Joint Clearing for the CME and CBOT?
Competition from the cash market has made the Chicago rivals
consider a mini-merger.
By Simon Boughey
The Chicago Mercantile Exchange and the Chicago Board of Trade recently
announced plans to consider something that would have been almost unthinkable
a few months earlier-merging their clearing facilities. By uniting their
clearing functions, the two exchanges hope to reclaim and maintain customers
that are increasingly leery of their high fees.
The action was taken on February 13, when the board of directors of both exchanges voted to create a special subcommittee to thrash out the details.
The subcommittee reports directly to the two boards and operates under the
umbrella of the CBOT-CME Joint Strategic Initiatives Committee, which was
set up in January 1996 to explore cost reducing efficiencies. By combining
their back-office clearing facilities, each exchange could save up to $20
million a year, which should be passed on to members and customers, according
to Professor Merton Miller of the University of Chicago, who chairs the
Why are the CBOT and the CME-bitter rivals that have maintained separate clearing facilities for more than a century-suddenly cooperating? Competition.
Commissions in the cash market have fallen dramatically in recent years, but the standard execution fee charged by the exchanges for each contract
bought or sold is still half a basis point. Some customers, in fact, are
beginning to find that hedging their exposures with cash instruments can
be cheaper than buying strips of Eurodollar futures.
Take, for instance, a typical swap trade. A dealer that decides to pay
three-year fixed to swap an issue by the FHLB in the bond market could hedge
its exposure by purchasing three-year Treasury notes or a three-year strip
of Eurodollar futures. If interest rates rise, the dealer would be able
to turn this position around at a profit by receiving three-year fixed at
a higher rate and unwinding the hedge positions. While the CME would charge
0.5 basis point in execution fees for a Eurodollar hedge, brokers fees in
the cash market have been squeezed to around 0.125 basis points.
"Half a basis point represents a good chunk of your profit. Chicago is taking notice of this disparity," says Tim Prister, a senior dealer
at Gen Re Financial Products. A senior futures dealer at the CBOT agrees:
"There is certainly a case to be made that the Eurodollar is no longer
the most cost-effective product. In certain instances, dealing in swaps,
OTC options and FRAs can be cheaper in the cash market. This was not the
case one or two years ago."
Sources say that unofficial talks between the two exchanges also received renewed impetus in January when the Board of Trade Clearing Corp. (BOTCC)
voted against having CBOT representatives sit on its board. The BOTCC is
entirely independent from the CBOT and has been since 1925. At the CME,
by contrast, clearing is performed in-house. A spokesman for the CBOT, however,
insists that relations between the two organizations have always been "positive."
Miller admits there are significant hurdles to be overcome if the merger of clearing functions is to be successful. The subcommittee must negotiate
not with two organizations but three: the CME, the CBOT and the BOTCC. All
of these bodies have entrenched bureaucracies that require near unanimous
support for any plan at both board and member levels. Governance of any
future joint clearing system may have to be more autocratic to be efficient.
The two exchanges, moreover, possess proprietary information that they will
not want to divulge in the negotiation process.
There are those who doubt whether the proposed alliance will ever amount to anything. A longtime member of the CME pointed to the difficulty of reconciling
dominant egos and different cultures. Nonetheless, Miller is optimistic.
He says that he hopes that by June a basic understanding will have been
reached, which will include an agreement on the basic strategic decisions
and a firm grasp of most of the details.
ABN AMRO Buys A Futures Business
Everybody and their brother seems to be exiting the futures commission
business these days, but the newest entrant into the field has big plans
for the future. Less than two months old, ABN AMRO Chicago Corp. Futures
Group is already on the road to becoming a major futures dealer.
The new futures group is the latest progeny of Dutch bank ABN AMRO, which bought the Chicago Corp. last year and formed ABN AMRO North America on
January 2. In April, ABN's new futures group will acquire Citicorp Futures,
adding another 125 staff members worldwide in four locations.
The goal, according to James Gary, executive vice president of ABN AMRO
Chicago Corp. Futures Group, is to construct a "fully fledged capital
markets group" with all the normal facilities. "The deal with
Citibank was not just about money," he says. "We wanted their
people and infrastructure. We're where I wanted to be 12 to 18 months from
The acquisition was driven by the objective of ABN AMRO Bank, the world's 14th largest, to become a major financial services supermarket by acquisition
rather than growing businesses internally-in the same way that Deutsche
Bank boosted its capital markets capabilities by buying Morgan Grenfell.
ABN AMRO North America also recently announced it would buy Standard Federal
Bancorporation of Michigan. The bank already has a thriving OTC derivatives
Gary predicts that ABN AMRO Chicago Corp. will be one of the world's
top futures brokers by the end of the century. He says that it is unique
among full service investment banking firms in that it has fully 20 percent
of its resources devoted solely to futures. It is particularly strong among
the nonfinancials, like coffee, grain and meats, and is working closely
with the Latin American branches of ABN AMRO to develop more clients in
that region. He adds that his firm plans to join LIFFE and the London Metal
Exchange in 1997 and SIMEX at a later date. It already employs 1,000 people
in Chicago, 250 in New York and 250 in its other offices.
