A Dimmer Future For Currency Futures?

With the dollar plunging, the yen and the German mark soaring, and other major currencies gyrating, it would seem like boom times for currency exchanges, which trade futures and options contracts. But that's not the case. Business is lagging badly at the Chicago Mercantile Exchange. Volume in Merc currency contracts dropped 17% in the first five months of 1995, after a 3% decline last year. The slump is even worse at the Philadelphia Stock Exchange, the other major player in listed currency derivatives, where turnover plunged 49% through May--on top of a 23% drop in 1994.

The immediate culprit is the treacherous currency market itself. Investors stung by last year's volatility are treading cautiously this year. The falling dollar alone sent many smaller U.S. investors to the sidelines and discouraged U.S. exporters from hedging foreign-currency exposure as exchange rates moved in their favor. But there is a more serious long-term problem: stiffer competition from the much larger interbank currency market. With business ebbing after a decade-long boom, it has responded by stealing some of the exchanges' bread-and-butter customers--especially commodity-fund managers.

That won't put the Merc out of business. Volume in Eurodollar contracts, an interest-rate play, has tripled as currencies have stagnated, and stock-index futures are thriving. But if banks continue to grab currency market share, the Merc could lose its status as the most visible pricing benchmark.

TO THE RESCUE. The Merc will fight to stay in the game, vows Chairman John F. Sandner, who launched a multipronged rescue plan on June 12. Along with a new advertising campaign, the exchange will try to woo retail business by offering market-price data on the Internet. On the trading floor, currency brokers will don two-way headsets so customers can get information directly from the boisterous pits. A new block-trading system will help accommodate large orders, which increasingly have gone to over-the-counter markets. And in a controversial move, the Merc intends to lift part of its ban on dual trading--allowing brokers to trade for their own accounts while filling customer orders. Supporters believe that practice enhances liquidity, though detractors say it invites fraud.

Watch also for a slew of new products. Encouraged by the Apr. 25 introduction of Mexican peso futures, the Merc plans to trade the lira, peseta, and Brazilian real. It's mulling over Asian currencies as well, including the Thai baht and Malaysian ringgit, Merc officials say. The Philadelphia exchange also plans to trade lire and pesetas. And both exchanges are experimenting with flexible contract formats that imitate the customized products available in over-the-counter markets.

FAILED INNOVATIONS. There's just one problem: Such efforts haven't worked in the past. Over the past few years, the Merc has launched products similar to those available in the interbank market, but they have never caught on. And contracts on secondary currencies have limited potential: Even the peso, which has met expectations, trades only a few hundred contracts per day. And the banks are stepping up trading in these currencies, too.

In addition, the exchanges have failed to compete effectively with the 24-hour trading desks at the likes of Chase Manhattan and Bank of Montreal. The Merc's Globex after-hours electronic system, which operates after Chicago's open-outcry markets close at 2 p.m. local time, has proven too costly and unwieldy to capture much volume. Finally, traders complain that the exchanges can't always handle large orders without disruption. "It's like trying to land a jumbo jet in a municipal airport," notes Gabriel Inoue, a Chase Manhattan Bank managing director who oversees foreign exchange.

Banks, meanwhile, have some big competitive edges. Their market is less heavily regulated. They offer margin accounts that provide the same leverage available through futures. And their customized contracts are still more flexible than the Merc's.

Dismissing the current malaise as cyclical, the Merc's Sandner is confident that currency activity at his exchange will recover when the dollar rebounds. He disputes bankers' claims that they have gained market share. But unless the Merc can become more competitive, its malaise could well become permanent.

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