How to Steal A Contract

Posted by Jeff Carter
on February 25th, 2013

Chicago Mercantile Exchange (Photo credit: milletre)

One of the main gripes about failed attempts at competing with existing exchanges is that there is no competition. Eurex, ELX, and many others have made failed attempts to wrest control of US Treasury futures trading ($ZT_F, $ZF_F, $ZN_F, $ZB_F) from the old CBOT, now CME. ($CME)

They cried to the CFTC that the CME had a stranglehold over clearing and that was the problem. It’s a straw man excuse for losing. Instead, let’s look at how virtually everyone behaves, including CME when it tries to steal other exchanges contracts competes.

What is their biggest value add?

Lower price.

As my 3M ($3M)sales manager Harry Toussaint used to tell me, if a sales guy competes on price, they are dead. The customer doesn’t understand the real benefit and value the product creates-and will only look at the price. If you sell them the “why”, why it exists, you are able to charge a higher price and the customer won’t think twice about it.

I also tell startups when they are pitching angels. If it’s only about the valuation and money, the investors don’t need “you”. If you aren’t adding value, you are the first thing they toss overboard.

Suppose an exchange were going to enter the fray today and try and steal an established contract from an established exchange today, how would they do it? How would they create more value? Why do they exist?

Problems you will have to solve:

Certainly, clearing gives the giants ($ICE) in the business an advantage. The reason is capital efficiency. Being able to cross margin among an array of asset classes allows exchanges to charge a cheaper economic price than their competitors. The commission they charge on any one contract is merely the accounting price-not the true cost of trading.

The other cost to trading is the width and depth of the bid/ask spread. Wider spreads increase costs. Especially in losing trades. Traders have to be able to unload positions and if the market is too wide, or the book lacks depth, it increases risk without increasing reward.

How can you solve them in a unique way?

It is via the options market. This strategy probably doesn’t make sense on the SEC regulated side of the marketplace, because clearing is fungible. But on the CFTC side it does.

If the competing exchange can list and attract volume to an options market, it can eventually steal the futures market away from an entrenched competitor.

Since electronic trading was introduced to futures markets, volume of contracts traded has gone up significantly. This is entirely because of electronic algorithmic trading and the speed of electronic trading versus the operational difficulties encountered with pit trading. As I learned early in my trading career from James Mulka (WEST), “sometimes you get tired”. Machines don’t.

But notice something else? Even when options make the jump to the screen, they don’t see the same increase in volume. As a matter of fact, most of the volume continues to be executed in well functioning pits. The reason for that varies, but a lot of it is because options take up massive bandwidth, and have a seemingly unlimited cornucopia of strategies to utilize for trading. It’s still more efficient to trade the options in the pit today.

Sometimes when options are forced to the screen, their volume actually drops. That shouldn’t be happening given what has happened to every contract when it becomes electronically traded.

It seems stupid, but what exchanges that try to steal contracts should do is create an options pit dedicated to that contract. It should offer all kinds of economic incentives to trade options on that contract for customers and market makers.

The exchange should electronically list the futures contract, but offer the means for the new options pit to hedge themselves in the existing electronic contract, even if it’s on another exchange. As option volume begins to migrate from one exchange to another, the futures contract will make the jump. Eventually, there will be a rollover when all the open interest is arbbed and moves.

Once moved, it won’t move back.

Electronic trading is just like any other startup on the internet. It’s the content that is created that becomes valuable. In futures options, the value created content is still human.

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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.