Innovation in the Exchange Space

Posted by Jeff Carter
on December 27th, 2010

ELX is whining again. Are they even relevant? Why waste ink, or precious bandwidth on them? This is an exchange that cries to the government every time they want to start a new business. I think they call that “crony capitalism”, not innovative capitalism. Look for ELX to ramp up its political donations because it will be the only new idea they have had. ELX is a classic example of how not to run a business in the new internet generation.

It proves my earlier points on this blog that ELX is a tool of the banks and only exits to keep CME from raising it’s commission prices significantly higher. An aside, technology is getting more powerful and cheaper. So, as exchanges invest in better tech, they get more bang from their buck. Commission rates can rise only slightly and exchanges recognize a lot more revenue.

Just because there are already big dominant players in a space it shouldn’t stop someone from opening a new business in that space. Technology and the internet make it really easy to do. For example, there are lots of charting companies out there. Aspen Graphics, CQG, Bloomberg. They have been there for a while. But along comes The Street, Yahoo!Finance to shake things up a bit. Then, from out of the blue comes a really innovative company for charting. Ycharts.com is breaking new ground in how the finance sector looks at and uses information. It’s a space with big dominant players, but Ycharts is transforming that space.

The exchange space has big dominant players too. In the US, it’s $CME, $NYX, $NASD. Then there are the other bit players like BATS and $ICE. They were started in the 1990′s. Along comes ELX in 2008.

What does ELX offer that nobody else does? How are they spurring innovation? How are they different? Do they have a killer ap?

The answer is no. ELX is no different than a kid opening up a lemonade stand next to an already existing lemonade stand. Not only that, but because of capital costs, margin efficiencies and the width of the bid/ask spread, ELX is significantly more expensive than the other exchanges its trying to compete with. Cantor Fitzgerald tried to go toe to toe with the CBOT back in the day. At least Cantor had a great cash bond business. ELX has nothing.

However, they can be a force if they were able to think out of the box a little bit.

For example, ELX listed a Eurodollar contract. Let’s look at the contract specifications of the ELX Eurodollar. They are exactly like the CME Eurodollar. It’s as if the ELX guys copied the CME rule book word for word and the announced to the street they were ready to trade. ”Hey, come and drink our lemonade.”

If ELX really wanted to put pressure on CME and innovate, they would have done this differently. There are fundamental economic reasons these contracts actually exist. They manage risk. They offer a way for speculators to trade and make money. At the end of the day, the exchange only cares about volume. Volume=Profits. Volume means it’s a successful contract. No volume means the market wasn’t ready or big enough, the exchange misread the market, or did a poor job marketing it.

If ELX would have thought out of the box, they might have launched a different way. First, is the 1M sized contract sacrosanct? I mean, it’s cash settled, so the size of the contract can be anything you want. Why not mess with the size? Second, once you mess with the size of the contract, why not mess with the tick value? What does ELX have to lose? They are in the banks back pocket, and they have no volume. They are parasites.

I would have increased the size of the contract. Make it cheaper for banks to hedge their short term interest rate (STIR) risk with less volume. A five million dollar sized contract would work. It also gives a natural spread between the CME Eurodollar and the new ELX contract-spreaders are accretive to volume. Plus, spreaders will hold open interest. Next, if you do a five million dollar contract, you adjust the tick size into tenths of a tick. Instead of trading like the CME Eurodollar does, massive size at every bid/ask, you’ll have less size but more volatility. Who likes that? High Frequency Traders and retail traders. You will have created a nice STIR that trades more like the long bond. Plus, if you are successful you force CME to list its own similar contract. That could hurt CME volume and at the end of the day, that’s really the purpose of the ELX. To try and keep exchanges like CME in check and out of the banks OTC turf.

Busting the Eurodollar up into smaller bite sized pieces doesn’t make sense. Many already complain that it’s too small at a million dollar size. E-mini Eurodollars would move less than the big contract-and there is no natural hedger. But a much larger contract is a good idea-if ELX truly wants to compete and innovate.

If ELX wants to continue to be a parasite, keep wearing the same hand me down clothes. Mr. Irrelevant=ELX.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.