Futures industry professionals at their annual bash in London last month were asked to debate the motion "futures exchanges have enjoyed their last good years". This wasn't about open outcry, since they'd condemned that roundly the year before, voting with hand-held electronic devices. Now the issue was whether exchanges, even automated ones, will thrive in any form.
In the pre-debate vote, 58% of those present said they won't. But by the end, as in all good debates, some of them had changed their mind: 52% now saw a rosy future for exchanges.
What had altered their view? Was it the powerful argument that futures and derivatives volumes have always increased year-on-year since the early 1980s? Was it the conclusion that almost any trading place, even the internet, qualifies as an exchange? Or was it another factor which could be called "the passion of Pat Catania"?
Dawn of the cybertrader
Catania, solid, forty-something, is executive vice president for business development at the Chicago Board of Trade (CBOT). Even his name - Irish with Italian connections - seems the essence of what put Chicago on the map. Catania, in an impassioned speech, praised the Chicago pits' ability to evolve along with new markets and new technology.
The CBOT had just introduced one of its fastest-growing and most successful products ever, on the Dow Jones Industrial Average. The CBOT's Project-A was taking it electronic, and its Chicago Board Brokerage (CBB) joint venture would automate US treasury cash and repo trading. The pit traders already have hand-held devices which can execute trades not only on their floor but in the cash markets in New York. Even if the pits go totally electronic, these exchanges will still flourish, said Catania.
"Yesterday we signed an agreement with the DTB," he said proudly. The DTB, the automated German futures exchange, recently killed the German Bund future contract on the London futures exchange Liffe - a minute's silence was held on the trading floor as the June contract expired: all the volume is now in Frankfurt. "The trend is your friend," said Catania, "and the great Chicago exchanges are following it."
It wasn't just what he said, but how he said it. Nostalgia for the roar of the 150-year-old Chicago pits, plus the notion that the security, transparency, liquidity and capital efficiency of an exchange will always be needed, carried the day.
And it is difficult to imagine a world without a bunch of macho traders somewhere, even if their coloured jackets are more like spacesuits and their fingers are wired to super-terminals. Much of this is happening.
Brian Kaye, chairman of Fimat International Banque, had a bet with colleagues at the meeting (sponsored by the Futures Industry Association and the Futures & Options Association) that, even in 10 years, open outcry will still exist in Chicago, if not in London. ("It's not a very big bet," he whispered.)
Kaye isn't convinced that computers have beaten open outcry. When Matif, the French futures exchange, put its electronic system in direct competition with its own trading floor in April, "the brokers had no choice but to close their teams within two days," says Kaye, "because of the strikes". Likewise the Bund contract wouldn't have come back to Frankfurt, says a Liffe official privately "if it hadn't been for a German national effort".
For defenders of open outcry, such as Liffe chief executive Daniel Hodson, the "jury is still out" on whether electronic systems are better than the pits at finely pricing short-term interest-rate (Stir) contracts or complex option trades. "Why throw out something that outperforms screen trading - yet?" echoes Liffe's deputy chief executive John Foyle. "Why follow some line of dogma?" Liffe plans to have full electronic capability, Liffe Connect, by the middle of 1999.
"If we could have done that by Thursday this week, we would have done it," admits Foyle. The best test is to run open outcry and electronic trading in parallel and see which one the customers prefer. "We're moving to a new paradigm," enthuses Hodson, "with open access, a modular system, API [application programmer interface - which gives access to multiple futures markets on a single screen], and global networking. We're testing radio headsets and automatic trader cards. In the future you'll see voice-recognition devices. It will be a pit surrounded by electronics." Although the CBOT is now 80% electronic and "the customer does everything electronically, floor trading is still good for options" says CBOE chief executive Bill Brodsky. With all the different strike prices "we're trading 50,000 different securities", he says.
Clearing is the key
CBOT chairman Pat Arbor commented last month however, that the CBOT would move totally from open outcry to electronic trading, if that is what the customer wants.
However, it must be pointed out that the customer, that is, the end user, is indifferent to the choice of system used, provided he gets the service he wants. He will choose the intermediary which produces the best price or the best execution. The intermediary must decide where and how to achieve that. It may be on- or off-exchange, electronic or open outcry.
Werner Seifert, chief executive of Deutsche Börse, warns that no exchange can be complacent. "An exchange doesn't have an end in itself. I can well imagine a world without exchanges. So exchanges can't avoid cooperating with each other."
