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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 subcommittee.

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 now."

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 group.

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.