Perks Live Forever at CME Amid Review of Trade IncentivesMatthew Leising
On the Chicago Mercantile Exchange, where competition among high-frequency traders is supposed to create a fairer market, some firms get a better deal than others. That’s piqued the interest of regulators.
Incentives granted to traders as long ago as 2005 by CME Group Inc. for help drumming up volume in Eurodollar futures, now one of its most popular contracts, remain in place today, according to regulatory filings. The Eurodollar trading perks, which can be used to reduce trading costs, are 10 times greater for the original market-making firms than new entrants.
The Commodity Futures Trading Commission is examining how the U.S. futures exchanges it regulates reward market makers that trade contracts based on everything from interest rates to foreign exchange and lumber. One issue under review is whether the incentives confer unequal privileges on favored firms.
“Programs should be open to any participant based on objective criteria,” said Matthew Andresen, the Chicago-based co-founder of Headlands Technologies Inc. and a pioneer of electronic trading. “Programs should not have a permanent and fixed list of participants; they should expire, or alternately they should allow new firms to earn their way in based on merit.”
Trading incentives in the U.S. stock market, the subject of a Senate hearing this week, are blamed by some for helping fuel the explosion of high-frequency trading in the last decade or so. Arrangements in futures markets have received less attention.
U.S. futures exchanges have hundreds of such incentives on file at the CFTC. The commission is asking for more detail on which firms get the perks, how much they are worth and whether the programs ever end. Exchanges say the programs are vital to getting products started, that they evolve as trading picks up, and market makers who aid that process deserve compensation. Some traders say the plans are sometimes closed to new participants and pay too much.
“By offering an incentive program, are you encouraging people to trade in ways they otherwise wouldn’t?” said Gary DeWaal, special counsel at Katten Muchin Rosenman LLP in New York. The concern is that you could “end up having people trading among themselves,” he said.
Regulators need to ensure that the buying and selling on the markets they oversee is bona fide, said DeWaal, who previously served as general counsel to futures brokerage Newedge Group SA. “It’s an enforcement concern on the CFTC side.”
Incentive programs at U.S. futures markets have boomed in the last decade, rising more than sixfold, with 341 on file with the CFTC as of 2013, compared with 56 in 2010, Commissioner Scott O’Malia said at a June 3 advisory meeting. The figures include modifications to existing programs, he said in a follow-up interview.
The CFTC’s review was first disclosed in March, when high-frequency trader Virtu Financial Inc. revealed that the commission asked for information on its “participation in certain incentive programs offered by exchanges or venues.” At the end of May, a person familiar with the matter told Bloomberg News that the CFTC wants to know who gets trading fee discounts, how much money they save, and whether programs to reward early adopters of new futures contracts ever end.
Attracting firms to a new contract in futures trading is profitable for exchanges because once established on one market, the contracts are hard to replicate on other venues.
“The fundamental premise is to develop and build markets,” Bryan Durkin, CME Group’s chief operating officer, told a CFTC advisory panel on June 3 when asked about the incentives. “In building up that liquidity, we have found it very effective to have programs in place in which we have market makers” that get “incentives in the context of reduction of fees, volume discounts, to build up a marketplace,” he said.
Eurodollars are futures contracts that allow investors to hedge against or speculate on short-term interest rates. The 90-day contracts are often used by traders to take a view on U.S. Federal Reserve policy. Interest-rate products like Eurodollars are the biggest revenue source at CME Group, and in May the contracts were the second-most-traded at the exchange, trailing only U.S. Treasury futures.
The types of Eurodollars in the CME Group incentive program are known as bundles and packs. Bundles aggregate one year or several years’ worth of Eurodollars into a single trade. A pack is a set of four consecutive Eurodollars that span a 12-month period up to 10 years in the future.
Bundles and packs are used by investors seeking broad exposure to the yield curve represented by several Eurodollar contracts strung together, and allow that strategy to be done in a single trade rather than several. In a five-year bundle, for example, an investor buys or sells the underlying 20 Eurodollar contracts at once rather than in 20 individual transactions.
The incentives have coincided with an increase in volume, according to CME Group data. Bundles and packs made up 3.6 percent of all Eurodollar average daily volume in 2006, the first full year after the program began in February 2005. During the first five months of this year, they’d grown to 16 percent of all Eurodollar volume, according to Laurie Bischel, a spokeswoman.
She declined to comment on the specifics of the incentive program or the CFTC review.
The CME Group program includes two types of market making firms: legacy participants who were involved from the beginning and later arrivals. CME Group last amended the incentive rules in November, adjusting the multipliers that determine how many credits a firm receives and withdrawing some packs from the system. Each credit can be used to lower a firm’s trading fees for buying and selling more Eurodollars.
The multipliers boost rewards in the Eurodollar incentive program. Legacy firms either receive 10, 20 or 30 credits for each bundle or pack they trade, depending on what they buy or sell. Firms that weren’t early adopters of the Eurodollar incentives and got in after the program began in 2005 can only get 2 credits.
A legacy market maker who trades a single five-year bundle of Eurodollars is actually buying or selling the underlying 20 contracts. That amount is then multiplied by the 20-to-1 ratio, yielding 400 fee credits. The value of those credits varies depending on how much volume a trader handles. The first 2.5 million credits are worth 9 cents apiece. At that level, the 400 credits would be valued at $36.
At this point, CME Group doesn’t write a $36 check to the trading firm. The market maker has to trade more Eurodollars, and the credits would reduce their execution costs dollar-for-dollar. It costs $2 in execution fees for CME Group’s biggest customers to buy or sell 20 Eurodollar futures.
CME Group caps the amount it will pay in credits at $750,000 per month per firm. That means Eurodollar traders who weren’t among the initial group of market makers must trade significantly more to receive reach that limit. Two traders, who asked to not be identified because they weren’t authorized to speak publicly, said the exchange has created an unfair system that overpays legacy market makers.
An executive at one of the firms getting the higher payout said the system is fair, given that it gives long-term incentives for the risk and investment from trading new products. The person also asked to not be named.
Like any other futures exchange, CME Group’s incentives for market makers span the breadth of its products, from foreign exchange to lumber to options on futures contracts. Chuck Vice, chief operating officer of Atlanta-based Intercontinental Exchange Inc., said incentives at his market may help it steal market share away from contracts dominated by CME Group.
“There’s a healthy amount of trying to compete with a comparable CME product, which I think is good for the marketplace,” he said at the June 3 meeting. ICE reviews, changes and may end any of its incentives as they near their expiration, he said.
“We are both for-profit companies, so I can assure you neither ICE nor CME has any program or any fee discount that it doesn’t think is absolutely necessary to build or maintain a market,” he said.
The CFTC hasn’t said when it plans to complete its review of incentives, and now wants more information on the programs -- or, as Commissioner O’Malia put it the June 3 meeting: “How do we ensure they’re good developments for the market?”