The Triumph Of 'Pork-Belly Crapshooters'

As the Chicago exchanges vie with others, pressure on capital costs will stay strong

Years from now, this decade might come to be viewed as the golden age of high finance. New markets are sprouting up everywhere, drawing huge amounts of capital and helping hold down rates. And the action is no longer confined to New York. Chicago in particular has emerged as a financial hub in its own right—with plenty of other cities coming on strong.

At the center of the explosion of markets and capital is vigorous competition. Banks, exchanges, and cities are vying for lucrative new trading business by focusing on three selling points: price, speed of execution, and innovation. The result can only benefit borrowers, who end up with a lower cost of capital.

The rise of Chicago's financial exchanges—and their current plans to expand—is emblematic of the creativity and entrepreneurial zeal worldwide that have helped create today's low-rate environment. In the 1970s, Leo Melamed was casting about for some way to increase the Chicago Mercantile Exchange's (CME ) competitive edge against its crosstown rival, the Chicago Board of Trade. But the notion of looking beyond cattle, pigs, and other farmland products to currencies and financial instruments seemed crazy. "The world thought it was foolish," recalls the CME's former chairman and current éminence grise. "How could a bunch of pork-belly crapshooters be trusted with foreign exchange?"

Undaunted, Melamed went on to develop financial futures, arguably the most important new financial product since the rise of stock markets. Now futures on everything from Treasury securities to European weather allow corporate treasurers, investors, and traders to lay off risks. This allows capital to flow more freely, which is essential to keeping rates low. The growth has been staggering: Chicago's two big exchanges handled more than 2.1 billion contracts last year, or 9 million contracts a day, up from 700,000 a day in 1986. And their innovations spurred the global market for over-the-counter derivatives, which has ballooned to around $300 trillion.

Like lots of revolutionary ideas, the notion behind financial futures is simple. For decades farmers would sell off parts of their crops months in advance to traders in the Chicago markets. The farmers got cash up front and didn't have to fret as much over bad weather or poor harvests. The traders got contracts they could then sell to others, making or losing money as harvest day neared and the crop looked more certain. By applying the same principle to currencies, first in 1972, the CME helped executives of multinational companies lay off the risk of fluctuating pounds or francs. Since then, the CBOT and CME have expanded to other types of derivatives and are still adding more. Soon traders will be able to wager on the price of commercial real estate and the likelihood that companies such as Tribune Co (TRB ). will go bankrupt.

But the global competition is forcing the Chicago exchanges to look for bigger scale and more efficiency to offer investors and borrowers better deals. Not only do they do battle with energy-oriented futures bourses in the U.S. but they also face Eurex, a European market that now leads the world in derivatives trading. Soon, China will step up its participation in futures with a new bourse in Shanghai expected to open this year. The appeal of futures is even blurring the lines among exchanges, as the New York Stock Exchange (NYX ), armed with a new derivatives unit that will come in with its Euronext acquisition, looks to expand.

All that competition is the reason the CME and the CBOT plan to merge by midyear in an $8 billion deal. The CME hosts stock index and currency futures, while the CBOT is home to Treasury contracts. CME Chairman Terrence A. Duffy and CEO Craig S. Donohue will hold the same positions at the combined CME Group. Together, the two exchanges will shoot past Eurex, with as many as 600 million more contracts traded yearly.

The exchanges are also hungrily eyeing expansions into the OTC market, a move that could provide investors and borrowers with more choices. Eurex soon plans to start trading a contract based on European credit default swaps, itself a multitrillion-dollar market. "The new Chicago entity is going to be under terrific competition as global alliances appear," says Michael Henry, a senior executive in the capital markets practice at consulting firm Accenture Ltd.(ACN ) For its part, the CME has teamed up with Reuters Group (RTRSY ) to push into the foreign exchange market and the OTC market for other derivatives known as interest-rate swaps.

Bold ideas in finance underlie all the growth. And thanks to expanding global competition, there's plenty of reason to believe it will continue. "If we weren't innovative throughout the years, we'd still be trading butter and eggs," says CME's Duffy. As long as there's money to be made and the ideas keep coming, the cost of capital will drop even further.

By Joseph Weber

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