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Battle of the Commodity Exchanges

Don Dawson

Over the past several years the Commodity Futures Exchanges have seen many mergers and one new Exchange arrival.  Most of this was done to be financially competitive with their International competition.  Each Exchange has large institutional and commercial customers that they must keep satisfied with low trade execution cost and excellent service.  The Exchanges’ trading volume here in the United States was primarily driven by trading pits (open outcry). This meant there was more physical location and employees needed to make this operation work.  In the end the cost to run an open outcry style Exchange is much more than an electronically traded Exchange.  In Europe they had already gone to a majority of electronic trading thereby keeping their operations cost down.  With lower operating cost they were able to pass these savings onto institutional and commercial traders.  The United States Exchanges saw this and immediately became concerned with losing their customers to the European Exchanges.

One of the biggest changes made to be competitive was the acquisition that the Chicago Mercantile Exchange (CME) made.  They bought the Chicago Board of Trade (CBOT) and the New York Mercantile Exchange (NYMEX) and created the new Exchange CMEGroup.  By doing this the CMEGroup was able to be more competitive with the Europeans based on operating cost.  The acquisition also created the world’s largest Futures Exchange, the CMEGroup.  No other Exchange comes close to the volume traded at the CMEGroup.  The European Exchanges come in at a distant second place.

The Chicago Futures markets started trading in 1848.  With a long track record of integrity and products needed  for the trading community it is no wonder traders feel so comfortable trading on the CMEGroup.

Competition keeps the world going and prices low around the world.  The Commodity Futures markets are no exception.  In early 2000 a new Exchange was developed that was purely electronically traded.  The Inter-Continental Exchange (ICE) is headquartered in Atlanta, Georgia.  ICE has electronic Exchanges in Canada and Europe as well.

After 9/11/2001, and the collapsing of the World Trade Center, the New York Board of Trade (NYBOT) was destroyed.  They moved to a backup facility until they were later acquired by ICE in 2007.

ICE has always tried to take volume away from the CMEGroup.  A couple of them were the Russell 2000 and the WTI Crude Oil contracts.

The Russell contract used to trade on the CMEGroup Exchange until September, 2008 and now resides at the ICE.  The volume is much less now that it trades on ICE.  The average volume since going to the ICE is now about 140K contracts per day.  When it traded on the CMEGroup the average was more like 250K to 300K per day.  Some of the reasons for the drop in volume was due to the swap Spreads between the ES (mini S&P) and the NQ (mini Nasdaq).  When the Russell traded on the CMEGroup the cross margin to Spread ES and NQ with the Russell was much less expensive.  Today traders would have to pay full margin on both legs of the Spread.  Even with the drop in average daily volume the Russell remains a good trading vehicle for Index Futures traders.

In 2006, ICE released a contract to compete with the CMEGroup’s WTI Crude Oil contract.  In 2007, the CMEGroup lost a court case trying to block this new contract being offered by ICE.  CMEGroup has managed to keep the bulk of volume traded on the WTI Crude Oil contract at about 480K per day, whereas the ICE WTI Crude Oil contract trades about 150K per day.  ICE was trying to launch a product that would allow its hedgers and speculators to more easily create arbitrage opportunities between WTI Crude Oil and Brent Crude Oil.  When Commodity products are traded on the same Exchange then the Exchanges offer reduced margin rates to speculators and hedgers.  In all fairness I guess you cannot blame ICE for wanting to create this new contract.

Just this week ICE announced some more new products to compete with the CMEGroup.  One of the original Futures products ever traded was the Agriculture sector, mainly the Grain markets.  Now some 200 years later ICE is going to try and take some of this business away from the CMEGroup by offering 5 Grain contracts.  The contracts will mirror the CMEGroup Wheat, Corn, Soybeans, Soybean Oil and Soybean Meal.  The contracts are reported to be ready to trade in May, 2012, pending regulatory approval.  The biggest difference between these two Exchange contracts will be that the ICE will be cash settled contracts while the CMEGroup will remain a physical delivery contract.  This will make the ICE contract more appealing to ETF’s that do not usually take delivery of the Commodity at contract expiration.  Currently ETF’s do very large volume figures in the Agricultural products.  If the ICE offers a lower cost to do business in these Grain products they may lure away some of the CMEGroup volume.

Taking business away from the well established CMEGroup will be a tough challenge for ICE.  Many farmers and other commercial interest have traded at the same exchange for years and are very comfortable placing trades on CMEGroup.  The Chicago region has always been a central hub for Grain trade.  With so many Grain elevators (places where Grains are stored until future delivery is made) in the vicinity of Chicago it will take some extremely good prices to lure them away from the CMEGroup.

As I mentioned earlier about the Russell and Crude Oil contracts that currently trade on ICE the one thing that will keep users from moving over to the ICE is the lack of volume and liquidity.  Imagine if you are a large Commercial trader and needed to place a hedge position.  If there is no liquidity then the price fills will be bad getting in the trade and exiting.  Also, large traders do not want to break up their trades into smaller block sizes to get trades done.  That is the big advantage CMEGroup has is these hedgers and large traders can place big position size and get filled very easily.

>It is interesting at the timing of this announcement.  Apparently ICE is trying to capitalize on the MF Global situation.  Many traders are still without their funds that have been lost due to the fall of MF Global.  Some feel that the CMEGroup dropped the ball on monitoring MF Global and their trades, creating a lack of confidence in the Futures markets due to the capital losses traders are experiencing.

As traders we need to be aware of these new products and plan our trades more carefully.  Just like the hedgers and large traders we small speculators still need liquidity to operate in any market.  I would always recommend you do some research when new products are released and look and see if the volume is there for us to trade.  Considering that the Commercial traders do about 60% of the daily volume I for one would not trade a market that they have no interest in.

This competition is actually good for all involved.  Without competition there is always a chance for a monopoly to occur and that would mean higher transaction costs for all of us.  The key is to let the big guys figure out when a product is ready to be traded.

“Difficulties in life are intended to make us better not bitter.”  Dan Reeves

Always be willing to learn,

-Don Dawson

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.