The Chicago Mercantile Exchange has decided it will build a derivative exchange in London to go with its futures and options exchanges in Chicago and New York. CME continues to react to the new regulatory structure brought by Dodd-Frank reforms and the needs of its best volume generators. In all, it signals another misstep as exchanges are taking away from their commercial customers, which will not help growth in the long run.
Exchanges such as the Chicago Merc have been in a tough spot since the electronization during the latter part of the last decade abandoned the individual floor trader and the retail customer. In the search for speed and volume, the exchanges have delivered increasing advantages to the high-frequency trader and electronic market maker but, in the process, have destroyed the livelihoods for most individual traders and retail brokerages in commodities. It was that change in futures markets that forced big independent and successful commercial shops such as MF Global to change their profit models in an effort to save them, which instead led ultimately to their demise.
The ultimate passage of Dodd-Frank reforms into the commodity futures markets will spell trouble for the big market makers and high-frequency-trading shops, as regulations are intended to control position limits, deliver more transparency in capitalization and put trading limits that should control price manipulation. All of these regulatory reforms will crimp the profits of these favored participants.
These last best remaining customers of the exchanges aren't taking these changes lying down. We know that they have fought passage of any fresh regulations with the U.S. Commodity Futures Trading Commission and slowed down progress on rule writing for the last two years, and the exchanges themselves are doing what they can to keep these volume producers happy. One way is to open alternative exchanges in more regulatory-friendly places such as London. Part of the legitimate resistance to new CFTC oversight has been the possibility of regulatory arbitrage, sending business from the U.S. overseas.
While it is natural for the CME to try to recapture business that might be lost by regulatory arbitrage, it is ultimately a fool's errand. As more concessions and advantages are delivered to the exchange's most favored clients, including access to offshore exchange portals, the real backbone of what used to be the exchange's business continues to run away farther. The oil companies and the grain elevators and retail traders who were the heart and soul of volume and price at the exchanges continue to get their profit margins and executions squeezed. They're getting played for fools every time they tee up positions at the CME. It's getting continually worse -- and they know it.
This is a battle that the CME and other derivative exchanges will continue to fight. As the commercial and retail users of derivatives become increasingly fed up with the overwhelming advantages delivered to favored customers, they will continue to disengage, which will drive less high-frequency-trading and market maker business and ultimately slash the growth of volumes at the CME and elsewhere.
CME Group (CME) shares have done virtually nothing for two years despite a doubling of stock indices. The announcement of a new exchange in London is not a sign that things are about to get any better over there over the long haul; it's a sign that it's going to continue to get worse.