CME, ELX and the CFTC

There is an undercurrent moving in the financial community that could affect American financial markets.  However, the undercurrent is hard to understand, and has a lot of abbreviations, and linkages.  I apologize for that before you start reading-but this could be critical someday.  The entire underpinnings of American finance could blow up.  Risk has been increased, not decreased.

The Commodity Futures Trading Commission(CFTC) ruled on a dispute between the ELX exchange and CME Group.  ELX passed a rule on its exchange that allows its customers to exchange positions on the ELX with positions on another exchange.  They call this an “exchange of futures for futures” (EFF).  CME says that it will not honor these transactions.

Here is a little history.  Futures exchanges have always allowed a swap of EFP’s, or exchange for physical which allows customers to manage risk within a clearinghouse.  A customer would swap a futures contract it held for the actual physical commodity.  Then, the New York Mercantile Exchange (NYMEX) decided it wanted to compete head to head with the International Petroleum Exchange in London.  NYMEX introduced an EFF for Brent Crude contracts-which the IPE never honored. (The IPE was based in London, and regulated by them)The rule still sits on NYMEX books, and NYMEX is owned by CME.

Now for some inside baseball sentiment.  New York and Chicago have always been at odds over the futures business.  New York cannot figure out how a bunch of upstarts from Chicago got the financial futures business from them-when the center of world finance is in New York City.  Not only that, but the CBOE gets the lion’s share of equity options business too!  The investment banks have tried to gerrymander the industry.  On the SEC regulated side, they have been largely successful.  They have turned the SEC side into a giant cash machine for their business. Markets are not transparent, and the customer gets screwed.  Any cursory examination of the corporate bond, or muni bond market will prove this statement out.  The lack of transparency adds significantly to the costs bond issuance, costing shareholders and taxpayers extra money.  On listed stocks, most of the volume is traded away from regulated exchanges and in dark pools of liquidity.  These private matching engines exist only to benefit the bank that runs them.  They add a lot of instability to the market place, because price and volume information is not known by the entire market. This is one of the reasons for the flash crash in May of 2010.

Let’s look at who started and backs the ELX.   Virtually all the investment banks, and two high frequency trading operations.  They didn’t start it to make the market more efficient.  They started it simply to line their own pockets.  The exchange was established merely to push the concept of fungibility into the futures industry.

Fungibility is banned.  It’s banned to protect customers.  Currently, futures markets are the most orderly, efficient, transparent markets in the world.  Retail customers play on an even playing field with everyone else.  Fungibility is also banned because one clearinghouse doesn’t want to worry about the credit worthiness of another clearinghouses customers; or the standards of the other clearinghouse.  Banning fungibility eliminates some random risk in the marketplace.

Many practices in the futures industry that are de rigueur in SEC regulated markets are banned.  Bucket trading, trading in front of order flow, trading against your customer are all banned on the futures side of the business-but generally accepted principles on the stock side. Same day clearing is standard on the futures side, but it takes three days to clear a trade on the stock side.  (Banks like to hang onto your money and earn a little more juice off it)  EFF’s would bring fungibility to futures.

With the new regulations in the Financial Regulation reform came new opportunity.  The law tries to get a lot of the over the counter (OTC) trading into regulated clearinghouses.  The theory being that clearinghouses will provide the transparency and oversight to stop a financial meltdown from happening again.  With OTC being pushed to clearinghouses, the clearinghouses were given the privilege of borrowing from the Federal Reserve Bank window.

Going back to the EFF.  One of the elegant things about a clearinghouse is that they eliminate counter party risk. One entity doesn’t have to worry about the credit worthiness of another customer.  The clearinghouse pays and collects margin and makes sure everyone has enough cash to play the game. Different clearinghouses have different standards and operations.  The Options Clearing Corp, The Clearing Corporation, CME, all clear trades.  But they all do it slightly differently to maximize the efficiency of the clearinghouse with regard to the business it provides service to.  If EFF’s were forced upon the market place and ICE was forced to offset CME’s trades-the credit worthiness of each clearinghouse would be in play.

Suppose that OTC derivatives were cleared in 2008.  Further suppose that the shenanigans the banks played with AIG Insurance were instead played within the ELX clearinghouse.  (assuming they would do the same thing since ELX is a dark pool for banks)  CME or ICE might have been forced to take ELX trades.  Those trades would have bankrupted both clearinghouses.  Then, they would have had to go to the Fed window to borrow money to cure their insolvency. This might have bankrupted the US government.

It’s not a farfetched left field idea.  Think about the total amount of capital pumped into economies by the world to prop up the financial system when AIG was ready to fail.  Trillions. The Fin Reg bill just gave the banks access to that cash via the Fed window.  Don’t think that someday they won’t use it.  Don’t assume that government is efficient enough to spot a bubble and pop it before it pops the American taxpayer.

A corollary would be this.  Pepsi, Coke and Dr. Pepper all make a cola flavored soft drink.  They have distribution systems.  Just because Pepsi says it wants to use Coke’s trucks to distribute its cola doesn’t mean that Coke has to do it.    EFF’s in the futures industry are no different.

  • Paul


    Excellent explanation of a very bothersome issue.

    ELX cannot create their own liquidity, so they are trying to steal it from CME. In the process, if they win, they will put CME and its Clearinghouse at risk.

    Your analogy was excellent about Coke and Pepsi.

    One question – so the NYMEX sought the rule but the IPE never allowed these transactions? Hmmm, sounds very similar to this situation. CME should not be forced to allow EFF’s just as IPE did not honor them.

  • @Paul. There is a difference since the IPE was not under CFTC jurisdiction. NYMEX was using it as a way to try and break into the Brent Crude Market. Failed.

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