Source: Euromoney magazine
Date: December '99
Author: Antony Currie
After the summer craze for investing in all things electronic and e-commerce-related, things have calmed down on the surface in the US. Now the challenge is to make the investments work. The major stock and derivatives exchanges know they have to respond more forcibly to the myriad threats to their franchises. At the same time the start-ups and the investment banks which are equity partners must transform their ideas into reality while trying to avoid the organizational nightmares which have plagued the exchanges. The next few months are more likely to be ones full of frustration for both groups, reports Antony Currie
When you first visit Richard Kilsby at his office there is a surprise in store. He is the chief executive of Tradepoint, the London-based for-profit electronic exchange saved from extinction in May by a consortium led by agency broker Instinet and also including investment banks, an asset manager and a US electronic commission network (ECN) called Archipelago which itself has since applied to become an exchange in the US.
What provokes the surprise is preconceived ideas of what an exchange should look like: large buildings in the centre of financial districts proudly showing off their history. In the executive dining room of the New York Stock Exchange, for example, hang the portraits of past chairmen, and in the corner stands a magnificent Faberge egg donated to the exchange by Tsar Nicholas II at the start of the century.
That is not Tradepoint's style. Its office is in London's Soho, better known for opera, Chinese restaurants and more recently for being one of London's gay meccas. It is only one of several businesses in the building, and the walls are adorned with posters of pop art by Ray Lichtenstein. While the NYSE ponders whether it should take advantage of the $600 million the City of New York has kindly provided it with to expand into more buildings in downtown Manhattan, Kilsby is looking at annual overheads of £10 million ($16 million)
Elsewhere, it's a similar story. In Manhattan the area around Union Square is fast becoming the city's silicon alley; home to new financial services companies. Wit Capital, the on-line retail investment bank run by former Salomon Smith Barney banker Bob Lessin and former Schwab vice-chairman Ron Readmond, is just south of the square on Broadway, based in cramped offices in a walk-up above one of the city's most famous second hand bookshops, the Strand.
Just north of the square, off Fifth Avenue, is an even newer operation, Creditex, set up in early summer by two former Deutsche Bank credit derivatives traders, Sunil Hirani and John McEvoy. They are creating a virtual market place to trade, initially, default swaps. They have less than 20 employees, occupying just one office of several on their floor. It is still so new that they have yet to put a proper sign on the door, instead having a double photocopy of the firm's name and photocopies of the main employees, stuck on with sellotape.
They are new, nimble, staffed with people who are experts in their field and lack all the organizational nightmares which are plaguing the incumbents. And, on the equities side at least, they would appear to have the backing of SEC chairman Arthur Levitt. His plan is to use the ECNs as a way to provide effective competition to the exchanges, and he has openly signalled that he is willing to end the regulatory bias in favour of the entrenched exchanges. "At one time or another, all of us have failed to act outside the scope of parochial interests - refusing to recognize the market as a marketplace, and not an institution," he said in a speech at New York's Columbia Law School at the end of September. "This is not the time to cling to the comforts of custom; it is time to demand value. We should be asking ourselves: what best serves the interests of investors? Anything that doesn't should be part of our history - not our future."
He has already proved willing to turn words into actions in the way he has dealt with the options exchanges. He made it clear that they needed to start to work with each other, even compete openly with each other by trading the others' contracts. They failed to do so for themselves, so he imposed it upon them. Now it is a free-for-all, with customers searching out the best price on all three major exchanges for the first time.
A month later he was back in New York speaking in front of the Economic Club of New York, this time speaking in favour of a level playing field for all investors. But one of the questions at the end referred back to his earlier speech. In fact, it tried to refer to just about everything. Bill Donaldson, co-founder of Donaldson, Lufkin and Jenrette, and a former president of the NYSE, spent five minutes asking a question which included so much information he must have hoped it would make him look clever. His bottom line was that the SEC should put all developments on hold and set up a commission to investigate what would be best for the market.
