Has Chicago Lost Its Edge?David Greising
Dec. 10, 1991, was a gala day at the Chicago Board of Trade. George Bush became the first U.S. President to ring in a trading session on a commodities exchange. It was an exhilarating gesture for an industry that has been beset by scandal and pummeled by foreign competition and off-exchange products. "This is what it's all about," Bush shouted above the din of cheering traders. "This is what we need in this country: We need free enterprise." A month later, however, the President decided we need something else: a 15 tax on every futures trade.
In Chicago, where 85% of the nation's futures contracts change hands, the proposal--for a levy of almost three times the exchanges' own fees--was a cruel slap in the face. The idea was put on the back burner, but the symbolism remains potent. Chicago is under siege.
The Chicago exchanges were a hothouse of financial innovation throughout the 1970s and early 1980s. They developed futures and options that shield companies from currency fluctuations and interest-rate risks and give money managers myriad ways to hedge against stock market declines. But the days of cutting-edge advances are gone. Today, the CBOT and its crosstown rival, the Chicago Mercantile Exchange, are seeing their days of preeminence fade fast.
FRESH THREAT. Over-the-counter futures products, notably currency and interest-rate swaps, are luring business from Chicago (charts). Foreign exchanges have seen their market share zoom from 18% in 1984 to 43% in 1991. And Globex, Chicago's after-hours trading system, has been delayed for three years while overseas bourses flourished.
To an extent, Chicago's decline was an inevitable outcome of the growth of foreign markets dealing in local instruments. The exchanges can hardly be faulted for that. Observes Merc Chairman John F. Sandner: "We cannot reach all the corners of the world in any reasonable period of time."
But it hasn't helped that Chicago has fallen behind in its traditional raison d'etre--new products. The city's last hot product, the Standard & Poor's 500-stock-index future, came on the market a decade ago. Since then, the exchanges have produced a succession of losers, such as futures in broiler chickens and Japanese government bonds. CBOT President Thomas R. Donovan draws a parallel between the futures industry today and the railroads years ago, when first confronted by air travel. "They were satisfied being railroads," says Donovan. "They didn't diversify. They didn't grow."
IN THE DUST. Growing at a 34% annual clip, foreign exchanges have cordoned off large sectors of the financialfutures market, from German government bonds to Japanese stock indexes. Last year,they claimed 10 of the world's 25 most active contracts. Overseas exchanges have lured capital from domestic exchanges because, among other things, they are not dominated by the computerized trading systems that have squeezed the profits in the U.S. Many bourses also offer an innovation that has long left Chicago in the dust--electronic trading. Not since the 1985 opening of the Marche a Terme International de France (MATIF) has a new exchange offered only pit-style "open outcry" trading. Such highly successful exchanges as the two-year-old Deutsche Terminborse in Frankfurt and the Tokyo International Financial Futures Exchange, established in 1989, are automated. Such trading accounts for 15% of world volume, vs. only 0.2% as recently as 1987.
Globex is Chicago's response to the foreign threat. It will match buyers and sellers electronically after the futures pits are closed. The idea is to keep overnight trading in Chicago and to draw business back from such overseas bourses as Tokyo, which trades U.S. Treasury futures long after the sun has set on the prairies. A great idea--in theory. In practice, Globex has stumbled badly. To design the system, the exchanges chose as their partner Reuters Holdings PLC, which had prior experience selling information but not creating trading systems. "Their software is old," complains one Merc member who has worked extensively on the Globex project. "It's just not state-of-the-art." Such sentiments are vigorously denied by Globex officials. "The entire system performed beautifully," says Donald Serpico, a Merc senior vice-president and a top Globex official.
LAUGHINGSTOCK. Still, repeated delays have cost the system confidence among traders. Just last fall, as the latest startup date approached, Globex switched to a larger computer, delaying the start yet again. Development costs have bumped past the $70 million range, three times original estimates, sources say. Traders joke that when people ask when Globex will start up, the answer is always "May--or may not." Concedes CBOT Chairman William F. O'Connor: "Globex is proceeding according to schedule. Whose schedule, I'm just not sure."Perhaps the joking will end soon. On Jan. 29, Globex was put to a successful test that may clear the way for a fall debut. Predicts Globex Chairman Leo Melamed, the father of the financial-futures markets: "Globex will be launched this year, and Globex will protect our markets."
