Chicago Futures in the Twenty First Century?
By Leo Melamed

The Future of Finance
University of Chicago Graduate School of Business
Gleacher Center, Chicago
April 28, 2000

The world of futures that I encountered when I came to the Chicago Mercantile Exchange as a runner in the 1950s is long gone. Our technology was then chalk, blackboards, and the teletype. Board markers scribbled transaction prices and volumes on the blackboard, and Sammy—best described as the Merc’s first CIO—sitting in a booth above the crowd, recorded the trade on the teletype. His work product was a tape that wound itself into the wastebasket. About a decade later, beginning in the late sixties and extending into the seventies, we graduated to computer-driven wallboards and a punch-card-driven clearing system. These became increasingly more sophisticated as the new technologies of the eighties and nineties infiltrated the business world. Still, the brick and mortar remained, as did the flashing quote boards and the shouting and pushing of traders, runners, and phone clerks. The world hasn’t seen a new exchange like that since 1986. Modern exchanges are incorporeal. Soon the only reminder of the past will be the flashing quotes, but these may mostly be on computer screens.

In few places has the impact of the computer and modern information technology, which affected every nook and cranny of life on this planet, been more pronounced than in the financial markets. Alas, U.S. financial exchanges, especially U.S. futures markets, have been slow to grasp the full implication of these transformations—their neglect eclipsed only by the inertia of U.S. regulators. The consequence of this compounded inaction, indifference, or ignorance may very well serve to validate last Sunday’s Chicago Tribune lead editorial which spoke of the imminent demise of Chicago as the capital of futures markets. The Tribune lamented the fact that “Anyone looking at the future of futures at the dawn of the twenty-first century must look east—across the Atlantic Ocean—to Eurex,” who surpassed the CBOT to become the world’s largest futures exchange.¹ But the editorial, as Mark Twain might have said, is a bit premature—maybe even dead wrong. Besides, it hardly touches the surface of the complex issues involved.

It is now within the grasp of most financial institutions to acquire and operate trade execution systems that duplicate the trading function of exchanges. As a result, every dealer is poised to create an exchange or join and expand the operation of an existing exchange. There is a major story almost every day announcing a new alliance to operate an exchange or a quasi exchange. There is no technological barrier to cross-border operations, and foreign exchanges want their share of the U.S. transaction business.

The only barrier to chaotic competition and a shakeout, are regulatory constraints. The new entrants are aghast that they might be subjected to CFTC jurisdiction and regulation if they create their own electronic exchanges. Thus we have been treated to a bizarre spectacle as every segment of the derivatives industry tries to explain why its proposed or projected exchange is not really an exchange and should not be treated like the CME, CBOT or NYMEX.

Technology alters reality far quicker than any regulator can respond. Blackbird, the derivatives trading platform operated by Derivatives Net, Inc., is the most visible of this recent trend. Blackbird appears to be an electronic multilateral transaction execution facility for swaps and other financial instruments. Each member’s bids and offers are live and available to every other participant that passes the automatic credit screen. The contracts traded are highly standardized. No legislation or regulation seems to exempt Blackbird from registration; yet it has apparently gone live. Reports are that it offers trading facilities for swaps, Forward Rate Agreements and other futures-like derivatives. Its members include many of the same major dealers that use traditional exchange markets with its array of financial futures. The essential difference between the two is that futures exchanges are subject to regulation and oversight and acknowledge important public responsibilities while Blackbird operates with no constraint.

The efforts of new exchange entrants to avoid a consistent, logical definition of exchanges that would subject them to CFTC jurisdiction have been matched only by the efforts of SEC regulated securities exchanges to keep futures markets from competing in turf they have reserved for themselves. Seventeen years ago, the Shad-Johnson Accord resolved a jurisdictional conflict between the SEC and the CFTC. It was not intended as a permanent barrier to innovation and growth. Stock index futures, invented on futures exchanges, have matured into vital financial management tools that enable pension funds, investment companies and others to manage their risk of adverse stock price movements. The options markets and the swaps dealers offer customers risk management tools and investment alternatives involving both sector indexes and single stock derivatives. Futures exchanges have been frozen out.

Under current law, public customers who want to trade a future on an equity need to go over-the-counter or to do a synthetic future through the facilities of an option exchange. A synthetic future requires two transactions at twice the commission and four times the cost of a simple future to achieve an identical result.² The SEC and their option exchanges are intent upon denying their customers the freedom to trade a single futures contract on a narrow index or an individual equity. The reasons advanced against reform of Shad-Johnson disguise competitive and/or political concerns. Today, Shad-Johnson is being used as a weapon against competition. The SEC, through statutory misinterpretation and, what the 7^th Circuit Court of Appeals in Board of Trade v. Securities and Exchange Commission, No. 98-2923 (August 10, 1999) has found to be at best “arbitrary and capricious,” and at worst “suspect” application of its powers, has denied futures exchanges the right to trade futures on stock indexes that reflect price movements in substantial market sectors. The court of appeals found that: “The stock exchanges prefer less competition; but if competition breaks out they prefer to trade the instruments themselves . . . . The Securities and Exchange Commission, which regulates stock markets, has sided with its clients.” Congress should lift the single stock futures ban and allow the marketplace to decide whether these instruments would be useful new risk management tools.