Advice For Better Audit Reports
By Poonkulali Thangavelu
For want of a horseshoe nail, a royal kingdom was lost, and for want
of attention to an audit report, the Barings Bank financial kingdom collapsed.
Everybody in risk management knows that independent audit reports are
an important part of any control system. But why do audits sometimes fail
to catch what they're supposed to catch? A recently released transcript
of a CFTC symposium on "Internal Controls and Risk Management Practices"
offered some advice on the topic: "What do users need from audit reports?"
Here are some of the points made by panelists.
1. Make auditors truly independent
In many cases, internal auditors who are supposed to be independent have subtle ties to the people they are assigned to audit. It's important to
make sure that auditors have true independence and direct access to senior
management. "Appropriate internal controls need to ensure that all
revenue-generating operations and their management should be completely
separated from the risk oversight control audit and reporting functions,"
says Debra Perry, managing director of the finance, insurance and securities
rating group at Moody's Investor Services. In fact, she says, the higher
up in an organization these reporting structures converge, the better.
"If the general auditor is concerned about senior management itself, that general auditor ought to feel free to go directly to the board of directors
with his or her concerns," adds Christine Cummings, a senior vice president
in the bank supervision group of the Federal Reserve Bank of New York.
In some cases, this means making sure auditors maintain an arms-length
relationship with the rest of the company. "Auditors want to be part
of the management team," says Donald Leslie, president and CEO of the
Canadian Investor Protection Fund. "Our view is we don't want them
to be part of the team, we want them to audit the team. They may have to
know what the management team does, but they are not part of the team."
2. Watch the implementation
Designing a risk management system can be the fun part. Making sure all
the steps are taken, however, involves patient attention to an enormous
amount of detail. The best-conceived risk management system will fail if
it's improperly implemented. "There is frequently a distinction between
formal risk management policies as articulated by management and actual
practice," says Moody's Debra Perry. "Even sophisticated and well-documented
risk management systems remain vulnerable."
3. Don't be afraid to ask tough questions
Nobody likes to be the office cop, but in some cases that attitude is
a breeding ground for future trouble. Leslie Rahl, a principal at Capital
Market Risk Advisors, said that in some a cultural change is often needed
and "rather than merely focusing on whether people are doing what they
said they would do, audits should focus on whether people are doing what
they should do."
4. Take a fresh look
People who see the same thing every day are not likely to notice anything new. William Pauly, chief financial officer of ING Futures and Options suggested
that it's beneficial to have someone come in periodically and take a fresh
look. "You get blinded by things, whether you're working on a letter
or a paper or you just see it on your computer screen over and over."
A peer review team from another company could be hired to evaluate controls,
provided the confidentiality issues are worked out.
5. Pay for quality
The human element in any risk management system is critical and should
not be neglected. Audit fees in general have gone down in recent years.
To get good internal and external auditors, companies should be willing
to pay well. "If you look at the incredible increase and the complexity
of transactions and the deals done, you'd have to ask yourself, 'How do
the garden-variety auditors even try to understand things like Value-at-Risk?'"
6. Read what's written
An audit report that is ignored makes a mockery of the entire audit process. "Most organizations do not take the internal audit department seriously,"
said Nicky Tan, judicial manager of Barings, Singapore. "If you have
an internal audit department but just ignore it, you're just wasting overhead."
Peso Play, Part II
Traders who have cashed in big on the CME's peso contract will soon have another Mexican trade to play. In the second quarter of this year, the Chicago
Mercantile Exchange plans to introduce Mexican cetes futures. The contract
opens up a new spread to vigilant and savvy traders: Eurodollar/peso interest
rate spreads against cetes futures calendar spreads.
The Merc's peso futures contract was introduced last year and averages
between 6,000 and 8,000 contracts a day. According to Ira Kawaller, vice
president-director of the New York office of the CME, the peso contract
was originally introduced with a mind to making this spread trading strategy
with the cetes and Eurodollar possible.
Covered interest arbitrage, which is the basis of fair pricing of currency futures and forwards, is also the foundation for this type of spread trading.
The covered interest rate arbitrage model says that the rate any investor
can earn on a Eurodollar deposit should be equal to the rate that could
be earned by (1) converting U.S. dollars to pesos at the spot rate; (2)
depositing the pesos in an account paying the cetes rate; or (3) locking
in the repatriation of pesos to U.S. dollars at the forward rate.
The equation thus involves the calculation of peso spot and forward prices, Eurodollar spot prices and cetes spot prices. "If these prices are
not in line, then you have a trading opportunity," explains Kawaller.
The strategy is already possible on the CME in the yen market, involving
yen futures, Eurodollar futures and Euroyen futures.
Calculating fair value is clearly not for everybody, but Kawaller says
he expects the new products to attract "anyone who is smart."
Though the peso contracts introduced last year are currently operating independently
of the cetes contract, it is a "natural evolution" to incorporate
them within a spread trading strategy. At the moment, the peso contract
is attracting a "nice mix" of institutional hedging and speculative
business, says Kawaller.