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Direct Competition and Futures Exchanges: The CFMA's Unfinished Business by Mark D. Young
Competition anchors our national economy. Everyone favors more competition,
including in the futures markets. Federal Reserve Board Chairman Alan
Greenspan: "competition has long served well both our overall economy and
our financial markets by fostering innovation and efficiency." The Federal Trade
Commission: "consumers would benefit from additional competition in the
market for futures trading services. Competition is the best mechanism for
achieving the optimal mix of products and services in terms of price, quantity,
and consumer choice." Chicago Mercantile Exchange Chairman Terrance Duffy:
"We have no issues with competition. We welcome the competition. We thrive
on it. We have done it for 105 years. We will for another 105 years."
Consistent with this competition consensus, a stated purpose of the
Commodity Exchange Act is to "promote fair competition among boards of
trade." That goal rests at the heart of the much-praised Commodity Futures
Modernization Act of 2000. In the CFMA, Congress promoted fair competition
by easing barriers to entry for competing exchanges and clearinghouses;
making regulation more flexible and less prescriptive; allowing new forms of
trading products; and granting legal certainty to OTC derivatives. The CFMA
envisions more exchanges, more trading facilities and more dealers offering
more products subject to more clearing systems, resulting in lower costs,
perpetual innovation and greater capital efficiency in futures trading. In that
sense, the CFMA is an experiment: Would regulatory flexibility provide longlasting
real competition?
Five years later, what has happened?
Volume on U.S. futures exchanges has
almost tripled, from 600 million contracts a
year to 1.6 billion for 2004. The number of
products traded on U.S. exchanges has more
than doubled, from 266 to 566. Twenty-two
new U.S. trading facilities have been
approved by the CFTC, including eight new
fully-fledged futures exchanges. OTC trading
also has grown substantially, as innovations
like credit derivatives have become a staple
of the financial risk management menu.
Many more products have begun to be traded
electronically and, post-Enron, many more
have been submitted to clearing systems.
On this record, a case could be made that
the CFMA has earned an "A" for promoting
competition. A closer analysis, however,
shows more business activity, but not more
lasting competition. In the past five years,
more attempts have been made by new
exchanges to compete by offering the same
products, that is, head-to-head or direct competition,
with existing exchanges. Those
efforts, however, have not resulted in sustainable,
meaningful direct competition. On
this score, a more accurate grade for the
CFMA would have to be "incomplete."
Today, as before the CFMA, Chicago
Mercantile Exchange remains the dominant
exchange for trading futures in Eurodollars,
various broad-based securities indexes and
livestock. The Chicago Board of Trade
remains the dominant exchange for trading
futures in U.S. Treasury securities and grains.
The New York Mercantile Exchange
remains the dominant exchange for trading
futures in energy and metals. If anything,
each exchange has solidified its dominance
since the CFMA.
The exchanges often say direct competition
is not the only kind of competition they
face. As counsel for Eurex US emphasized in
2003, "no exchange—no exchange; I will
repeat that; no exchange benefits from
vibrant off-exchange markets, because offexchange
markets compete with exchange
markets." Insofar as the CFMA's legal certainty
facilitates OTC derivatives trading, it
could be said to be helping the exchanges
"indirect" competitors put some competitive
pressure on the exchanges.
But even the most zealous advocates of
indirect competition would have to agree
that direct competition is different. When a
challenger exchange lists for trading and
offers to clear a product substantially similar
to that offered by a dominant exchange, the
challenger must be seen as a greater threat
than an OTC product.
Post-CFMA, three major, direct competition
efforts have been attempted. Despite
the conventional "king of the hill" wisdom
that no dominant exchange with a liquid
trading market can be unseated by a challenger
exchange, two sophisticated, wellendowed
foreign exchanges—Eurex and
Euronext.liffe—have tried in the last few
years to do just that. Another challenger, the
IntercontinentalExchange, is trying to outflank
the Nymex by offering centralized trading
and clearing in energy products. The
CFMA helped to spur these efforts at direct
competition; without its reforms these challengers
may not have tried to scale the hill to
unseat the king.
This article will not speculate on whether
the challengers have embarked on a competitive
mission impossible. Its focus will be on
one thing we know for sure about these three
challenges. Each has led to significant legal
proceedings in the courts and at the
Commodity Futures Trading Commission.
Considering each of these legal disputes
helps to illuminate the core issues of direct
competition and the possible future role of
the antitrust courts and the CFTC in
addressing these issues.
ICE vs. Nymex
ICE offers an electronic trading market
for OTC transactions in, among other
things, Henry Hub natural gas and West
Texas Intermediate crude oil. Relying on
new categories developed in the CFMA, ICE
is an "exempt commercial market" and its
market participants are "eligible commercial
entities." ICE is subject to limited CFTC
oversight. ICE also offers clearing services for
some of its products through its partnership
with LCH.Clearnet.
ICE alleges that its contracts are "fungible
economic substitutes" for, and compete
with, futures on Henry Hub natural gas and
WTI crude oil that are traded and cleared
through Nymex. For both commodities,
Nymex operates liquid trading markets and
provides well-accepted industry pricing
benchmarks through its published settlement
prices. ICE uses these Nymex settlement
prices in its trading and clearing
operations.