Thus, traditional U.S. exchanges are being squeezed by the combination of their own immobility, internal establishment pressures, technological advances, and U.S. regulatory inertia. Further, while the SEC and its clients are fighting to constrain the ability of U.S. exchanges to trade equity derivatives, foreign exchanges and the OTC market are eager to fill that gap. Foreign exchanges are pouring into the U.S., but no guarantee of reciprocity has been extracted that would permit U.S. exchanges equivalent treatment in foreign jurisdictions. Also lost in the current legislative stampede to give the OTC markets total freedom to act as an exchange without the burdens of a regulated exchange, is the underlying value of clearing houses of the traditional futures markets. Their proved ability at risk management have served this nation well for over a century without the public ever being victimized because of a defaulting broker. The Federal Reserve never had to step in and help bail us out. The new game plan with its “pick-the-regulator-of-your-choice,” will clearly be more competitive and open. However, in diminishing the strength of CFTC-ordained clearing houses, the question begged is to what extent this introduces the specter of unbridled systemic risk. Only the next Long Term Capital Management debacle will provide the answer.

The foregoing realities are driving nearly every traditional exchange to consider a transformation of its structure.³ For centuries financial exchanges have been member-owned organizations. But nearly all of them are considering a change from a non-profit, member-owned structure to a for-profit entity with publicly traded stock. The shift toward electronic trading of stocks, futures, and options changes not only the manner of how these instruments are traded but also the organization, governance, and finances of the exchanges on which they are traded. At the Chicago Merc this transformation is nearly completed.

The fundamental reasons for this evolution are three-fold: 1) Technology is expensive. Large sums of money are necessary to transform the trading floor into an electronic state-of-the-art trading system, money that is mostly available in public equity markets; 2) Competition has become fierce and promises to get fiercer. Electronic Communication Networks (ECNs), and a growing number of electronic exchanges, as previously noted, have created a competitive environment which demands efficient decision-making processes. Rules, procedures, and decisions based on an archaic system of floor politics, committees, and establishment controls, cannot compete in today’s world where decisions demand instant recognition and must be based solely on competitive considerations. Only the lean and mean will survive; 3) Electronic trading leads to“disintermediation.” With electronic trading, many of the middlemen essential to the operation of an exchange floor will play a much different role. Historically, intermediaries—brokerage firms, floor brokers, and market makers—owned seats on exchanges either to protect their competitive positions or as a source of specialized income. Electronic exchanges and the Internet change all that and will offer the marketplace to a much larger universe of participants many of whom will gain direct access, taking the place of the former intermediary whose function is bound to shift. Already futures traders have learned to trade by way of the screen. Electronic trading rooms may be the wave of the future.

Recently Banking Committee Chairman Phil Gramm issued an invitation to a May 8, 2000 hearing on the regulation of derivative markets and asked the key question that Congress and the regulators need to address, "What regulatory and market structures would enhance the value of our markets?" The Chicago Mercantile Exchange has offered testimony which provides much of the answer.

By way of historical context, the CME, in juxtaposition to other American markets and contrary to the broad brush of condemnation used in the Chicago Tribune editorial,⁴ anticipated the impact of advances in information technology. In 1972, we initiated the idea of financial futures. A decade or so later, our Globex concept first introduced the world to the idea of electronic trading in futures. We spent years negotiating with foreign regulators to secure access to offshore markets. We spent tens of millions rewriting our clearing system, making it the standard for the industry. We consistently updated our contracts to reflect new competitive realities. We used technology to expand the capacity of our existing trading floor. Sadly, the CME too for a long time lost precious ground in a fierce tug-of-war between the certainty of an open-outcry past and the insecurity of a technological future. Nevertheless, about two years ago the process righted itself and we began reshaping the corporate structure of the Merc to a for-profit composition. We expect to be the first American exchange to achieve this objective.

In the regulatory realm, our goal was and remains equivalent regulatory treatment for functionally equivalent execution facilities, clearinghouses and intermediaries. U.S. regulated futures exchanges suffer compared to offshore competitors and the domestic OTC market. Overly detailed regulation of futures exchanges increases direct costs and time to market of innovative products. We support relief for the OTC market, we support opening our markets to foreign competitors, but we cannot support a package that gives relief to one segment of the derivative market at the expense of domestic exchanges. We have proposed a holistic approach to regulatory reform that will bring legal certainty to the OTC market, relief to exchange markets and resolve the Shad-Johnson restriction.

But the hour is late. If the clock strikes midnight before the futures markets of Chicago—the very entities that created financial futures—do not complete their modernization agenda or are not allowed to compete equally with every other derivatives counterpart, whether foreign or domestic, then the Chicago Tribune will indeed be proven right.⁵ I pray not.

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