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The 1980s and early 90s were a golden age for pit traders at the Chicago Mercantile Exchange. If you could find the nearly $500,000 needed to purchase a seat on the exchange, you won access to an exhilarating & highly lucrative way of life. Experienced floor traders on a good day could walk into the CME pits, make a few trades, collect tens or even hundreds of thousands in profits & be out the door before lunch.
How could making money in the pits be so easy? While traders tested plenty of strategies to find their edge, one routinely rose to the top: find the big FCMs and trade on their coattails. FCMs - futures commission merchants - were brokerages representing the biggest banks, institutions & corporations in the world. If a big hedge fund or other trader needed to buy $50 million of S&P 500 futures in the 1980s, they would call their FCM in the CME pits and relay the order. That broker would turn around and execute the purchase on their behalf, broadcasting the hedge fund’s intentions to the rest of the pit. If you knew which brokers represented the informed, smart money clients, you could use them as a signal to trade before their orders flooded in to move the market.
For decades FCMs ruled the futures business. In return for hefty commissions, they sold access to the deepest, most liquid trading products in existence. Processing institutional client orders allowed them to see markets in ways no one else could, and many FCMs traded for their own account in addition to brokering. FCMs held multiple exchange seats to execute trades & grow their business, which at the time meant owning the exchange itself. Exchanges like CME once existed solely to serve its FCM member-owners. The below quote from a former exchange employee helps to get a sense of the social order:
So, an acquaintance of mine, when he joined the [exchange] in the 1960s, one of his jobs was to dust off the partner’s top hat, and at the end of the day, go and sit in the first class compartment of a train, wait for the partner to come along […] Jack would wait for him and if he didn’t get on that train, Jack would have to go sit in another train, and wait for him to arrive… that was when principals [members] owned the firms…
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While there were hundreds of successful FCMs at the time, none were larger or more impactful than Refco, a multi-billion dollar brokerage with humble beginnings in the late 1960s. What began as an agricultural brokerage serving farmers & food companies soon grew into a financial behemoth as futures markets matured. Refco became a hub for hedge funds, corporations, professional traders, and even governments looking to trade CME’s products without having to buy an exchange seat themselves.
Refco’s rise didn’t come without its share of controversy. Remember Hillary Clinton’s cattle futures trading scandal? Refco was her broker. With $1,000 in her account in October 1978, Clinton made just under $100,000 in profit in about four months, an un-heard of return for any trader, let alone a first-timer. Refco was later levied a record-breaking fine by the CME for giving Clinton special treatment & abusing margin rules to let her make more money. At the time, Bill Clinton was Attorney General of Arkansas & had a bright political career ahead of him. 60 Minutes did a great expose below on CME, Refco and the scandal when it made headlines back in 1994:
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Despite the Clinton fine and others like it, no one was able to unseat Refco as the CME’s largest and most active FCM. In 2005, Refco went public on the NYSE at a $4 billion valuation, boasting revenues of $1.3 billion and annual growth of +25% per year from 2000 - 2005. Investors were excited about Refco’s position considering the rapid rise of electronic futures trading; the broker would be able to lower costs & improve margins as markets moved onto the screen. The IPO marked a peak for both Refco’s prospects & the FCM industry as a whole.
This peak wouldn’t last long.
On October 10, 2005 - 60 days after its IPO - Refco put out an explosive press release that would lead to its swift and decisive end. It was revealed that Refco CEO Phillip Bennett had for years been misstating SEC filings to conceal $430 million of Refco debt from investors & the public. He & other executives were charged with securities fraud and sent to prison, and the company he once lead entered a death spiral. While Refco still operated a large successful brokerage despite Bennett’s fraud, its brand had been permanently tarnished. On Wall Street, your word is your bond, and Refco’s word meant next to nothing after October 10. In the succeeding days, Refco saw historic client defections as competing brokers leveraged the scandal to take business away from their largest rival. Seven days after Bennett’s hidden debt had been revealed, Refco entered bankruptcy. It was one of the largest Wall Street bankruptcies in history, and the speed at which it happened so soon after going public made it particularly jarring for markets & spectators. A once rosy outlook for the FCM industry’s shining star had instantly evaporated.
In the ensuing fire-sale, Refco’s assets were auctioned to a firm that would go on to become MF Global, taking with it the crown as the industry’s largest independent FCM. With Refco’s assets now in tow, MF Global quickly ran into hard times as the global financial crisis hurt trading volumes and margin lending rates. The firm was levied additional fines when an employee lost $141 million trading wheat futures, and liquidity problems soon surfaced. MF Global managed to survive the financial crisis, but new leadership was needed to turn the broker around.
Enter Jon Corzine, former Goldman Sachs CEO and governor of New Jersey. After a volatile but decorated political career, Corzine’s move to become CEO of MF Global “was as if a manager of the New York Yankees was making a comeback in the minor leagues” according to the NY Times. Corzine had a vision of turning MF Global into a full-service investment bank, and began in 2010 by making huge bets on European sovereign debt as the EU struggled with a financial crisis of its own. Corzine’s bets became so big that the entire firm’s future was dependent on this trade, extending well beyond responsible risk limits.
