that
more members are better: the more trades exchanges handle, the more liquidity
they can provide and the more activity they attract.
The CME managed to benefit from the same virtuous cycle in futures. It was not
the first to offer contracts on currencies, but it had the best timing. Leo
Melamed, the Chicago Merc s chairman from 1968 to 1973, had learned firsthand
about the value of currency trading from the black markets in Tokyo, where he
lived briefly as a refugee from Nazi Germany. When the Bretton Woods system of
fixed exchange rates fell apart in 1972, CME was quick to offer currency
futures. Contracts tied to the London Interbank Offered Rate (LIBOR) and the
Standard & Poor s 500 index followed.
This allowed CME to lead the creation of an entirely new class of securities,
explains Michael Gorham of the Stuart School of Business at the Illinois
Institute of Technology. Between 1972 and 1982 futures, which once locked in
prices only of physical commodities, were increasingly used for financial
products. These types of futures have since experienced staggering growth and
today makes up more than 80% of the business.
The CME also negotiated the shift to electronic trading better than its
competitors. It was not particularly quick to convert, but it did move once it
faced a genuine threat from European competitors. Other American exchanges,
such as the once larger Chicago Board of Trade (CBOT) and the NYMEX, which then
dominated energy trading, were slower to change. They were taken over by CME.
Leading the pack, the CME was able to benefit from powerful network effects,
just as it did in its old business of handling trades in cattle and pork
bellies. These effects are even stronger in the case of futures tied to
copyrighted indices such as the S&P 500 and because of proprietary clearing ,
meaning contracts initiated on one futures market cannot be transferred to
another much as apps written for the iPhone only run on Apple s devices. In
contrast, options and equities can be traded on any exchange. This explains why
the NYSE s share-trading franchise has many rivals and lost much of its value.
Ordinarily, a big market share supported by strong network effects which help
deter competitors would attract the wrath of trustbusters. But CME has been
left alone so far. In fact, it may now benefit from new regulation, passed in
reaction to the financial crisis. Clauses in the Dodd-Frank act require more
products to be cleared on exchanges, which will push business CME s way.
CME does face long-term competition: others may innovate around it. But, as in
the case of Apple, the CME s main problem is to develop new markets. It has
begun offering niche products tied to areas like a single harvest or debt with
an unusual term structure, such as four years rather than five or ten. That may
seem trivial, but such iterations add up to something bigger: CME is evolving
into an ever more sophisticated institution that plays a key role in many sorts
of financing. If tourists want to get a glimpse of the inner workings of
capitalism, they now have to make a trip to the lovely city of Chicago.
From the print edition: Finance and economics