Nymex, not wanting ICE to get a free
ride on its settlement prices, sued to stop violations
of its copyright. In response, ICE
alleged that threatening to deny or restrict
access to the settlement price was intended
to squelch competition and violated
antitrust law. ICE's case turned on whether a
dominant exchange can prevent or restrict adirect or near direct competitor from obtaining
access to the dominant exchange's settlement
prices.
The district court dismissed ICE's
antitrust claim finding that ICE's primary
contention of improper withholding of
access had been foreclosed by Supreme Court
precedent since the CFTC "has effective
power to compel sharing and to regulate its
scope and terms." Given the CFTC's power
to regulate competitors' access to an
exchange's settlement prices, the court
declined to substitute itself for the agency.
"The CFTC is in a better position than a
general antitrust court to determine the
scope and terms of any forced sharing of settlement
prices among the exchanges that it
regulates."
Ironically, even after what some considered
the CFMA's de-regulation of
exchanges, the courts still look to the CFTC
to sort out competitive disputes over
exchange activities—here settlement prices.
This court saw the CEA's "core principles"
for exchanges as a broad grant of CFTC
authority, not the flexibility and freedom for
individual exchanges many had thought. Far
from a "CFTC hands-off" approach to competition
between two exchanges, the
Nymex-ICE dispute suggests courts will want
the CFTC to resolve disputes, not just referee.
Eurex US vs. CBOT
Since February 2004, Eurex US has
attempted to compete directly with the
CBOT for U.S. Treasury futures. Eurex US
admits that to date it has "failed to capture a
more than trivial portion of the market." It
blames its failure on the allegedly anticompetitive
tactics of the CBOT as well as CME.
These allegations include predatory pricing,
denying access to potential customers,
threatening traders who considered doing
business with Eurex US, and launching a
campaign based on intentional misrepresentations
designed to sow doubt in the minds of
traders and others about the viability of
Eurex US.
Whether Eurex US can prove any of
these accusations will be decided in court.
Even before Eurex US became a CFTCapproved
exchange and began to compete,
Eurex and Eurex US filed an antitrust suit
against the CBOT and CME. Both defendants
moved to dismiss that action, arguing
that it had no legal validity. In August 2005,
Judge James Nagel denied that motion.
Many of the substantive allegations in
the Eurex US suit were raised during the
CFTC and congressional consideration of
the Eurex US application. Yet Eurex US
chose to pursue antitrust litigation rather
than seek some form of redress from the
CFTC to remedy its grievances against the
dominant exchanges, apparently concluding
that the CFTC's powers did not extend to
rectifying past anticompetitive acts.
In contrast to the district court's decision
on the Nymex/ICE settlement price issue,
Judge Nagel held that the courts had jurisdiction
to hear this direct competition case.
Judge Nagel even rejected, or considered premature,
the claim that alleged anticompetitive
tactics related to the CBOT/CME
clearing link, which is subject to CFTC oversight,
were immune from the scrutiny of an
antitrust court. Thus, not all courts will simply
hand off to the CFTC whenever they are
presented with competition disputes among
exchanges.
Euronext.liffe vs. CME
In March 2004, Euronext.liffe established
a "basis trading facility" in Eurodollars that
allows a trader simultaneously to liquidate a
Eurodollar position on one exchange and
reestablish that Eurodollar position on
another at the same price. This BTF was
designed to allow a trader to move positions
from CME to Euronext.liffe in order to provide
"an effective means to manage open
interest, operational risk and capital utilization
across financial instruments." Euronext.
liffe claimed that this facility could also
be used to move positions from Euronext.liffe
to CME. A number of traders took advantage
of the BTF after its introduction to move
CME positions to Euronext.liffe.
This got CME's attention. On July 9,
2004, CME issued an interpretation stating
that it would be a violation of its fictitious
trading rules to engage in a "prearranged
transaction or series of transactions by means
of which one or more parties engages in a
transaction at CME and reverses that transaction
at CME or any other board of trade."
Relying on powers conferred under the
CFMA, the CME self-certified that its interpretation
did not violate, and was not inconsistent
with, the CEA.
Euronext.liffe cried foul and filed a letter
with the CFTC challenging CME's certification.
In Euronext.liffe's view, CME violated
Core Principle #18 because its new rule was
not "necessary or appropriate to achieve the
objectives of the CEA" and would result in
an "unreasonable restraint of trade." CME's
rule attempts to reach conduct not only on
its exchange, but also on Euronext.liffe. Does
the CME have authority to do so? Of course,
Euronext.liffe's BTF does affect conduct on
CME, that's the whole point of the system.
Should Euronext.liffe be able to influence or
affect trading on CME? Isn't that what competition
is supposed to be about? How else
can a challenger make it?