Few outside the exchanges, and probably not too many inside them, would be all that keen. "We don't want to see the regulators coming in to sort this out for us," says Richard Korhammer, CEO of Lava Trading, a developer of trading systems that provides direct access to all sources of liquidity. "It should be left up to competitive forces. There are applications, such as ours, which can address Levitt's desire to tap all pools of liquidity efficiently once regulations allow."
Levitt appears to agree. After a stifled giggle at the preposterous length of Donaldson's speech, and a short pause during which most of the audience must have feared that he would ask for Donaldson to repeat the question, Levitt answered. No, a commission would be counter-productive and waste too much time - a year, possibly longer. So the stock exchanges remain on the back foot, destined to be forced to prove their worth without the regulatory barriers to entry which have in the past kept them in almost unassailable positions.
Good news for the new firms, but no guarantee that they will as a result prosper, or even, where appropriate, replace, the incumbent institutions they compete with. E-commerce is a wonderful tag to be able to put on a business, but if the main focus is on the technology there could be trouble ahead. In other words, they need to use the 'e' to maximize the benefit of the 'commerce'.
New start-up exchanges, the ECNs in the US, Brokertec, Cantor Exchange, ChicagoFutures, all suffer from one or more hindrances: lack of name recognition and brand, lack of sufficient business and liquidity, or encumbering rules and regulations which grant the incumbents an advantage.
And then there is the matter of what the market players actually want. Several of the major investment banks refer to their investments in the ECNs as hedging their bets. Among these are the two largest investors, Goldman Sachs and Merrill Lynch, but also Salomon Smith Barney, Morgan Stanley Dean Witter, and others. Their investments in new exchanges may be a forcing function to get the incumbents to get their act together (for a complete list of major firms' investments in new ventures see the table below).
| Who’s done what – investments in internet and electronic trading vehicles | |
| Bear Stearns | |
| Strike | ECN, set up by Bear Stearns |
| Barclays Capital | |
| Brokertec | Invited in as an equity partner in the inter-dealer broker by the intial consortium in December; 12 banks in total |
| EuroMTS | Inter-dealer broker for European market. 24 banks involved |
| Tradeweb | On-line trading platform for US treasuries. Barclays joined in early 1999 |
| Credit Suisse First Boston | |
| Tradeweb | electronic trading network in US treasury products, set up 1997; instigated by CSFB |
| Brokertec | Global inter-dealer broking system for bonds and futures. One of seven in initial consortium; 12 members now |
| EuroMTS | Inter-dealer broker for European market. 24 banks involved |
| Optimark | Alternative trading system, minority stake (undisclosed) |
| Tradepoint | European electronic stock exchange based in London, 9.74% of consortium, which owns 54% of the exchange |
| Reditrade | ECN, joint venture with Schwab, Fidelity, Spear Leeds Kellog and DLJdirect |
| Deutsche Bank | |
| Tradepoint | European electronic stock exchange based in London; 9.74% of consortium, which owns 54% of the exchange |
| Brokertec | one of the seven founders (12 banks now members) |
| EuroMTS | Inter-dealer broker for European market. 24 banks involved |
| DLJ/DLJdirect | |
| Strike | ECN, minority interest |
| Reditrade | ECN, joint venture with Schwab, Fidelity, Spear Leeds Kellog and CSFB |
| Dresdner Kleinwort Benson | |
| Brokertec | Invited in as an equity partner in the inter-dealer broker by the intial consortium in October |
| EuroMTS | Inter-dealer broker for the European bond market. 24 banks involved |
| Tradepoint | European electronic stock exchange based in London, 9.74% of consortium, which owns 54% of the exchange |
| Goldman Sachs | |
| Wit Capital | retail on-line investment bank, 20% stake |
