FMX Futures Vs. CME Group - Why Copycats Fail (2024)

Introduction

In two earlier posts, here and here, I argue that the road to success in inter-stock-exchange competition is through new listings, not copycats. Here I move from stock exchanges to futures exchanges. I introduce a hypothetical mate for the securities exchange, ENEX, a prototype of the qualities that will successfully compete with the overwhelmingly dominant CME Group.

A new exchange has entered the futures markets, attracted by CME's enormous profit margins. Most recently, FMX Futures, part of Cantor Fitz, has been 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 doomed to fail.

With the failure of Eurodollar futures and due to the enormous positive difference between the potential profitability of a new stock exchange and a new futures exchange, a rare opportunity presents itself. The opportunity to capture the CME futures franchise. In futures markets, unlike stock markets, the Economics favor one exchange, not many. FMX must either replace CME or die.

This article considers an ENEX mate - ENEX Futures, that plans to list the markets that FMX needs to succeed.

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

Picking new listings

Criteria

In the second post, I describe a straightforward way to decide what to list. My conclusion is that the best way is to originate instruments different from CME, the only success among futures exchanges managers now. The simplest place to start is with large underrepresented markets.

There are enormous underrepresented markets - Treasury bills at the retail level, and short-term corporate debt; or any futures market that settles by marking the settlement price to an index.

A new futures exchange will either fail or push CME aside, unless the two make peace.

In the second post, I identify a private short-term debt bellwether - a commercial-paper-backed instrument. It satisfies some basic criteria that ENEX Futures might adopt for listing each new instrument.

1. Economic significance. The instrument should represent a market that is a substantial share of national savings.
2. Investor Need. The instrument should provide prospective investors with an alternative that is not available elsewhere. Not an imitation.
3. Financial Safety. The instrument should be less vulnerable to liquidity crises than other instruments available to investors with otherwise like characteristics.

New Products and Tactics

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

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

• Originate futures contract settlement instruments,

• Prevent competitors from imitating ENEX futures,

• And issue more investor-friendly securities.

The second article's choice of a commercial paper-based bellwether chases the profit abyss created by the termination of Eurodollar futures trading.

ENEX Futures

There are many alternative ways to design both the futures contract terms and properties and issue dates for the deliverable instruments. The choice should not be casual. Here are ways to challenge the existing CME methods.

1. Create the capacity to originate the deliverable instrument.
2. Alter settlement dates to accommodate investors.
3. Consider treaties with CME.
4. Avoid half-measures. The closer an FMX contract comes to a CME contract, the greater the likelihood of failure.

Possible terms for the futures contracts

Capacity to originate

The most important lesson of the failure of the Eurodollar futures market was that CME was trapped, held hostage to the financial institutions that issued London interbank wholesale deposits. London deposit market failures include:

1. The instrument traded was a time deposit. Time deposits handicap liquidity since they do not trade in a secondary market.
2. The banks of the London market are regulated by the Bank of England and the Fed. This meant that the market was vulnerable to regulatory decisions.
3. The first thing the regulators decided was to increase the regulatory capital requirements for deposit issuing banks.
4. Once the regulators had reduced issuance through capital charges, the resulting illiquidity opened the door for market manipulation, both by Eurodollar traders and by the regulators themselves.
5. The London branches insisted that the CME settle its futures contracts with an index. Since the index was not a market price, Eurodollar futures were weakened further.

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 financial futures markets weekly with a new issue the way the Treasury does it.

The effect would be to match trading in the Treasury when-issued market. But ENEX futures would have an enormous advantage over the Treasury when-issued market. The when-issued market is an insider's market. There are no margin requirements due to the restriction of the market to government securities markets only. ENEX Futures would use futures-style margin requirements, permitting retail investors with sufficient funds to participate, expanding the market dramatically.

Consider a treaty with CME

This treaty would address margins. A primary effect of the futures-style clearinghouse is the major advantage to incumbent exchanges it creates. Read here for a description of the FTX plan.

"CME has a key advantage in fending off competition. In addition to running the market where traders buy and sell futures, CME runs the related clearinghouse - the underlying plumbing system that holds collateral for big trading firms and moves cash around to settle winning and losing trades."

"Rival exchanges can't use CME's clearinghouse, and convincing traders to connect to a different one has historically been difficult for competitors. Trading firms would need to post collateral in two separate places to support a new futures exchange, since they are unlikely to abandon CME altogether for an untested startup."

"Lutnick (CEO of Cantor Fitz) has tried to solve that dilemma by agreeing to clear FMX's trades through LCH, owned by London Stock Exchange Group. LCH is one of the world's major clearinghouses, used by many banks to clear trades in interest-rate swaps. Among the unsuccessful challengers to CME in years past was NYSE Euronext, the old parent company of the New York Stock Exchange. Lutnick backed an interest-rate futures exchange that launched in 2009, but the venture, ELX Futures, struggled to gain traction. Lutnick blamed the failure on weaknesses in its clearing arrangements."

Avoid half-measures

The closer the FTX contract comes to a match for the CME version, the greater the CME advantage described above. This consideration leads to two major distinctions between the CME contracts and a successful alternative.

• The contracts should settle on different days from the CME.

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

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

Settlement days. Settlement days match investor needs.

Physical settlement. Treasury asset-based instruments with individual Treasury components published daily at the close.

Exchange-originated. Since the exchange itself buys and sells the Treasury assets and since the composition of the portfolio is unknown until the close. The opportunity to imitate is not available to rival exchanges.

Competitive analysis

The FTX proposed futures contracts trade Treasury-based yields. It plans a Secured Overnight Financing rate (SOFR)-based contract and contracts based on several Treasury yields. The FTX contracts are perhaps different from the CME version of these same markets. However, no doubt the SOFR contract will settle at the Fed-calculated rate. Moreover, the Treasury futures will very likely forgo CME's physical delivery option in favor of settlement at the auction rate.

If the difference between the FTX contracts and the CME version are limited to this sort of triviality these contracts will fail. Trivial differences open the door for CME contracts that more closely match the FTX contracts. Turnabout is fair play.

The way forward

The key to successful futures inter-exchange competition is to understand and take advantage of the impact of futures style clearinghouses. Here are the key effects.

1. Inter-futures-exchange arbitrage is not economic. Futures markets are not HFT-arbitrage friendly. To be simultaneously long and short the same or similar contracts is inefficient. In this low-risk strategy pursued on both exchanges, margins are doubled, not canceled by an opposing position.
2. Reverse imitation is likely. If the FTX exchange makes minor changes in the CME versions, CME can easily list two versions - A the FTX-like version and the original CME version. This will bring all the FTX /CME basis trades directly to the CME. Moreover, the FTX imitation contracts will trade on the CME than on the FTX exchange.
3. There are only two choices in futures interexchange competition. The first option is to replace CME; the second to sign a treaty with CME.

Conclusion

The most interesting inter-exchange competition in a generation is beginning. The established highly profitable CME is being attacked by a new exchange, FTX futures, a component of Cantor Fitz. FTX wisely reveals only the minimum information necessary to obtain CFTC approval. Yet that information suggests that unless FTX also includes an option, a second suite of contracts that take a greater change in direction, FTX futures will fail.

Kurt Dew