Common Clearing in Chicago: What A Short, Strange Trip It's Been
By Robert Hunter
Although the rivalry between the Chicago Mercantile Exchange and the Chicago Board of Trade has never come to physical blows—it has resembled Harvard vs. Yale more than Hatfield vs. McCoy—it has produced a number of painful consequences, particularly for the end-users of futures, the futures commission merchants and the member firms who keep the two exchanges alive. The costs of managing two clearing operations have made doing business in both places more expensive than it might be if clearing operations were consolidated.
Faced with the prospect of losing significant business to the competing cash and over-the-counter derivatives markets, the CBOT and the Merc decided last April to discuss the possibility of merging their clearing functions. An entity dubbed the Joint Strategic Initiatives Committee (JSIC), representing members of the CME, the CBOT and the Board of Trade Clearing Corp., the CBOT's independent clearing organization, was convened to try to thresh out a plan. The trading community hoped that the JSIC could devise an organization like the Options Clearing Corp., which clears options from the American Stock Exchange, the Chicago Board Options Exchange, the Pacific Stock Exchange and the Philadelphia Stock Exchange. The OCC offers customers, among other things, uniformity in markets, standardized expiration cycles and lower bank fees.
A number of people wondered whether the two long-time competitors, each with entrenched bureaucracies, distinct cultures and dominant egos, could figure out a way to live with one another. The early signs weren't very promising. The Merc strolled out of the gate last September with a proposal that called for the CBOT to adopt its Clearing 21 system. By mid-September, the prospects for common clearing were dim.
Luckily, the Futures Industry Association hadn't been sitting on its hands. In May 1997, it had formed the FIA Task Force on Common Clearing, which represented 25 clearing member firms. The task force rolled up its sleeves and began working on a solution to the common clearing problem, taking some ideas from the Merc's September plan and adding many that appealed to member firms.
On November 3, 1997, the FIA released a plan that focused on two main areas: governance and financial safeguards. It called for a new clearing entity to be governed by 15 directors representing the exchanges, member firms and the public. It also adopted financial protections for small clearing firms and exchanges. Participating exchanges would control a portion of the total clearing organization's systems development budget, and each exchange would retain the right to undertake development efforts beyond those approved by the new board. In addition, clearing members would be entitled to certain unalterable veto rights and super majority requirements on key issues. CBOT chairman Pat Arbor reacted to the plan with optimism. "While the working document is not perfect,” he said, "I believe it has great promise. I believe it will help bring us to our goal of common clearing.”
The FIA's unprecedented action sent CBOT and Merc directors scurrying to digest the plan, and representatives from both exchanges have met a number of times since, including twice in two weeks last November. "The momentum for a deal to be struck now appears so strong there would seem to be little that could stop it from happening,” claimed an unnamed source in a recent article in Securities Week.
What price joint clearing?
The second meeting between the CME and the Merc netted some promising results. The two agreed on a couple of governance issues—most important, that both should have a veto power over new exchanges joining the new clearing organization and that new exchanges should be afforded only one director on the board. "We've had a number of positive discussions, and continue to remain optimistic,” says a Merc spokeswoman.
But beyond these few settled areas, the exchanges have found little agreement. The main issue, sources say, is determining just how much savings joint clearing will produce for the trading community. In early April, the JSIC voted to hire a financial and technology consultant to study the issue. The consultant determined initially that common clearing would save money, but that another study would be necessary to determine precisely how much. The subsequent study, it said, would cost $3 million. The JSIC decided that was too much to pay, even though the costs would be split evenly among its constituent firms.
The result: as of late January, no quantitative study had determined precisely how much money joint clearing would save exchange customers. "Purely from a business perspective,” says a highly placed player familiar with the negotiations, "you don't make these decisions until you know what the final costs are, and then whether there are any real cost savings to your customers.”
There are a number of other vexing issues as well. Each side wants assurances that joint clearing will not hinder its competitiveness. If one exchange launches a new product to compete directly with a product of the other exchange, the latter is forced under joint clearing to guarantee and clear a product it believes is detracting from its own business—clearly a conflict of interest. The two sides are reportedly also haggling over a preliminary budget, and are still trying to resolve some governance issues.
While the two exchanges may appear to be trying to hammer out these problems behind closed doors, many customers wonder why a preliminary step as simple—and as beneficial to customers—as cross-margining index products has not yet been taken. When the CBOT secured the rights to issue futures on the Dow Jones Industrial Average and other Dow indices, it immediately struck a cross-margining agreement with the Chicago Board Options Exchange, which won the rights to list options on the Dow. Investors who are long the Dow at one exchange and short the Dow at the other are thus freed from the constraints of two margin requirements for offsetting positions—a single margin suffices. The CBOT has proposed a similar deal to the Merc that would allow customers to pay one margin when taking offsetting Dow and S&P positions, but the Merc has thus far refused.
Few believe the Merc, CBOT and BOTCC are close to resolving their differences. Until a quantitative cost-savings study is completed, progress will be glacial, and some believe the trading community is wrong to assume the savings will be high. "The clearing fees themselves will never go down,” says a Chicago-based consultant. "The Merc brought its fees down last year to match the BOTCC, and there's no way anyone can reduce them any more.” Even long-run savings could be negligible. "Sure, when equipment is updated or changed, only one clearinghouse will have to pay instead of two,” he says, "but even that's not going to bring down costs that much. And staffing levels won't be reduced much either, because you'll still need Merc people to do the Merc products and CBOT people to do the CBOT products.”
And there is an even more fundamental issue at play. CBOT officials believe the Merc's public support for common clearing is hollow. The Merc, they point out, owns its clearing organization, and will be reluctant to give it up anytime soon. "The Merc derives a huge amount of revenue from clearing,” says the Chicago consultant. "It has been able to keep its costs higher because it didn't charge exchange fees per se—its exchange fee was part of its clearing fee. This has been a real profit house for the exchange, and that's the reason the Merc always is able to outspend the CBOT on new projects. It's just holding this possibility out there and waiting for somebody else to say ‘No,' so it doesn't look like the bad guy. While the CBOT would never say this publicly, it would love to own its clearing organization, for the same reason.”
Is all hope lost?
There is a glimmer of hope on the horizon for fee-weary customers. As of late January, the CBOT and the Merc were close to hammering out a deal for common banking, which will allow clearing members of each exchange's clearinghouse to use their individual accounts across clearing organizations, so they will no longer have to maintain separate accounts.
Perhaps more important, there is a possibility that the top-three exchanges could be using the same electronic clearing system in the near future. The JSIC commissioned Arthur Andersen last year to evaluate the BOTCC's electronic clearing system. It found that while the system is adequate for the BOTCC's current needs, it is not equipped to deal with the futures markets of tomorrow. After some starts and stops, the Merc allowed the JSIC to commission Andersen to study Clearing 21. The BOTCC says that it will consider switching over to Clearing 21 if it meets a number of specific criteria, which may or may not coincide with Andersen's criteria for evaluation. The results of Andersen's study are expected early this month. If the study comes out positively, it would rekindle the hope that the CBOT, the Merc and the NYMEX would be on a single, unified system. And that might end the whole common clearing discussion for a long time to come.