New Futures Exchange to Compete with Chicago Mercantile Exchange

As if the financial industry hasn’t seen enough of a market shake-up in recent months, a new futures exchange is set to launch in early 2008. The exchange, backed by heavy hitters in the capital markets, will serve as a low-cost alternative in the existing futures market. The exchange will start trading U.S. Treasury futures and then move into currencies, stock indexes and wheat products.

Founders of this new venture were concerned that the Chicago Mercantile Exchange (CME) Group, a working collaboration of the Chicago Mercantile Exchange and the Chicago Board of Trade, had cornered the futures market and inflated prices. To bring competition to the futures industry, Merrill Lynch, JP Morgan, Citigroup, Barclays Capital, Credit Suisse, the Royal Bank of Scotland, Bank of America and Deutsche Bank have formed an alliance to spawn this yet unnamed futures exchange.

Other investors in this exchange include the online company e-Speed, which will provide electronic trading platforms and three Chicago based trading firms: Peak 6, Getco and the hedge fund giant Citadel.

Robert Hamada, a former Chicago Board of Trade (CBOT) director, recently spoke with the Chicago Tribune about the new exchange. He said that the founders of the new futures exchange wanted to prohibit the CME Group from becoming a “monolithic monopolist.”

“What keeps prices down is the potential for competition,” Hamada explained.

While many believe the industry needs this competition to thrive, others see this move as a sign of a major industry overhaul.

John Lothian, a futures broker, reminded investors of Cantor Fitzgerald’s attempt at forming an exchange in 1999 and of BrokerTech, a combined effort by investment banks in 2001. Both failed as competitors but did prove successful as change agents.

“[These exchanges] prompted the Chicago Board of Trade to offer more and better electronic trading,” said Lothian. He also pointed out the more serious overseas threat to the domestic futures market in Eurex US.

“The Eurex US effort that combined the interests of the BrokerTech futures exchange consortium and the German Swiss Eurex AG was the challenge that brought truly lower U.S. Treasury product fees to the CBOT,” Lothian said.

In fact, Lothian explained that the fee drop was so significant that the Eurex exchange brought a lawsuit against the CBOT for anti-competitive prices.

Even though start-up exchanges have been unsuccessful in the past, the present confluence of economic circumstances could lead to a different outcome for this launch.

Many factors that exist in today’s market were not present when the last exchange launches were contemplated. First, the financial landscape is very different than it was 10 years ago. The majority of trading transactions are now done on an electronic platform.

Second, funds like Citadel, Getco and Peak6 have tremendous power in the fast, high volume electronic markets. They globally trade massive a volume of stock and options exchanges and in turn, serve as market-makers. As backers in the new exchange, these funds could successfully establish a liquid market.

Also, by launching with U.S. Treasury contracts, the new exchange has an opportunity to get off the ground with a “grand opening sale.” With continuing credit concerns bogging down many institutional investors, U.S. Treasury contracts are viewed as safe buying opportunities.

The founder’s state of mind could play into the success of the new exchange. Many of the organizations backing the new exchange are leading users of the CME Group’s services. The fact that these CME customers are backing a new exchange demonstrates how worried participants are about the formation of monopolies.

The CME Group’s stock fell a day after the competitor’s plans were announced. At the close of business on December 21, 2007, the stock was positioned at $710.95. By Monday, December 24, 2007, the stock had falled 2.4% to $690. And the news kept getting worse. By January 9, 2008, the day before this article went to press, CME stock had fallen to 599.26 in after-hours trading.

Even with the decrease in profits, the CME Group is optimistic about the effect that competition will have on the futures market in the long-term.

In an article published by the Chicago Sun-Times, the CME Group’s representative said, “Our business thrives on competition. We expect to continue to innovate, broaden our reach and provide our customers with leading-edge risk management products. We will continue to focus on our customer service and efficiencies to provide the lowest cost liquidity.”

The new exchange is looking to launch I early 2008. If you have an opinion on how the competition will affect the market, we want to hear it. Otherwise, we will just have to wait and see what will happen …