| Archipelago | ECN, and would-be exchange, 12.5% stake |
| Optimark | ATS Minority stake (undisclosed) |
| Brut | ECN, 10% stake |
| Primex Trading | Joint venture with Merill Lynch, Morgan Stanley, Salomon Smith Barney and Madoff Securities |
| Strike | ECN – 5% stake through Hull Group (options trading firm bought by Goldman for $531 million in 1999) |
| Brokertec | Global inter-dealer broking system for bonds and futures; Goldman is the force |
| behind it, but holds an equal stake with 11 other investment banks | |
| EuroMTS | Inter-dealer broker for the European market |
| Tradeweb | electronic trading network in US treasury products |
| Easdaq | European Stock exchange, undisclosed stake |
| JP Morgan | |
| Archipelago | ECN and would-be exchange, 12.5% |
| Tradepoint | European electronic stock exchange based in London; 9.74% of consortium, which owns 54% of the exchange |
| Tradeweb | electronic trading network in US treasury products. Consortium of nine banks |
| EuroMTS | Inter-dealer broker for European market. 24 banks involved |
| Lehman Brothers | |
| Strike | ECN, minority stake |
| Brokertec | one of the seven founders (11 banks now members) |
| EuroMTS | Inter-dealer broker for European market. 24 banks involved |
| Tradeweb | electronic trading network in US treasury products |
| Merrill Lynch | |
| Brokertec | Global inter-dealer broking system for bonds and futures. One of seven in initial consortium; 11 now members |
| EuroMTS | Inter-dealer broker for European market. 24 banks involved |
| Primex | Joint venture with Morgan Stanley, Salomon Smith Barney and Madoff Securities |
| Strike/Brut | ECN, minority stake |
| Archipelago | ECN, 12.5% |
| Tradepoint | European electronic stock exchange based in London; 9.74% of consortium, which owns 54% of the exchange |
| Tradeweb | electronic trading network in US treasury products |
| Optimark | Alternative trading system; minority stake |
| Morgan Stanley Dean Witter | |
| Tradepoint | European electronic stock exchange based in London; 9.74% of consortium, which owns 54% of the exchange |
| Easdaq | 2.5% stake |
| Brut | ECN, minority interest |
| MarketXT | ECN pushing after hours trading, minority interest |
| Primex | Joint venture with Merill Lynch, Salomon Smith Barney and Madoff Securities |
| Salomon Smith Barney/Citigroup | |
| Strike | ECN, minority stake |
| Brokertec | Interdealer bond and futures broking system; one of seven founder members |
| Tradeweb | electronic trading network in US treasury products; Salomon one of four banks |
| in initial consortium (now stands at nine) | |
| Primex | Joint venture with Merill Lynch, Morgan Stanley and Madoff Securities |
| EuroMTS | Inter-dealer broker for European market. 24 banks involved |
| MarketXT | Joint venture with Merill Lynch, Salomon Smith Barney and Madoff Securities |
| Warburg Dillon Read | |
| Tradepoint | European electronic stock exchange based in London; 9.74% of consortium, which owns 54% of the exchange |
| EuroMTS | Inter-dealer broker for European market. 24 banks involved |
| Brokertec | Invited into the consortium as equity partner in December 1999 |
| Note | The ECNs Strike and Brut recently announced their intention to merge |
That's fine as the strategic view but what about tactics? As a community, the large investment banks speak more or less with one voice about the stock exchanges. The top 10 banks between them bring 55% to 60% of the order flow to the NYSE, which makes for a powerful voice. To oversimplify somewhat, it's the big guys against the other members - the small or independent floor brokers at the NYSE, or the specialists. The big firms all repeat the same line: they know NYSE chairman Richard Grasso understands what they say and agrees with them on most counts, but it is the other members who hinder the process of change. "A lot of the smaller guys say such things as 'just give me another two years at this'," says one investment banker. "As if in two years they will have made enough, with no ill effects for the exchange. But it'll be too late by then."