The key to their survival may be cross-border clearing. There is certainly more confidence in the future of clearing houses than in exchanges. A subsequent vote, at that London meeting, on whether clearing houses will be more important than exchanges, had a thundering 87% of voters saying yes.
Exchanges should seize the opportunity to become part of big clearing networks that cross-margin and clear multiple products, including hybrid and over-the-counter instruments such as swaps and foreign exchange, say practitioners. "Clearing is the key," says Jack Lehman, senior executive vice-president of Salomon Smith Barney, "it's leveragable. The customer will want to do the trading on the screen himself."
Seifert believes that the best way for exchanges to save their customers money is through cross-margining agreements with other exchanges - that means common clearing. "I hear market participants in London and Frankfurt saying that the next most useful step would be further cross-margining," he told Euromoney. "Eurex [the combined German and Swiss futures exchanges] gives us this chance."
There are difficulties with cross-border clearing however. There must be certainty of offset in the case of bankruptcy, and so far no two jurisdictions have affirmed that certainty. "We've had offset with Simex (the Singapore futures exchange) since 1984," corrects Rick Kilcollin, chief executive of the CME. But he doubts whether another jurisdiction would now be as flexible as Singapore, which at that time was desperate to develop the futures business. Switzerland and Germany may achieve it with Eurex, but cross-border clearing between the UK and the US, or between the UK and Germany, as Seifert proposes, could be a legal nightmare. "It's not so easy," says Clive King , operations manager at Fimat in Frankfurt. "It's not just clearing systems but standardization of holidays, settlement periods, the single currency payment mechanism Target, and Soffex's three-day settlement versus the DTB's two-day settlement period."
Exchanges no longer compete on products, but on the cost and efficiency of their systems, clearing and settlement, and their distribution network. "The end-user is getting closer and closer to the market," says Christopher Sharples, chairman of futures broker GNI in London. Intermediaries add value by offering comprehensive access to multiple markets, and front-end software vendors are making that easier, by offering packages that put data and dealing pages from many markets onto a single screen. "The front-end suppliers are putting facilities on screen that they weren't doing even six months ago," says John Foyle at Liffe. But should exchanges be forging links with each other when brokers and software vendors are doing it anyway. "Is that what the brokers want?" asks Foyle. "The brokers want to supply that facility to you, without the links."
Seifert in Frankfurt disagrees. "More and more people are saying that it would be useful if there were cross-margining. If the clients want it, then we can't refuse to make links." The Deutsche Börse is the furthest down this road. It is merging the DTB and Soffex (the Swiss futures exchange) to form Eurex, selling its services to the Vienna exchange, linking with Matif, and with the CBOT. If that is the future then the Deutsche Börse is the closest to embracing it, apart from the criticism that its management is not very international. "Not true, we have for example a foreign banker, Peter Coym of Lehman Brothers, on our supervisory board," says Seifert, omitting to mention that Coym is German and won his spurs at Commerzbank.
But Seifert argues that geographical location is irrelevant: "Exchanges will in the future be virtual, efficient networks." Exchanges can justify their existence by providing elements that data vendors such as Reuters or Bloomberg haven't yet developed: "contract design, clearing arrangements, regulation and liquidity", says Foyle at Liffe.
The internet is still a way off providing the full services of an exchange, although Futurecom in the US has applied to offer exchange-traded bond futures.
In the US it seems the monopoly on treasury bond clearing, held by GSCC (Government Securities Clearing Corporation) is under attack as brokers try to make cash and futures cross-marginable. Two competing projects, Cantor Fitzgerald Futures Exchange (CFFE) and Chicago Board Brokerage (CBB) are about to go live, if they can solve some legal differences. CFFE is a joint venture between Cantor Fitzgerald and the New York Cotton Exchange which plans to add a futures capability to Cantor's cash US treasury business. "There's an inexorable move towards linking cash and derivatives," says Stephen Kingsley, partner with Arthur Andersen. CBB, a joint venture between the CBOT and inter-dealer broker Prebon Yamane, plans to add automated cash trading cross-clearable with futures trades on the CBOT, saving users an estimated 85% of their margining costs. But both projects are threatened by a legal wrangle. Cantor accuses CBOT of planning to use MarketPower software developed by Cantor's own joint venture Market Data Corporation in a way that would damage Cantor's business as a government bond broker. The CBOT complains that Cantor's CFFE is not an exchange at all but an untransparent internal market controlled by Cantor interests. A judge must decide on Cantor's complaint at a hearing on July 6. CBB intends to start trading on July 13. The US futures watchdog, the Commodity Futures Trading Commission (CFTC), is in the process of weighing objections to the Cantor exchange, raised by CBOT, CBOE and the American Stock Exchange (Amex).
