Majestic Research

Rough Justice for the Chicago Merc

By Joseph Weber
Published: February 07, 2008

In the face of recent regulatory criticism, the futures-exchange firm’s stock has been slammed by investors fretting over the fate of its merger with Nymex

Having watched their stock lose almost $134 a share, nearly 22%, in two days of withering criticism from the Justice Dept., leaders of the Chicago Mercantile Exchange are firing back. They sought on Feb. 6 to reassure investors that any dramatic industry changes would require prolonged hearings and an act of Congress, and are extremely unlikely.

“It’s just one opinion, and they are not the primary regulator on this industry,” Chief Executive Craig Donohue of the exchange’s parent, CME Group (CME), said in a hastily convened analyst conference call. “We will continue to be vigilant in defending our interests.”

Falling Stock
But Justice, which called for a fundamental shakeup in how the futures industry is organized in a commentary sought by Treasury officials, could wield some heavy clubs if it battles the Chicago Exchange on the issue. It could, for instance, withhold approval for the CME’s planned acquisition of the New York Mercantile Exchange (NMX) in a $11 billion deal now under discussion by the two bourses. Or it could make a spin-off of the CME clearinghouse, its lucrative trade-clearing operation, a condition of such a deal.

Taking a longer view, some outsiders suggest that Justice staffers who have long fretted over the CME’s hefty market power in futures could even be laying the groundwork for an overhaul of the industry if trust-busting Democrats win the White House this fall. Certainly, the CME is reeling from the blast by Justice, which suggested on Feb. 5 that “greater head-to-head competition” would lead to more innovation, lower trading costs, and increased trading volume. Over Feb. 5-6, the CME’s stock shed about $133.75 a share, to close on Feb. 6 at 485.25, and the shares had already slid dramatically in recent months with the overall market fall; the stock fetched more than $714 a share in December. Nymex’s stock has gotten caught in the downdraft, too, falling nearly $26 a share in the last two days, to 87.88.

The Future of Futures Trading
The Justice Dept. contrasted the futures industry, where the CME handles more than 85% of all the contracts traded in the U.S., with the more fragmented world of stocks. The New York Stock Exchange (NYX), Nasdaq (NDAQ), and several other exchanges or trading facilities, including low-cost upstarts such as St. Louis-based BATS Trading, compete for volume in stocks, and business is spread out widely. Investors can buy a stock at a New York exchange and sell it on a Chicago bourse, for instance, using a central clearinghouse owned by all the exchanges.

But the futures market is quite different. Customers who buy Eurodollar contracts at the CME can sell them only there and only by using the CME’s clearinghouse. Amid bare-knuckle competition, the cost of trading stocks has fallen sharply, while futures-trading costs have seldom budged.

Justice suggested that clearinghouses should be separate from the exchanges. It argued that the current market structure in futures “has made it difficult for exchanges to enter and compete in the trading of financial futures contracts.” Justice added that current rules and policies “may be unnecessarily inhibiting competition among futures exchanges in the development and trading of financial futures contracts, to the detriment of the economy and consumers.”

"Not at All Impressed"
CME executives counter that competition in the futures world is global and that only a powerful U.S. exchange can go head to head with foreign rivals. Further, they say there’s been no shortage of innovation in new products and that trading costs have dropped as volumes have grown sharply. They argue, too, that newcomers, such as the Atlanta-based energy-oriented IntercontinentalExchange (ICE), demonstrate there is room for more players. Finally, they note that Justice did not stand in the way last year of CME’s $11.9 billion purchase of longtime rival, the Chicago Board of Trade.

“We think that we’ve got the correct view of the market and competition within the market,” argued CEO Donohue.

Some outsiders, puzzled by the timing of the Justice Dept. opinion, argue it will ultimately come to naught. If the staffers wanted to move against the industry and particularly CME, they should have barred the merger of the CME and CBOT, they say. “That was the perfect context,” says Daniel Waldman, former general counsel of the Commodity Futures Trading Commission, the exchange regulator, and now a Washington lawyer. “This comment letter strikes me as a hand-off to the Treasury Dept.”

Others were even more dismissive: “I’m not at all impressed or persuaded,”
says Craig Pirrong, a professor of finance at the University of Houston who studies market regulation. “It’s kind of like, ‘Here’s what we want the world to look like,’ like a policy paper.”

Alternative Exchange
Going a step further, some critics say Justice is just trying to look tough in light of the credit crisis and rogue trading at France’s Société Générale (SOGN). “In our opinion, the odds are pretty good that this is purely optics,” says Doug Atkin, chief executive of the independent New York-based equity research firm Majestic Research.

Still, not everyone is convinced Justice’s move will be toothless or change is not needed. The Futures Industry Assn., a customer group that includes many of Wall Street’s biggest firms, is siding with Justice. “The FIA has consistently supported polices that promote competition in the futures industry,” FIA President John Damgard said in a statement. “We agree with the Justice Dept.’s recommendation that the Treasury Dept. review whether exchange-controlled clearing of financial futures best serves market participants and the overall competitiveness of our financial markets.”

And there clearly is worry among customers that the CME has too much market power. A dozen major firms that use the CME, including Chicago-based hedge giant Citadel, recently banded together to form an alternative futures exchange. Market-technology firm eSpeed (ESPD) CEO Howard Lutnick, working with the firms, has said the upstart will be operating by June.

Same Old, Same Old?
Ironically, if the maverick customers can get their alternative exchange up and running, that would weaken Justice’s case. But recent history is littered with newcomers who failed to make their marks: BrokerTec Futures Exchange, formed by several large investment banks in 2000, tried to compete with the CBOT in Treasury bond futures and failed. A European giant, Eurex, tried in 2004 to do the same, but the CBOT held onto its business by cutting fees as much as 54%, driving Eurex out. Fees then rose sharply. Euronext.Liffe, now part of NYSE Euronext, similarly couldn’t make inroads against CME in Eurodollar contracts in 2004.

“One lesson of this brief history is that when entry into an existing product by a second exchange has occurred, there have been substantial beneficial effects—whether in lower prices, increased innovation, or expanded choice,” the Justice Dept. argued. “Given the benefits of exchange competition, examining potential changes in regulatory policy appears warranted….”

Such arguments, however, are part of an old debate settled long ago in favor of the current rules, CME officials argue. And when all the arguing is through, they could carry the day with Congress, which has long sided with the Chicago markets. Not incidentally, the CME has long, deep, and lucrative ties to politicians in Washington. Former House Speaker Dennis Hastert was just nominated to be a CME director, for instance, and Presidential candidate Senator Barack Obama (D-Ill.) has at times sided with the exchange.

With such clout, the Justice Dept.’s opinion could prove to be little more than an intellectual exercise. “Brokers have been trumpeting this issue for five years at least, and nothing has happened,” says former CFTC Counsel Waldman. “CME is very powerful politically.”