Take the big guys away from the arcane distractions of exchange politics, though, and it can be a different matter. The banks themselves are also worried: what if the ECNs succeed in winning flow from a wide range of equities trading rather than just the narrower field of technology and growth stocks on Nasdaq? It would wreck much of their business, so rather than be cannibalized it's better to get involved in the cannibalization themselves. When decent systems come along, such as Archipelago, for example (one of the main ECNs and the first to register its intent to become an exchange), several banks jump in as investors and board members, and feel compelled to act together in the better interests of the market.
But it won't be long before old rivalries and conflicting ideas between the firms resurface on the boards of the start-ups. The banks have bought into these operations partly to force the market, partly to benefit financially from investing, but also because they want greater control over what happens.
So this then threatens to turn the nimble new guys into parodies of the old models. One of the investors in Archipelago is worried that this is already happening. "We and our competitors may check our guns in at the door to start with, but it increasingly looks like the NYSE," he says with just enough annoyance to imply that it's not just a joke. "Getting us all to work together is not easy for one thing. For another, we're sitting there creating more mechanisms and structures." In other words, what is happening at the new entities is that the seeds for future discord are already being sewn.
First, there is the question of which firms to allow on board. In the case of Tradepoint, there are now 10 institutions in the consortium; Doug Atkin, CEO of Instinet and the man credited with forming the consortium, says that there are about 75 others who want to join. That is clearly untenable, as it would make the decision-making process as torturous as at the old exchanges. In any case, bickering and fighting on the boards of these start-ups is inevitable as each tries to reconcile the lofty longer-term aims for the market as a whole with the shorter-term desire, inbred since starting on Wall Street, to put oneself and one's own firm first. Investment banks thrive on competition, traditionally have managers who focus on product, and are not renowned for being adept at managing multiple channels; to expect them to be able completely to put that aside is too unrealistic.
Another problem could well be an increase in conflicts of interest for those such as Merrill and Goldman which have invested in a plethora of systems and start-ups. Will they be prevented from taking one course with one of them because it conflicts with the aims of another? This has already caused some friction at the Chicago Board of Trade, where those banks involved in Brokertec, the Goldman Sachs-led consortium of nine banks to set up an electronic inter-dealer fixed-income broking concern, have felt compelled to refrain from voting on any Brokertec-related matters brought before the CBOT. If that were applied to the ECNs and cash exchanges, nothing would ever get done.
The founder of another start-up, on-line investment bank Wit Capital, predicted in an off-the-cuff remark that it would be 10 years or more before his firm began to suffer from the organizational nightmares which plague incumbents today. But for many the challenges have already started. It could be time to brush up on those game theory skills.
NASDAQ let down by its own technology
It's just gone 3.30 on a Tuesday afternoon in mid-November. Discussing his firm's e-commerce strategy for equities is the trading head for one of Wall Street's top 10 trading houses. One of his traders comes in. "I just thought you'd better know that Nasdaq's down," he tells his boss. Strange that, disturbing a meeting to give a quick check on which way stocks are going. Er, no. It quickly becomes clear that the intruder is talking about the system. Not the bank's system, but Nasdaq's. Less than half an hour before the close of normal trading hours, no trading can be done.
Unfazed, the trading head turns his attention back to the meeting. He seems remarkably composed. "This happens a lot," says the banker. "Nasdaq wasn't built for these volumes." The worst case was on September 30, the quarter end rebalance for all types of investment funds. And this one just happened to see a lot of activity. "But the system went down soon after 3pm," says the banker. "All the deals are pegged to the last trade, so this really screwed up the quarter-end rebalancing. In the end, Nasdaq decided to turn the system back on for a second or so to sort out the last trades. But they didn't tell anyone. It was a shambles."
 Nasdaq chairman Frank Zarb |
The stock exchange for technology stocks being let down by technology? An amusing irony, perhaps, but also a worrying state of affairs. Such problems have also hit the on-line brokers, such as Schwab and E*Trade, but for the whole system of an exchange to crash is much more worrying. Deal flow has increased dramatically in the last three years: Merrill Lynch reports that currently it often handles up to 1 million trades a day; in 1996 that figure was 50,000 a day. But if the banks can prepare for it and handle it, so should the exchanges.
