porcorex
The importance of the CME’s move to become a Futures Commission Merchant (FCM) is limited only by the imagination of the CME’s management.
This article describes the inadequate service stock exchanges and futures exchanges provide to retail traders. It shows how CME has embarked on a path that could lead CME or competitors to revolutionize the retail trading space. The result would be much reduced retail investor costs and a less risky financial marketplace.
CME’s application comes despite CEO Terrence Duffy’s earlier objection to an application for the same capability by FTX, a much smaller exchange. CME joined a chorus of complaints about the FTX application, saying “The FTX model would significantly increase market risk.” FTX for its part believes its proposal will bring 21st-century technology to U.S. markets, adding that it has safeguards to limit risk.
This article argues that to revolutionize our financial market structure – to enhance market stability and bring retail costs of trading to a bare minimum, the CME should be confronted by a new competitor that truly represents the interests of retail investors.
To assure that this new exchange serves the interests of retail traders it should have a different structure of ownership. This exchange might be owned by its retail customers, like Vanguard’s ownership model. In fact, the cheapest way to get this new exchange up and running would be for the new exchange to be closely affiliated with Vanguard itself.
The CME, in a move that received little attention from the media, asked the Commodity Futures Trading Commission (CFTC) for permission to become an FCM. The usually open-minded CFTC is likely to approve.
What is the potential benefit to the retail trading public? The sky is the limit, up to and including replacing the SEC’s securities exchanges as the dominant locus of global trading.
Of course, for the CME to suggest this revolutionary outcome would immediately kill its FCM application. CME claims the application is a defensive response to an application by FTX (largely a cryptocurrency exchange) for the same FCM privilege. Of course, an alternative interpretation is that the CME maneuver is indeed a lamb-like defensive move.
If so, CME must believe there is a possibility that retail investors will understand the value to them of an exchange with an FCM license and that their users might defect to FTX unless FTX’s lower costs are matched by the CME.
For now, there will be more than enough controversy created by the short-run likelihood that the CME will compete directly with its own clearing FCMs, most of which are subsidiaries of holding companies that also house SEC-approved broker-dealers. These bulge bracket players carry heavy weight in Washington and on Wall Street. If they oppose the CME move, CFTC approval will be less likely.
CME self-clearing will plainly reduce the cost to day traders and hedgers of using futures markets. But to truly shake up financial markets, CME need only add one more capability –to become a securities portfolio manager as well.
The SEC’s National Market System (NMS) is a complete failure. The SEC’s espoused NMS rules are intended to promote:
What is wrong with the NMS? The NMS has fallen short of these objectives. Instead, the NMS has disastrously reduced retail investors’ direct use of SEC-approved exchanges. These exchanges are now dominated by algorithm-generated computer-initiated transactions, which now constitute up to 70% of all securities exchange transactions.
Retail trades are now mostly executed by Wholesalers (big impersonal trading firms, for example, Citadel’s brokerage servicing sub, Virtu, Jump Trading) that pay retail brokerage firms for their retail orders, bundled by the retailers in a volume sufficient to be profitable to the Wholesalers. This practice is known as Payment for Order Flow (PFOF).
What has ruined the NMS? Several unexpected aspects of electronic trading have inspired the big three exchange management firms (CBOE, NYSE, NASDAQ) to cater to algo traders (traders who program computers to execute transactions that profit from the inefficiencies of the NMS). Algo traders are another aspect of wholesaler activity, known as High-Frequency Trading (HFT). There is a symbiotic relationship between these wholesaler HFTs and exchanges that benefits both but at the expense of retail traders and taxpayers.
A firm that combines a securities portfolio manager with a futures clearinghouse and a broker-dealer directly addresses the shortcomings of both securities exchanges and futures exchanges.
One reason the CME is empowered to fix the NMS mess is that it is not part of the NMS. Moreover, the rules of futures trading eliminate the problems the SEC created for itself with the NMS.
If the CME settles for FCM designation without exploiting the opportunities that capability creates, little will come of it.
But if the bulge bracket FCMs lose their clearing member privileges, I believe they will open competition in FCM-created new futures or futures-like exchanges. These new exchanges if they simply clone the CME model will come to nothing. CME’s liquidity advantage will blow away any de novo futures exchange that does nothing other than imitating the standard futures exchange model.
The path to marketplace domination will depend upon a de novo exchange initiative to combine the advantages of futures trading with the security exchanges’ ability to originate their own securities.
I doubt that CME is seeing the enormous opportunity in the addition of an FCM capability that I see. On the other hand as this Wall Street Journal article reports, Craig Pirrong, a finance professor at the University of Houston, points out that “By setting up its own FCM, the company may be laying the groundwork for a regulatory decision that shakes up the traditional relationship between futures exchanges and brokerages.” That outcome is the minimum that is possible when firms like FTX goad established firms like CME to reluctantly consider an improvement in the status quo.
This article was written by
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.