Whatever the short-term outcome there is no doubt that there is strong demand among dealers for a CFFE and a CBB, and that the Chicago exchanges and the GSCC must surrender some market share.
Even more interesting, if it succeeds, is Swapclear, a project by the London Clearing House (LCH) to clear plain vanilla interest-rate swaps and forward rate agreements (FRAs). The contracts are written over-the-counter (OTC), then the LCH steps in as counterparty to both sides, calling for margin only on the net of each members' position with the clearing house. But can the LCH succeed in capturing a good volume of this OTC market which is growing at least twice as fast as exchange-traded futures?
Traders battle interference
One obstacle is regulation in the US. The clearing of swaps on an exchange needs "safe harbour" to exempt it from CFTC oversight and regulation under the US commodity exchange act. The CFTC is pondering this question at the moment. Lawyers acting for the London Clearing House say the exemption should be straightforward, but the CFTC itself is "in a fight for its life in Washington", according to Robert Paul, legal counsel at Credit Suisse First Boston in New York. The LCH project could get caught up in the CFTC's Washington turf war, which centres on its claim to have responsibility for the OTC derivatives market. In 1993 it exempted that market from oversight but reserved the right to revisit the issue, saying that it wasn't quite sure what a swap is. Swap dealers had argued that any interference, especially outlawing existing contracts, would have a devastating effect on financial markets. Since then the swap market has changed, with plain vanilla swaps becoming almost a commodity product arguably more akin to interest rate futures. When last year the Securities & Exchange Commission (SEC) issued a proposal for lighter regulation of US broker-dealers, dubbed "broker-dealer lite", in order to bring swaps onto broker-dealer balance sheets and out of unregulated affiliates, the CFTC saw this as a threat to its position on swaps. The CFTC issued a "concept release" in May saying that it was revisiting the swap issue (but even if it makes new rules they won't work retroactively). The swap community took up its cudgels again and, with the backing of the US treasury and some congressmen, is fighting the CFTC tooth and nail. "This time perhaps the CFTC went a bridge too far," says CSFB's Paul. LCH lawyers believe swap clearing is a separate issue. So does the CFTC. But it may still decide to include the concept of swap clearing in a complete rule-change on swaps.
The LCH Swapclear project hopes to demonstrate that all manner of over-the-counter hybrids can be brought under the clearing umbrella, offering the advantage of multilateral netting. But the instruments need to be liquid, "for risk management reasons", says Sara Williams, director of business development at LCH. "We need to establish end-of-day prices and collect margin". The International Swaps & Derivatives Assocation (Isda) and the British Bankers Assocation (BBA) are considering supplying swap prices to Swapclear "for the exercise of swaptions [options to enter an interest rate swap]", Williams says.
The CFTC is the focus - and the bottleneck - of many new developments in the futures and derivatives industry. It is reviewing the issue of remote terminals, placed in the US, by exchanges operating in other countries.
In 1996 it gave the DTB a "no action letter" allowing it to place its terminals with FCMs (futures commission merchants) in the US, provided they accounted for no more than 5% of DTB business. The DTB now has 11 terminals in the US which account for 18% of the volume on its biggest contract, the Bund future. "Is it fair to say that's less than 5% of its business, even though it may be true in terms of overall DTB volume?" muses Michael Greenberger, director of the trading and markets division of the CFTC.
The CFTC has several other concerns - one of them being the rise and rise of automated trading. In 1996 nobody thought those terminals would be so successful, admit CFTC and Deutsche Börse officials. "We're not exactly sure what the parameters are that the DTB is operating in," says Greenberger. For example, the DTB terminals are not supposed to be put in customers' offices. "It turns out there may well be some," Greenberger says. "Some software companies have been able to make a very advanced computer screen.
"There are concerns," says Greenberger, "about the integrity of the DTB system, the rules in Germany, the need for an FCM to be involved somewhere, and reciprocity." Now there will most likely be a freeze on any new remote terminals in the US until the CFTC has fashioned a new set of rules. Sydney Futures Exchange is among those in the queue. Some participants complain that the freeze itself, which may last to at least the end of the year, is anti-competitive.
