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Clash of the Titans

By Robert Hunter

The Chicago Board of Trade wants to trade cash bonds along with its Treasury futures. Cantor Fitzgerald wants to trade Treasury futures with its cash bonds. The fur is about to fly.

In 1995, when the CFTC granted the Chicago Board of Trade permission to begin brokering cash Treasuries, precious little was made out of the news by the financial press. But New York-based Cantor Fitzgerald, far and away the world's leading broker of cash Treasuries, took note. It began talking with the American Stock Exchange about creating an electronic system to trade Treasury futures, the CBOT's franchise product. Suddenly, rivals had been created where there had been none, and the battle for market share had begun.

Fast forward to 1997. After months of negotiations, the CBOT announced that it was partnering with Liberty, the world's second-largest cash Treasury broker, and Prebon Yamane, a huge derivatives interdealer broker, to form the Chicago Board Brokerage, an electronic system to trade cash Treasuries. The venture looked promising, uniting three formidable players with vast resources and liquid markets. But just a few months later, Liberty dropped out of the CBB alliance, and many thought the project was dead because it had lost Liberty's cash Treasury expertise.

Then last fall, the CBOT shocked naysayers when it put before its membership a proposal to forge ahead with the CBB without Liberty, and the members approved the deal by a considerable margin. The Market Power trading system is now in beta testing, and could be available by summer.

Meanwhile, Cantor Fitzgerald announced that it had struck a partnership with the New York Cotton Exchange to trade Treasury futures electronically on its existing cash Treasury trading system. It filed an application for approval with the Commodity Futures Trading Commission ended in early February. A 60-day comment period ended April 6, and the CFTC is expected to make a decision in the near future.

On that same day, Cantor filed a law suit in Delaware Chancery Court against Iris Cantor, the widow of B. Gerald Cantor, the firm's founder. The suit alleges that Iris Cantor, who controls Cantor affiliate Market Data Corp., gave key proprietary technology to the CBB through a partnership with Prebon and the CBOT called Ceres Trading L.P. The technology, the suit alleges, formed the basis for the CBB's Market Power system, the CBB's centerpiece. Iris Cantor and Cantor Fitzgerald have been battling since a messy settlement of ownership of the corporation was reached in 1996, following Gerald Cantor's death. At press time, there had been no additional legal revelations.

Different routes

At first glance, it appears as though the CBOT and Cantor Fitzgerald are taking square aim at each other's franchise markets. But, legal wrangling notwithstanding, each views these as merely the first steps of much more ambitious plans. The Cantor-NYCE link, called the Cantor Fitzgerald Futures Exchange (CFFE), drafted its CFTC application with flexibility in mind, in the hopes that, once approved to trade Treasury futures, it can mimic—and create—many more futures contracts. The CBB, meanwhile, hopes to use cash Treasuries as a foundation for more aggressive forays into the over-the-counter derivatives market, Prebon's specialty. In 1996, for example, Prebon transacted some $42 trillion in OTC products, nearly doubling the notional value of all the contracts the CBOT traded that year.

Nevertheless, the best chance for the CFFE and the CBB to expand their businesses is if they demonstrate to their customers that they can provide cheap, efficient and liquid markets. At least initially, they will be battling each other for their parents' market share—the CFFE vs. the CBOT and the CBB vs. Cantor Fitzgerald. With their grand plans in place, two questions remain: who are these guys, and how do they plan to get your business?

The CFFE at a Glance
Governing structure: A 13-person board, eight from Cantor and five from the NYCE. NYCE will be responsible for handling all of the CFFE's regulatory duties.

Clearing: Performed by the New York Board of Clearing, a subsidiary of the New York Clearing Corp. (NYCE's clearing entity).

Products: Initially, the CFFE will list four Treasury future contracts—the 30-year, the 10-year, the five-year and the two-year.

Trading hours: 7:30 a.m. to 5:30 p.m., with plans to go to 24 hours in the future.

The CFFE is hard wired to begin trading futures literally the day after approval from the CFTC. Only NYCE clearing members will be eligible to trade on the fledgling exchange, and the CFFE is already making the rounds to its cash customers, trying to get as many signed up as possible before launch. One issue that troubles some customers is the exchange's failure thus far to outline a cross-margining arrangement, wherein customers with offsetting positions in the cash and futures markets would have to reserve less cash to cover margins than they would if they did their deals in separate places, as they have always done. In this area the CBB has jumped out in front, already promising customers significant margin cost savings.

But what the CFFE lacks in cross-margining arrangements it makes up for in technology. It will use the same electronic trading system that Cantor uses in its cash Treasuries business, the Cantor Fitzgerald Trading System, which it rolled out in February 1996. The key to the system is Interactive Matching, the trading concept that Cantor believes will revolutionize financial trading around the world. Interactive Matching works as follows: proprietary trading screens around the world carry basic information—the best bid and offer prices for each of Cantor's Treasury markets, which cover the full spectrum of the yield curve. Each of the products is segregated into its own area on the screen. Brokers at Cantor's trading facility have additional information at their disposal, including the number of buyers and sellers in line to scarf up the best bids and offers for each product. Customers interested in making a play based on the prices they see call their broker at Cantor, who tries to make the deal or tells the customer where he or she is in line. The system allows customers to play the entire yield curve based on live prices with one phone call. And as with all electronic trading, anonymity is guaranteed.

The CFFE will essentially piggyback the Cantor system. On day one, Cantor customers will see information on the four futures contracts offered by the CFFE as well as all the cash products. Cantor has set up satellite trading floors in London and Toronto, and plans to open one in Tokyo soon. But more important, Cantor has thousands of customer screens all around the world, and its Treasury prices are carried on Dow Jones Markets as well, adding more than 90,000 screens to its network. "We have the instant ability to put our futures contracts in front of our customers,” says Deborah Walton-Collings, managing director at Cantor. "The infrastructure is in place, our distribution system is in place and the incremental cost of introducing new products is quite low.”