The bets failed. When news leaked that MF Global was over-exposed to EU sovereign debt, customers & lenders panicked, and the resulting liquidity crunch revealed how little money the FCM had left. On Halloween 2011 MF Global entered bankruptcy, nearly six years to the day after Refco’s blowup. MF Global’s implosion became the eighth largest bankruptcy in US history at the time. Jon Corzine was personally fined $5 million and received a lifetime ban from CFTC markets for his role in the firm’s collapse.
Coming out of the Refco - MF Global debacle, FCMs faced a starkly different financial world than they did in the heyday of the 1980s. Secularly low interest rates had crushed their ability to collect money on margin deposits. Compliance & regulatory costs placed burden after burden on their operations. Exchanges, once in business to serve the FCMs, had demutualized, became public companies and had agendas of their own, often contrary to the broker’s benefit. Market data costs kept rising year after year, and new technology meant additional investment needed to keep up. The industry’s top institutional & high frequency traders no longer needed to work through a broker, but could connect directly to the exchange and cut out the middleman. FCMs faced pressure on all sides and across all parts of their P&L.
Which brings us to today’s grim reality - FCMs are dropping like flies. The below chart from the FIA shows there are only 51 FCMs left in the US, down over -50% from the early 2000s:
(Source)
Smaller firms are either going out of business or consolidating to manage rising costs more effectively. Many are also diversifying away from futures, expanding to equities, options and even crypto brokering to stay afloat. The impact of higher costs & regulatory burden has benefitted the big banks, who are better able to absorb the expense. All of the top ten FCMs are now big banks, with JP Morgan leading the pack. The current regulatory environment has made it so independent firms like Refco or MF Global can’t compete.
Regulators have begun to ask the question - what are the downstream impacts of this? Is FCM concentration good for markets? Not much in the way of guidance or policy has been released. If anything, it makes the banks & exchanges that much more “too big to fail”. God forbid JP Morgan or some other large bank has a Refco/MF Global moment and does permanent damage to the industry. The impacts of concentration will only grow as smaller firms keep falling by the wayside and barriers to entry become insurmountable.
Although FCMs play a critical role in providing cheap access to futures markets, the days of pit trading, fat commissions & market power are long gone. The blowup of the industry’s top two firms, combined with low interest rates & changing regulations have radically transformed the business and put power in the hands of exchanges, banks & HFT.
Honorable Mentions
There’s a new ATS coming to US equity markets, and it’s checking all the right boxes so far. PureStream, a startup trading venue backed by ex Goldman & Citigroup executives, this week chose Nasdaq to host its technology platform when it launches sometime in Q2 2021. Interestingly, Nasdaq also participated in a PureStream funding round earlier this year and has equity in the new venture.
MarketAxess released statistics on its green bond trading business this week, citing over $27 billion of green bond trading volume in 2020 and 20% global market share. Green bonds are fixed income products designed to support environmental projects, which are seeing a surge in demand as investors allocate more money towards ESG investments.
S&P Global’s merger with IHS Markit received overwhelming approval at a recent shareholder meeting, with over 99% of votes cast in favor of the deal. The merger is expected to close in the second half of 2021 after receiving needed regulatory clearance.
The CEOs of ICE and CME shared their thoughts on the Gamestop r/wallstreetbets drama during a recent FIA conference. ICE CEO Jeff Sprecher said Gamestop’s wild price action revealed “some of the inherent flaws in the U.S. equity market”, without getting into much detail explaining what those flaws are. CME CEO Terry Duffy gave a more laissez-faire opinion - “The public says: We don’t want to be protected from ourselves. So you have to give them what they want.” The comments highlight the wide range of opinions among even the upper echelon of exchange leadership about what problems exist and what should be done to improve market structure.
Chart of the Week
The far-reaching power of index providers was put on full display yet again this week, this time in the massive & systemically important oil market.
Platts, the energy arm of S&P Global, recently announced emergency changes to its Brent benchmark, used to price over two-thirds of the world’s crude oil. For years, the North Sea has been the primary source of Brent crude oil with smaller oilfields slowly added to the benchmark over time. Today, the North Sea is producing less & less oil and is becoming a less important part of the Brent index. Loadings of North Sea oil have become so low that Platts is trying to add WTI, the American oil grade, to its Brent price.
This has big downstream implications to both ICE and CME, who compete for trading volume in the Brent & WTI futures market. If WTI is added to the Brent index and the market accepts these changes, CME should stand to benefit.
(Source)
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Disclaimer: I am not a financial advisor. Nothing on this site or in the Front Month newsletter should be considered investment advice. Any discussion about future results or projections may not pan out as expected. Do your own research & speak to a licensed professional before making any investment decisions. As of the publishing of this newsletter, I am long ICE, CME, TW, NDAQ and VIRT. I am also long Bitcoin.