But will it? With a panoply of exchanges trading around the globe, investors may well ignore Globex and use other, more liquid marketplaces during their daytime trading hours. "At 8 a.m. in Tokyo, the big trading firms aren't going to put positions on a screen originating from Chicago," says the head of one large brokerage firm. Another top futures honcho, Max C. Chapman Jr., chairman of Nomura Securities International Inc., says the repeated delays have fatally wounded Globex. "It's not going to be a savior," says Chapman. "It's not going to be a factor at all."
Even as the Chicago exchanges plan to take the offensive with Globex, they're stuck playing defense in the battle against over-the-counter trading. It goes by a variety of names--swaps, collars, floors, "swaptions," and OTC equity derivatives. Whatever the moniker, they are futures-like products, custom-tailored by financial firms to help corporate customers guard against the risk of currency fluctuations, interest-rate shifts, or stock market moves. Since 1987, swap volume alone has more than tripled (chart).
In a typical interest rate-swap, two parties exchange interest payments. That might come in handy for, say, a bank that gets an income stream from fixed-rate mortgages while paying deposit interest that moves with short-term rates. which would not have met their needs quite so precisely.
MORE RULES. As demand grows, major banks and brokerages are pouring huge chunks of capital into swaps. Chicago gets little out of it, because most swap dealers hedge against risk by buying or selling swap contracts instead of futures. Nomura Securities Co. recently set up a Nomura Options International unit to handle OTC dealings in the U.S., Tokyo, and London. And Bankers Trust Co. is investing a large share of its $350 million in technology enhancements each year in its swaps trading systems. "The futures exchanges will remain viable," predicts Scott P. George, managing director of BT Securities Corp. "However, the relative importance of the exchanges against the overall market will decline dramatically."
The Merc has added longer-term expirations to its Eurodollar contract to compete with interest-rate swaps. But it's tough to compete with such custom-tailored products, so futures executives are turning for help to the Commodity Futures Trading Commission. They have tried to subdue the swaps business by asking the CFTC to declare that swaps are futures contracts and thus under CFTC purview.
An appeal for more regulation seems odd for the exchanges, which for years have beefed about regulatory excess. From new product introductions to trading rules to capital requirements, the exchanges have complained about their chief regulator. In one oft-cited instance, the Merc in 1985 applied to trade futures on the Nikkei 225-stock index. Regulators insisted that the exchange win cooperation from the Tokyo Stock Exchange. By the time that happened, in 1987, Tokyo had launched a Nikkei 225 contract of its own. Today, it's the world's most successful stock-index future.
Such dramatic examples of overregulation are rare. Instead, the industry complains that regulation bleeds it with small cuts. Applications for new contracts take at least a year for approval, while foreign exchanges often have no formal approval process. With stringent U.S. capital standards, firms trading on domestic exchanges must tie up far more money than they do when trading overseas. CFTC Chairwoman Wendy L. Gramm is sensitive to complaints of overregulation but says: "It's too easy to find some kind of scapegoat, like 'the costs are less elsewhere.' "
The exchanges in recent months have been loosening their rules. They have reduced position limits in Eurodollar futures and inaugurated a new large-order execution rule in the Merc's S&P 500-stock-index futures pit to facilitate block trading. The exchanges are considering combining clearing operations to streamline processing and cut costs. They're also beefing up their trade-tracking systems to boost investor confidence.
`ROCK BOTTOM.' But such efforts may be too little, too late. For many futures firms today, mere survival is a challenge. With floor brokers often netting less than $1 per contract, trading operations are hard-pressed just to break even. Firms that typically saw returns on equity top 30% during the early 1980s, watched average ROE dip to below 7% through the first three quarters of last year. Nearly a third of the firms lost money. The ranks of U.S. futures-trading firms have fallen by 20% since 1987 (chart, page 77 43 ), with such old-line outfits as Shatkin Trading, Stotler, and Clayton Brokerage dropping from sight. Firms are turning to bank borrowings and note offerings to shore up their capital. Says Z. Lou Guttman, chairman of the New York Mercantile Exchange: "Firms have hit rock bottom."
For every loser in the futures pits there is a winner. And so it is in the global futures markets. While the Chicago exchanges have been taking it on the chin, the overseas and swaps markets are soaring. If Chicago does not rekindle its old innovative fire, futures trading will continue to flourish--elsewhere.