And consider this: at present stocks in the US are traded in sixteenths of a dollar. As of summer next year the process will be decimalized. This is a slightly misleading term for the result is that trades can then be done in increments of one cent rather than 10 cents, as the term implies. Jim Lehman, managing director at Salomon Smith Barney, puts a conservative estimate of 300% on the increase in trades this will bring. If Nasdaq is struggling to cope at present trading levels, imagine what a mess there could be after decimalization.
Of course, this is by no means Nasdaq's only problem. If it were simply a matter of revamping its systems to cope with increased flow, matters would be relatively simple. But Nasdaq's big threat is still some months away. Much has been made of the inroads the ECNs have made in capturing 30% or more of Nasdaq trading flows. One insider at Nasdaq states that this hits the broker-dealers more than Nasdaq as they lose the business, whereas the trades still come to Nasdaq. True, but Nasdaq does lose its execution fee when trades aren't executed on Nasdaq, such as when two members of an ECN trade between themselves. Such trades still get reported to Nasdaq for regulatory purposes, but there is no fee for this service.
Some of these ECNs might not be around for much longer in any case, as their raison d'être - the way fees are currently charged for dealing in Nasdaq-listed stocks - might be terminated by the SEC. But if, or more likely when, some of these ECNs themselves become exchanges, Nasdaq will be sitting in a much more precarious situation.
Already two of the largest have signalled their intent to do this. One is Island, owned by Datek, a favourite of the day traders and rivalling the largest ECN, Instinet, for the volume of flow it handles; the other is Archipelago, an order-routing system which has attracted investments from several investment banks (including Goldman Sachs, JP Morgan, Merrill Lynch and CSFB), Instinet, investment manager American Century (45%-owned by JP Morgan), and even the US news organization CNBC. "It's an intelligent electronic order routing system," says Kilsby, in whose electronic exchange, Tradepoint, Archipelago holds a stake. "It hunts round all liquidity providers and gets best execution."
There are other, similar, tools, of course. One, Lava Trading, is waiting to receive its patent. Another, Optimark, has joined forces with Nasdaq to try to capture some of the flow going through ECNs. Institutions which have invested, such as Goldman Sachs and Merrill Lynch, were not as impressed with Optimark's progress as they were with other entities before the Nasdaq link was made, and other market players complain that it is too complex. Cynics suggest that both parties view the joint venture as salvation for each of them. This is no doubt too harsh, but Nasdaq chairman Frank Zarb has described Optimark as the system which Nasdaq ought to have built.
But Archipelago is both an operational ECN capturing order flow, as well as being built with open architecture, so is not limited to being an ECN (some of the other ECNs are simple order-matching systems and nothing else). Its flexibility, as well as its speed and intelligent software, is what has incited so many institutions to buy into Archipelago. As for Island, it has succeeded in capturing a large amount of flow in dealing in Nasdaq stocks, and in recent weeks it has embarked on an advertising campaign on US television depicting itself as the driving force allowing the general public to storm the barricades of the stock exchanges. If and when either or both become exchanges, they already have solid content to be able to give Nasdaq, and who knows, even the NYSE, a run for their money.
To be able to compete more efficiently, Nasdaq has joined the NYSE and the two major derivatives exchanges, in announcing its intention to become a for-profit organization. For Nasdaq, this would involve satisfying the needs of 5,500 broker-dealer members. But it is also aggressively pushing to get active involvement from some of those companies listed on Nasdaq, whether as equity holders, systems developers, or both. So the big technology companies such as Microsoft, Sun and Oracle are being courted. But Oracle and Sun, as with many technology companies, do not enjoy particularly cordial relationships with Microsoft, and are not keen to be involved if Bill Gates' company is.
