FMX Futures vs. CME Group – Why imitators fail

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introduction

In two previous posts, here and here, I argued that the path to success in competition between exchanges lies through new listings, not copycats. Here I switch from exchanges to futures exchanges. I present a hypothetical partner for the securities Exchange, ENEX, a prototype of the qualities that will successfully compete with the overwhelmingly dominant CME Group.

Attracted by CME's huge profit margins, a new exchange has entered the futures markets. Most recently, FMX Futures, part of Cantor Fitz, was approved by the CFTC to open for business. This exchange will either change direction or fail. Now it appears that FMX will rely on copycat markets, a strategy that is doomed to fail.

With the failure of Eurodollar futures and due to the huge positive difference between the potential profitability of a new exchange and a new futures Exchange presents a rare opportunity. The opportunity to capture the CME futures franchise. Unlike stock markets, in futures markets economists prefer one exchange rather than many. FMX must either replace CME or die.

This article is about an ENEX partner – ENEX Futures, which aims to list the markets that FMX needs to be successful.

My conclusion is that in order for a new exchange to compete with the established CME exchange, it must maximize the differences between them.

Selection of new offers

criteria

In the second post I describe an easy way to decide what to list. My conclusion is that the best way is to develop instruments other than CME, which is currently the only success among futures exchange managers. The easiest place to start is with large, underrepresented markets.

There are hugely underrepresented markets – retail government bonds and short-term corporate bonds; or any futures market that is settled by tying the settlement price to an index.

A new futures exchange will either fail or displace CME unless the two make peace.

In the second post, I identify a leading indicator of private short-term debt – an instrument backed by commercial paper. It meets some basic criteria that ENEX Futures could apply to the listing of any new instrument.

1. Economical meaning. The instrument should represent a market that represents a significant part of national savings.
2. Investor needs. The instrument is intended to offer potential investors an alternative that is not available elsewhere. No imitation.
3. Financial security. The instrument should be less vulnerable to liquidity crises than other instruments available to investors with otherwise similar characteristics.

New products and tactics

Read the second article for a detailed description of the new tactics. In short, the exchange should

• Adopting the cheaper, safer trading and clearing methods of futures markets,

• create settlement instruments for futures contracts,

• Prevent competitors from imitating ENEX futures.

• And issue more investor-friendly securities.

The choice of a commercial paper-based leading indicator in the second article attempts to overcome the profit chasm created by the cessation of Eurodollar futures trading.

ENEX futures

There are many alternative ways to design both the futures contract terms and the characteristics and issuance dates of the instruments to be delivered. The choice should not be random. Here you will find ways to challenge the existing CME methods.

1. Create the capacity to do so arise the available instrument.
2. Change billing dates to accommodate investors.
3. Consider contracts with CME.
4. Avoid half measures. The closer an FMX contract is to a CME contract, the greater the chance of failure.

Possible terms for the futures contracts

ability to emerge

The key lesson from the failure of the Eurodollar futures market was that CME was trapped and held hostage by the financial institutions that had issued London wholesale interbank deposits. Failures in the London deposit market include:

1. The instrument traded was a fixed-term deposit. Term deposits impact liquidity because they are not traded on a secondary market.
2. The London Market banks are regulated by the Bank of England and the Fed. This meant the market was vulnerable to regulatory decisions.
3. First, regulators decided to increase regulatory capital requirements for deposit-taking banks.
4. After regulators reduced issuance activity through capital requirements, the resulting illiquidity opened the door to market manipulation, both by Eurodollar traders and regulators themselves.
5. The London branches insisted that the CME settle its futures contracts through an index. Since the index was not a market price, Eurodollar futures were further weakened.

Investor-friendly settlement dates

The typical futures market has four quarterly settlements – the March cycle (March, June, September, December). It might be more investor-friendly to settle the financial futures markets with a new issue every week, as the Treasury does.