CME responded that its interpretation
merely reasserted its wash sale/fictitious
trading powers to make sure that no one got
the wrong idea about how much real trading
volume that CME has. CME had no problem
if a trader liquidates a position on CME
and then reestablishes that position on
Euronext.liffe so long as both transactions
are bona fide trades with market risk
attached. But it claimed it has no duty to
acquiesce to the transfer of open interest to
Euronext.liffe: "failure to give up business is
not a violation of the antitrust laws. The
standard in antitrust laws and the CEA is
‘unreasonable restraint of trade' not ‘refusal
to assist a competitor'."
The CFTC is continuing to review this
issue; it has not suspended CME's certification
of its interpretive rule. The CFTC's staff has asked numerous questions of CME and
Euronext.liffe, and has received multiple letter-
briefs from the parties. While the CFTC
has not asked for public comment on the rule
and has not indicated publicly how it intends
to proceed, the length of time and care it has
taken underscore the importance of what is
at stake.
One reason for the CFTC's inaction may
be the statute itself. While the CFMA was
premised on encouraging competition among
markets, it had no provisions specially
designed for helping the agency sort out the
issues direct competition disputes raise.
Which interests are paramount? Promoting
direct competition among exchanges?
Allowing traders the freedom to chose trading
and clearing venues? Facilitating efficient
use of capital? Preventing the appearance of
painting the tape through risk-free transactions?
Should a dominant exchange or a challenger
exchange be able to self-certify any
rule changes before its competitor weighs in
with any objections to the CFTC? How will
the CFTC harmonize regulatory policy on a
host of inter-market issues among exchanges
trading the same contracts, from position limits
to risk offsets? The CFMA surely gave the
CFTC the flexibility to resolve these issues,
but little in the way of statutory guideposts
pointing the direction to a solution.
Euronext.liffe has indicated that for now
it will not vigorously promote its Eurodollar
market, not quite "throwing in the towel"
but something pretty close. Whether CME's
rule and the CFTC's delay contributed to
Euronext.liffe's competitive struggle is
unknown, but it did not make it any easier
for the challenger. The dominant exchange
seems to have used its regulatory tools as an
adjunct to its vaunted liquidity in order to
make the challenger's uphill climb even
steeper.
Forced Sharing
The district court's decision in Nymex v.
ICE teed up the question whether the CFTC
should force Nymex to share its settlement
prices with its competitors, and if so, on what
terms. In effect, the CME's rule interpretation
raises the same issue: should the dominant
exchange be forced to cooperate with
the challenger? The concept of forced sharing
of business assets with a competitor is jarring
at first. As the CME's counsel observed:
"I can't use my United miles on Jet Blue: this
impedes Jet Blue's market entry. It does not
violate the antitrust laws." But no airline has
a nationwide monopoly, whereas it is hard to
look at the futures exchanges as anything but
monopolies within their spheres of liquidity.
In some respects, the antitrust laws treat
monopolists in a different manner than other
competitors, imposing special restraints on
those with special market power. Should the
CFTC do the same under the CEA?
An analogy to other areas of commerce
may be helpful. Each dominant exchange has
a liquidity advantage over its competitors, an
advantage that antitrust law calls "network
effects." Microsoft, for example, was viewed
as having a monopoly because any competitor
faced a "chicken and egg" problem: a
buyer of a computer wants to use an operating
system for which software developers
write programs and developers want to
develop programs for an operating system
that is the most widely used by consumers.
This partially explains Microsoft's dominance
of the operating system and office software
market. The settlement agreement
reached by the Justice Department and
Microsoft in 2001 included provisions obligating
Microsoft to share parts of its source
code with competitors to allow them to
implement software that could interface with
Microsoft's products. Another example is in
the telecommunications business, where traditional
telecom companies have been
forced to share equipment and wires with
new long distance carriers to enhance competition
subject to the oversight of the
Federal Communications Commission.
Should the CFTC do the same? Should it
serve the congressional goal of promoting fair
competition by forcing dominant exchanges
to share? And who would benefit if it did?
Just the challengers or futures market participants
and the economy as a whole?
Experience thus far supports the conclusion
that just the prospect of direct competition
has already served all market participants
by making the dominant exchanges better
trading markets. As the CBOT Chairman
Charlie Carey acknowledged in an interview
with the Financial Times, "Eurex was a serious
threat. They were a successful exchange.
And I knew that we had to be better. We
made a lot of changes that probably should
have been made [earlier] but the fact of the
matter is, staring at that type of competition,
the members gave us license to drive the
kind of change that was required to succeed."
Direct competition helps to make the
exchanges better and even allows them to
overcome an entrenched hostility to change
for the good of the markets and their participants.
That is why Congress wants to see
direct competition promoted. The challenge
that the CFTC faces now is to determine the
best way to achieve this goal on a lasting
basis. As the three cases cited above have
shown, the new era of post-CFMA competition
has given rise to several complicated disputes
among competing exchanges, and it is
not yet clear whether the courts or the
CFTC will prove more effective in resolving
these disputes. One thing that is clear, however,
is that in the absence of CFTC action
in this area, future competitors very likely
will take their disputes to the courts, and it is
quite possible that the antitrust courts will
end up with more influence over futures market
regulatory policy than anyone would care
to imagine.
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