And there is another issue. What do these companies do if a publicly-traded Nasdaq does badly? If it starts to lose market share to, say, Archipelago, the share price drops, and share-trading in the investing companies shifts more and more to other trading arenas? It is highly unlikely that Microsoft or anyone else would be willing to be tied to Nasdaq in such a situation.
Perhaps this is a crisis only for the more distant future, perhaps not. Nasdaq is stretching itself in a way that few public companies would be allowed to. It has announced joint ventures for setting up exchanges in both Japan and Europe, with internet venture capital firm Softbank in both cases, and News Corporation joining in for Europe. But the costs will not be small, and in Europe there is already an, admittedly stalling, move to a pan-European agreement among the stock exchanges, as well as two other active competitors, Easdaq and Tradepoint.
In addition its systems at home are under pressure, and for all its protestations that it is the broker-dealers alone who suffer from the success of the ECNs, 30% or more of order flow is going through technology which does not belong to Nasdaq.
"No public company CEO would still be in office if that were to happen to his or her company," says one financial markets consultant. And that competition will only increase. So when an IPO does finally occur, the management team will have to meet these challenges with initiative and speed.
NYSE members differ over demutualization
If predictions of its demise were true, the New York Stock Exchange would have been killed off long ago. Yet it is still there, on the corner of Wall Street and Broad Street, now so busy that it is looking at expanding into other buildings downtown, for which it has received $600 million from the City of New York.
That is a decision not to be taken lightly. Getting such new premises ready could take a couple of years or more, by which time they could be irrelevant. It is similar to the dilemma faced by Liffe two years ago. Eventually the London futures exchange ditched plans for a new trading floor and moved all its contracts to an electronic platform.
There are those who would like to see that happen at the NYSE. One, Harold Bradley, senior vice-president at US asset manager American Century, is infuriated by what he calls the bucket brigade - the number of hands, often up to six, that an order must pass through to get to the counterparty on the other side. His firm has made a series of investments in electronic systems, such as Optimark and Archipelago.
 The SEC's Levitt and NYSE's Grasso have differing views on NYSE self-regulation |
How much value human intermediation can offer is being severely tested. Can individuals really cope with the demands of the large investors any more? If a fund manager wants to change a $3 billion portfolio in a matter of days, it would surely be more efficient, and more speedy to route as many of the orders through an electronic platform providing best price, price discovery and anonymity as possible. Is the open outcry method the best for dealing with programme trades, which can have over 6000 stocks in them? With the floor of the exchange already crowded and frantic, bringing in decimalization could multiply trading very quickly, and leave the specialists way behind.
It could be that one possible model is for the large, heavily-traded stocks to move onto an electronic platform, and for the specialists on the floor making markets to concentrate on making markets in the less liquid stocks where their intermediation would be of more value.
The senior management at the NYSE is clued in, say bankers. "Some of the best ideas come out of the committee session there," says a managing director of one bank's equities division. "From simple things such as no smoking right outside the building to issues as complex as whether they should trade Nasdaq stocks. The only problem is that while the committees are excellent places for generating ideas, the process for getting them implemented is miserable as more and more people get brought in."
Walking a tightrope
That's something which the exchange hopes will change if it demutualizes. But chairman Richard Grasso is walking a tightrope above the various sections of the membership. "He understands what's going on, and knows he has to act," says one banker. "But he can't come out and say so in public for fear of alienating one or more sections of the membership." To get membership acceptance for demutualization 60% of the members need to vote in favour of it.
The problem is not the specialists. The larger specialists understand the challenges. Spear, Leeds and Kellogg (SLK), for example, owns REDIbook, an ECN which in recent months has taken on several strategic partners: Schwab, DLJdirect, Fidelity and CSFB. One of SLK's employees who works on the floor of the NYSE admits he fears for the future of his job, but also feels that his firm at least is positioning itself for change. Another specialist on the floor who works for Labranche, which in August became the first specialist firm to go public, is convinced that there is still value in using human intermediaries, but accepts that at some point the model has to change significantly.
