In the early 1980s Milton Friedman phoned up Leo Melamed, then the head of the Chicago Mercantile Exchange, with an idea for a Consumer Price Index-based futures contract.
“This is near the hand of God handing something down, so I said, ‘of course, send me your notes’,” says Mr Melamed, now chairman emeritus of CME Group. “Our people came back almost in embarrassment and said, ‘Leo, we don’t know if we can make a market with this’.”
Mr Friedman took the product elsewhere. “I think history will show that they listed it and it failed,” says Mr Melamed.
Mr Melamed and Mr Friedman, perhaps more than most, are responsible for the soaring fortunes of the Windy City in the past 30 years as futures trading has moved from a minor sideline to one of the main ways investors speculate and hedge risk. The lack of fungibility in futures products has helped provide the Chicago Mercantile Exchange (CME) with a near-monopoly of the US futures industry.
The new rules around over-the-counter (OTC) derivatives passed under the Dodd-Frank Act present a great opportunity for the CME, which Mr Melamed helped to grow into the world’s largest futures exchange operator. Some institutions will be required to clear off-exchange trades, including credit default and interest rate swaps, forcing them to put up more margin and collateral to back their trades.
Analysts said the CME was likely to be one of the biggest winners as it owns one of the clearing houses in which US OTC swaps are likely to be cleared.
CME, its main domestic rival IntercontinentalExchange (ICE), headquartered in Atlanta, and Chicago-based start-up Eris Exchange are also seeking to capitalise on the new rules as investors switch from tailored but expensive swaps to cheaper but standardised listed futures to offset their risk. The exchanges have also created new products such as “swap futures” – hybrid products that promise the economic benefits of swaps but trade on an exchange.
But Mr Melamed’s story about his Nobel-prize-winning friend illustrates the vast uncertainty of the prospects of futures products. After all, if the “hand of God” doesn’t always get it right, who can?
“The probability of new products succeeding is really low,” says Don Wilson, head of DRW, a major proprietary trading firm, and a co-founder of Eris. “But in this Dodd-Frank driven environment, the probability of success is much higher than it otherwise would be.”
Eris has seen a surge of open interest as the new rules have come online, recently crossing 50,000 contracts, compared to around 20,000 contracts at the beginning of this year. Still, its trades will clear at CME’s clearing house.
In energy trading and clearing, CME faces competition from ICE. It also faces a challenge in clearing from LCH.Clearnet, the clearing house which launched a US-domiciled version of its interest-rate swap clearing service in June. The London Stock Exchange Group-controlled company is the world’s largest clearer of interest rate swaps, though CME is gradually chipping away at its lead.
Rich Repetto, principal at Sandler O’Neill, says the opportunity presented by the new clearing mandate is already playing out. “The magnitude of it is what is still unclear.”
The CME’s market share in OTC interest rate swap clearing has continually grown since the first clearing mandate in March, hitting a record 29 per cent in August while LCH has seen its share drop, to 71 per cent in August.
CME will face some competition from swap execution facilities (Sef), which are seen as reforming OTC derivatives without forcing activity on to exchanges. But the higher cost may lead to swaps shifting toward exchanges, where the price of margin is less.
But with around a dozen entities, including Bloomberg and ICAP, applying to offer Sefs, liquidity is likely to be very poor, says John Fay, global head of commodities and currencies at Newedge. With only a few places that can act as clearing houses, “the clear winners will be the established players”.
That includes ICE, though Mr Repetto says ICE is not a threat to CME’s dominance in the US in the near term. Instead, NYSE Liffe, which the company will acquire if its $10bn acquisition of NYSE closes later this year as expected, makes the company a much greater threat to Eurex in Europe.
One of CME’s greatest opportunities may lie elsewhere. Phupinder Gill, chief executive, recently argued that Asia, and China specifically, may provide the most promising medium- to long-term boost.
In the US, CME and ICE have largely grown separately because the lack of fungibility in the futures market “creates an environment [in which] the unique products of an exchange drive the business”, says Matt Simon, analyst at the TABB Group.
Mr Simon says the growth of unique products as each company attempts to draw interest, combined with the potential for arbitrage opportunities if the exchanges attempt to market similar products, could be beneficial for all participants.
“This actually could be better for the market overall, for both to grow side by side and succeed,” he says.
NYSE Liffe’s exclusive agreement with MSCI and ICE’s with Russell will create key advantages for the joint entity, Mr Simon adds. But CME’s S&P Dow Jones agreement has its own advantages, and bolsters the case that ICE and CME “could do very well if the entire futures market continues to grow”.
“The brokerage community and some of the futures desks are actually looking forward to that pairing up, because it will now provide opportunities for potential more pricing arbitrage and new trading opportunities,” says Mr Simon.