Agreements by Eurex and Matif with the CBOT and CME respectively, to provide after-hours automatic trading, may get around the freeze on terminals. The CFTC will shortly publish a concept letter on remote terminals which invites comment within 60 days. That might be followed by another concept letter before new rules are published.
Linkages have yet to work
The CFTC, like the European Commission, is trying to nail down the concept of distant selling and how far end-users in the remote country should be protected. One cultural difference is the US part-30 rule stipulating that client accounts must be segregated, with set procedures and priorities if batch orders are only partly filled. Germany has no such segregation principle, which may make dealing easier, but could give customers a raw deal - "This has nothing to do with client profitability and everything to do with universal bank rip-off," says Timothy Plews, a partner with lawyers Clifford Chance. The segregation requirement, says Greenberger at the CFTC, "is the holy grail of our accounting system. And because there's no insurance system on the futures side, the rules are highly restrictive. We're now looking very carefully at how much these should be relaxed." Even US affiliates in the UK can't exempt their clients from the segregation principle, even if the client wants it. "We have to go to the higher rulebook in the US," says an official of the UK's new Financial Services Authority.
Although the future of linkages and remote terminals is fraught with obstacles all exchanges continue to sign up with each other. "I've yet to see a linkage work properly," says Jeff Ryan, vice president, futures and options operations at JP Morgan Securities in London. He was commenting on the demise of links between Liffe and the CBOT after a mere nine months in December 1997. "The CME/Simex link is not a real example [of success]. I'm very much for some sort of common clearer. But I have enough problems getting the systems within JP Morgan to talk to each other," says Ryan.
Seifert at Deutsche Börse talks blithely of cross-margining between London and Frankfurt, but such a thing has never been done before. Liffe's future on the Eurotop 100 stock index launched on May 12 is complemented by an option on the future on the Amsterdam Options Exchange, but there's no cross-margining. "What people would like is offset," says Foyle at Liffe. Common clearing just between Chicago exchanges "has been debated on and off for decades," says CBOE chairman Ron Hersch. But it may soon happen, at least between CME and CBOT: on June 17 they signed an agreement to allow the establishment of cross-margin accounts.
The biggest shakeup to futures exchanges in the next few years will be their shareholding and the way they are run. Liffe has been paralyzed recently by the narrow vision of its member/shareholders. On June 9 they voted for change and Liffe will re-invent itself as a for-profit company. "For-profit is not optimal," warns Ruben Lee, director of Oxford Financial Group. But he explains the move of many exchanges to a for-profit basis in terms of their changing customer-base: "More business is coming from institutions, and the guys on the floor can't justify keeping all the profit." (Lee will publish a book in September called What is an exchange?)
The Deutsche Börse, which is already a joint-stock company, may sell its shares to the public, to end the impression that it's run by German banks. The Amsterdam and Melbourne exchanges have already gone public. "When you move to a global economy," says Lynton Jones, chief executive of the International Petroleum Exchange in London, "exchanges find themselves exposed to much more competition. They have to act more like companies."
Systems for survival
Will those companies survive? Or will they be overtaken by a new generation of data vendors-turned-broker, brokers turned collateral managers, and clearing houses taking any instrument that can be marked to market? "We'll be introducing exchange-traded credit derivatives," throws in Kilcollin of the CME. But he admits it isn't new products that will keep exchanges ahead of the curve, it is systems and technology. The CME is re-launching Globex, its 1987 venture with Reuters, as Globex2, incorporating the Paris Bourse's NSC/GL electronic system. Kilcollin says CME studies told them it is the best system in the business. Liffe's APT system, launched in 1989, and the DTB/Soffex system launched in 1988 are 1980s technology, although both bourses claim updates still make them competitive. But CBB claims that its MarketPower technology, the "first truly interactive system for trading US treasuries", is extremely fast. "It takes less than half a second to show your bid," says Anne Gorski spokesperson for CBB, "and one-and-a-half seconds to confirm a trade". What about errors? "There are some 'Are you sure?' features," says Gorski, "but the system is definitely for grown-ups - and good typists."
The futures industry is in turmoil. It has changed more in six months than in the last six years and is likely to change as much again in the next six months. Those bourses which appear visionary today will most likely look like dodos tomorrow as the march of technology and the markets moves on. But there's a fair chance that somewhere in the mixture that emerges will be a throwback to the Chicago tradition, with the intensity and the passion of Pat Catania.