Resistance to change is more pronounced among members who rent their seats out to independent brokers. "It's the retired members, or outsiders who own seats," which are the problem, says one banker. "The $2 brokers who lease from them ring them up and tell them that this demutualization plan is a bad idea. Being away from the front line these members don't appreciate what else is going on, so would rather sit on their hands and hope that they can continue leasing out their seat in perpetuity."
And then there is the thorny issue of regulation. Grasso is determined to maintain self-regulation for the NYSE, and is using it as part of the exchange's brand, talking up its success. He has told the Senate banking Committee that "self-regulatory duties literally permeate every part of the exchange".
It is not always successful however. There are several court cases outstanding against the floor brokers, one involving president Bill Johnston. Michael Frayler was a floor broker for Oakford (now gone out of business), and is one of six former Oakford employees now on trial for trading for their own profit. Frayler's trade was in 1996, in AT&T stock. Johnston was the specialist handling the trade, and Frayler's contention is that Johnston, then a vice-chairman of the exchange, overheard him boasting of the profit he'd made but said "I didn't hear that".
This and other cases have eroded the notion that the NYSE is an effective self-regulator. The fear is that a public company would be even less inclined to be vigilant. SEC chairman Levitt has suggested that one option is for the stock exchanges to cede their self-regulatory powers to a separate, overarching body in the event of demutualization. Nasdaq seems more willing to do this but the NYSE's chairman Grasso, at present, is still standing firm.
Chicago's fallen giants make progress of sorts
Try telling 150,00 people that many of them might soon be out of a job. That is the bottom line in Chicago, where the three derivatives exchanges - the Board of Trade, the Mercantile Exchange and the Board Options Exchange - are among the city's major employers. Roughly 50,000 are jobs directly linked to the exchanges, the other 100,000 indirectly.
The Chicago exchanges are a peculiar breed, especially the Merc and the CBOT, which have been around since the last century. By playing such a large role in the local economy and by being so much more isolated from the rest of the financial universe than the New York-based exchanges, it has been easy for them to allow themselves to get bogged down in their own little space. A senior executive from one of the banks in the Brokertec consortium has little time for Chicago any more. "Their views are extremely narrow up there. They can't see beyond the Chicago river."
That is beginning to change but it has taken some time. Down in New York, the Wall Street bankers have almost given up on the goings-on in the Windy City.
"My interest in it is so much less," says one. "The world doesn't hinge on them any more, so none of us feel the same anxiety any more about what they do."
 CBOT chairman David Brennan has been forced to watch Eurex become the world's largest derivatives exchangeself-regulation |
In part that is because they have grown tired of the squabbling and suspicion of change which has been a major feature of dealing with Chicago over the last few years; and in part because technology now allows for more competitors such as Eurex, or new start-ups like the Cantor Exchange and Brokertec. Or even in-house systems, such as PrimeTrade, developed by Phillipe Buhannic at Credit Suisse First Boston, which allow futures trades to be conducted electronically, so bypassing some or all of the process of going through exchanges.
New role models
The exchanges in Chicago face the twin problems which beset the NYSE and Nasdaq: the rise and rise of electronic trading, and organizational inertia. Both have taken steps to deal in part with the former: the CBOT has its alliance with Eurex, now the world's largest derivatives exchange and an all-electronic exchange as well. And the Merc has formed a strategic alliance with Liffe, which just last month ceased the last vestiges of open outcry trading, with all orders now going through on its high-tech trading platform, Liffe Connect.
Liffe should serve as an apt role model for the Merc: here is an institution which just two years ago was planning to open a new, larger trading floor and offer both open outcry and electronic broking, but competition from Eurex forced it to reevaluate, forced it to work more closely and effectively with its members, and change its business model and its senior staff. But Liffe is much younger (founded in 1981), so has less pull from history, and is right in the centre of the City of London, not out on a limb.