But inventing a marketplace isn't enough—traders are needed to make the market run, and liquidity is the key. If the market is inefficient and illiquid, it doesn't matter how many people know its prices—it's going to flounder. How does the CFFE hope build liquidity? By rewarding market makers. Customers who are willing to put up a market—by showing a bid or offer price—are automatically the first in line should a match develop. "We think that the person who puts his picture on the screen should get some priority over someone who just watches and jumps in when they see a trade,” says Glenn Kirwin, executive vice president at Cantor. "When the futures contracts come out, we'll program the system to allow for that.”

Second, and perhaps more important, the CFFE will offer what it calls aggressor pricing. Both trading participants will pay a clearing fee and an exchange fee, which Kirwin calls "nominal,” but only the "aggressive” party—the one who makes a trade based on the market picture on the screen—pays the transaction fee; the market maker who simply introduces a possible price is exempt. "The dealers are very interested in that,” says Kirwin.

To appeal to less time-sensitive customers, such as portfolio managers, who make few trades in the course of the day and don't want or need to stare for hours at the screen to take advantage of a single uptick or downtick, the CFFE plans to offer "cross trading.” At set intervals throughout the day, potential trades that have lined up in the cross queue are matched all at once based on the average price during the interval. "Longer time frame traders are usually happy just to get their trade done,” says Walton-Collings. "Cross trading lets them spend more time on their other duties while still getting a good price.”

While the CFFE hopes to build on Cantor's extensive client base, it realizes that the key to building liquidity will be getting FCMs onboard. It thinks it has what it takes to do so. "We expect that the FCM community will be drawn to the CFFE because, absent the cost of a floor operation, we hope to be very cost efficient in our execution of futures,” says Walton-Collings. Its trading day will be 7:30 a.m. to 5:30 p.m. New York time—as compared with 8:20 a.m.–3:00 p.m. New York time in the CBOT's Treasury pit—and it plans eventually to go to 24-hour trading. It will also commit "significant resources” to marketing, including road shows to FCMs, direct mail and advertising.

How does Cantor see its chances? "We're very excited,” says Walton-Collings. "The customer base is there, the distribution is there and the demand is there.”

The CBB at a Glance
Governing structure: Split equally between the CBOT and Prebon Yamane, although the CBOT will retain a 60 percent interest and Prebon 40 percent.

Clearing: Clearing and settlement will be handled by the Clearing Corporation for Options and Securities, a subsidiary of the Board of Trade Clearing Corp., and the CBB plans to link with the Government Securities Clearing Corp. in the future.

Products: The full range of U.S. Treasury securities—bills, notes and bonds—as well as overnight repurchase agreements (both general and specials, for cash and regular settlement) and basis trades (cash Treasuries against futures).

Trading hours: 8:00 a.m. to 5:30 p.m., with plans to expand to 24 hours in the future.

The CBB's answer to Cantor's Interactive Matching system is Market Power, the cash Treasury trading system developed by Prebon, with the help of Market Data Corp. The two systems could not be more different. Whereas the Interactive Matching system is carried across dedicated terminals around the world, Market Power is a Windows-based application that runs on customers' own PCs, connected to a central server. More important, says Ann Gorski, managing director of sales and marketing at Prebon, "Market Power is the only fully automated Treasury trading system in the world. All the other systems involve some kind of human interaction in order to place an order, withdraw an order or what have you. Ours does not.”

Traders hooked up to the system can enter their own trades and have them executed quickly, without the need to get on the phone and deal with harried Treasury brokers. The system boasts a number of other salient features: all price information is updated in real time; orders are matched on a first-in, first-out basis; certainty of execution is always guaranteed—there are never "out trades”; and the system keeps a real-time electronic record of positions and completed trades, which can be filtered through back-office systems or simply printed out for a hard copy.

The key to all electronic trading, of course, is speed, and the CBB thinks it has created a roadrunner. "We guarantee that if you put in a bid or an offer, everyone who's logged onto the system will see it within half a second,” says Gorski. "If you do a hit or a take, you'll receive confirmation—your trade history will reflect that trade—within a second and a half, and within five seconds the trade will be shipped off to the clearinghouse.”

One of the main benefits of Market Power, says Gorski, is the picture of market depth it provides. While systems such as Cantor's Interactive Matching show only the best bid and offer prices, Market Power displays the top five price levels of bids and offers, as well as the high and the low for the day, to give traders more of a sense of the market's direction. The system is also customizable to reflect traders' preferences and styles. A color-coded system indicates when certain preprogrammed price conditions are present, and "hot keys” can be configured to perform functions in one keystroke—what Gorski calls "turbo trading.” In terms of oversight, the CBB's system administrator can open and close sessions, while trading group administrators can set position limits to control trading activities.

These days, the CBB is focusing on serving only CBOT members, 90 of which have made precommitments to buy the Market Power system. For them, the most attractive feature of the CBB may be its cross-margining arrangement. Customers trading, say, 30-year bond futures against 30-year cash will pay a basis charge (because the market prices aren't identical), but as long as they are fully hedged they'll save 85 percent of the margining costs they would have paid using separate pools. "For a firm that trades a lot of cash and futures in a day,” says Gorski, "cross margining could save a significant amount of money.”

The CBB has been set July 13 as a tentative launch date for the system. Additional features in the works include capabilities for linked trades, benchmark trades, Treasury swaps and an API that will allow users to link Market Power to their own front-end systems.