This would have the effect of equalizing trading in the Treasury when-issued market. But ENEX futures would have a huge advantage over the Treasury when-issued market. The emissions market is an insider market. Due to the market being limited to government securities markets, there are no margin requirements. ENEX futures would use futures-style margin requirements to allow retail investors with sufficient funds to participate and dramatically expand the market.

Consider contracting with CME

This contract would address margins. A key effect of the futures-like clearinghouse is the major advantage it creates for established exchanges. Read here for a description of the FTX plan.

“CME has a distinct advantage when it comes to fending off competition. In addition to operating the market where traders buy and sell futures, CME also operates the associated clearinghouse – the underlying system that holds collateral for large trading firms and moves cash to offset profits and losses in trades.”

“Competitive exchanges cannot use CME's clearinghouse, and convincing traders to join another clearinghouse has historically been difficult for competitors. Trading firms would have to deposit collateral in two different places to support a new futures exchange, as they are unlikely to abandon CME overall for an untested startup.”

“Lutnick (CEO of Cantor Fitz) attempted to resolve this dilemma by agreeing to transact FMX’s operations through LCH, which is owned by the London Stock Exchange Group. LCH is one of the largest clearing houses in the world, used by many banks to process interest rate transactions.” Swaps. Among CME's unsuccessful challengers in recent years was NYSE Euronext, the old parent company of the New York Stock Exchange. Lutnick backed an interest rate futures exchange that was founded in 2009, but the company, ELX Futures, struggled to gain traction. Lutnick blamed the failure on weaknesses in his clearing agreements.”

Avoid half measures

The closer the FTX contract is to the CME version, the greater the CME advantage described above. This consideration leads to two key differences between CME contracts and a successful alternative.

• The contracts should be processed by the CME on different days.

• Settlement based on a publicly available index, such as SOFR, can be easily replicated by the CME. A physically settled contract would better separate the two markets.

• If the security delivered by the FTX contract originates and is issued by the exchange, CME imitation would be impossible.

Billing days. The settlement days correspond to the needs of investors.

Physical settlement. Treasury asset-based instruments with individual treasury components are published daily at market close.

Coming from the stock exchange. Since the exchange itself buys and sells the assets of the Treasury and the composition of the portfolio is unknown until the close of the exchange. Competing exchanges have no opportunity to imitate.

Competitive analysis

FTX's proposed futures contracts trade Treasury-based yields. A SOFR-based contract (Secured Overnight Financing Rate) and contracts based on multiple treasury yields are planned. The FTX contracts may differ from the CME version of these markets. However, there is no doubt that the SOFR contract will settle at the interest rate charged by the Fed. Additionally, Treasury futures will most likely forego the option of physical delivery by CME in favor of settlement at the auction price.

If the difference between the FTX contracts and the CME version boils down to this kind of triviality, these contracts will fail. Trivial differences open the door for CME contracts to be more in line with FTX contracts. Turnabout is fair play.

The way forward

The key to a successful futures exchange competition is understanding and leveraging the impact of futures-style clearinghouses. Here are the most important effects.

1. Arbitrage between futures exchanges is not economical. Futures markets are not HFT arbitrage friendly. It is inefficient to simultaneously take long and short positions on the same or similar contracts. With this low-risk strategy pursued on both exchanges, margins are doubled and are not canceled out by an opposing position.
2. A reverse imitation is likely. If the FTX exchange makes minor changes to the CME versions, CME can easily list two versions – A the FTX-like version and the original CME version. This means that all FTX/CME base trades are transferred directly to the CME. Additionally, the FTX imitation contracts are traded on the CME instead of the FTX exchange.
3. There are only two options in futures exchange competition. The first option is to replace CME. the second to sign a contract with CME.

Diploma

The most interesting stock market competition in a generation begins. The established, highly profitable CME is under attack by a new exchange, FTX Futures, part of Cantor Fitz. FTX wisely discloses only the minimum information required to obtain CFTC approval. However, this information suggests that FTX futures will fail unless FTX also includes an option, a second set of contracts that requires a major change in direction.