The Merc is also much further down the path of changing its organizational structure. For all the hype about Nasdaq and the NYSE demutualizing, as well as the CBOT, none is as far along with the process as the Merc, which last month published its plan for going public. Its chairman, Scott Gordon, instigated the strategic review last November. There are five major objectives behind demutualizing: to improve governance; create a strong financial decision-making model; facilitate the pursuit of new business strategies; unlock the equity values of exchange members; and provide a signal and a currency for working with strategic partners.
The Merc is much less fraught with internal political struggles and Gordon seems to have the support of the members, and yet it still took 12 months to get this far. The members still have to approve the plan (a vote is due in February) but even then much will still need to be done. Only once listed will the exchange be able to act effectively, but to do so requires a management team geared to running a public, for-profit company. That may or may not include Gordon and others now in senior positions.
Bottom falls out of seats
Then after all this will come the really hard decisions. The members will be the main shareholders, and many will also still earn their living by trading at the exchange. Seat prices may be under pressure now, but if the wider markets feel that CME Inc is not packing much punch, the stock price will go down quickly. Do they then sell and risk losing the influence over running the exchange they always used to have? Or do they hold on to their shares and vote themselves out of business, whether by embracing change and so becoming redundant, or by resisting it and dying where they stand?
Over at the CBOT, they are nowhere near having to endure such torture. The decisions its members have to make are much more trivial. As usual, it is the Chicago Board of Trade which provides the best examples of burying itself in trivia. Last month was a fairly typical one. Members were voting on five governance issues, two of which aroused the ire of president, Tom Donovan. One was to curtail his power by allowing the nominating committee - dominated by exchange members - to appoint outside directors instead of the president. The other called for the salaries of directors and senior officials to be made public.
These issues were high on the agenda, never mind that Eurex has surpassed the CBOT as the largest derivatives exchange in the world. Or that arch rival, the Chicago Mercantile Exchange, is a year further ahead in its own belated moves to join the 1990s, having made public its detailed plan to take the exchange public last month.
No time to lose
The CBOT feels it has the luxury to indulge in bizarre wasting of time. It's indicative of the way that internal politics so often cloud the bigger picture. In the summer the CBOT announced that it, too, was considering changing its structure by becoming a for-profit business which would make much of last month's vote pointless.
It was the CBOT which was largely responsible for scuppering last year's deal on common clearing with the CME, and the CBOT which in February this year rejected the proposed alliance with Eurex. It reversed its policy on both, the former being closed just before Christmas last year, the latter in June this year.
Some blame management for this but the reality is much more interesting. The CBOT is a mini-conspiracy theory in its own right, with everyone convinced that everyone else is working against them. David Brennan, formerly a soybean trader, won a surprise victory to become chairman last December, but is viewed as either myopic or naïve by the futures commission merchants (FCMs) - Chicago's name for the big banks. The FCMs are also wary of the directors, the majority of whom are locals; there are no FCMs running for any of the six available director slots later this month, and they are convinced that the exchange is run for the locals. President Tom Donovan still wields considerable power, as he proved when Brennan tried to force him out in May. Meanwhile the local traders remain convinced that the big companies get all the breaks.
The result? Fear, resentment and inaction - or at best slow response times. When Brokertec was making courtesy calls before its official launch, for example, they found open minds at other potential rivals, such as Cantor Fitzgerald and Liffe. At the CBOT they felt as if the point was not getting through.
The last two years have been a time of reaction rather than innovation, in which the CBOT has gone from arrogant leader to flailing junior partner. The Cantor exchange was taken as an upstart to be treated with derision; the CME is a rival to be treated warily, hence the stalling of the common clearing agreement; Eurex is electronic, so not wanted, oh yes it is, oh no it isn't, oh, yes, alright then; Brokertec is the next threat. And it has lost its crown: Eurex is now the largest derivatives exchange in the world
At present the CBOT lacks the mindset and the infrastructure to compete effectively. It is unlikely that they will be able to take the belated steps which its arch rival ten minutes' walk down the road has done.