IN THE competition for most inauspicious introduction to finance, Terrence Duffy, the executive chairman of CME Group, must surely be the winner. Soon after convincing his mother in 1981 to borrow $50,000 so he could buy a seat to trade futures on what was then known as the Chicago Mercantile Exchange, he lost $150,000 because of a misheard order.
The anecdote holds a number of lessons: how quickly money can evaporate in the futures market; how trivial the cause can be; and how important it is to honour an agreement (at least in this area of finance). But the most important lesson became apparent only belatedly: a disastrous trade can be offset by a big bet gone right. In Mr Duffy’s case that was joining an institution which has become one of the finance industry’s brightest stars.
It did so largely unnoticed by the public. Tourists continue to line up outside the historic building of the New York Stock Exchange on Wall Street, hoping to see the inner workings of capitalism—even as the NYSE is becoming increasingly irrelevant.
The magnitude of CME’s success is easy to miss. Its quarterly earnings, reported on May 2nd, were mixed. Profits dipped. The fear that prompts firms to purchase futures (the contracts traded on the CME to protect firms against changes, for instance, in the level of a currency and the price of energy) was less acute. A little more havoc would have been good for business.
Yet CME’s growth in recent years has been nothing short of spectacular (see chart). It now boasts a market valuation of more than $20 billion, nearly twice as much as Intercontinental Exchange (ICE), another rising star in the financial firmament. The NYSE is, meanwhile, now worth less than $10 billion.
When Mr Duffy joined the Chicago Merc, relationships with key companies were considered a financial firm’s most important asset. That was certainly true for J.P. Morgan, Dillon Read and Morgan Stanley, then among the leading banks, and for the NYSE. But the fate of these firms shows that such relationships may not help much: two of the banks were absorbed in semi-distress sales; the NYSE will soon be swallowed by ICE. Morgan Stanley survives, but is in search of a viable strategy.
In contrast, the Chicago Merc’s business was tied to products, not customers. At first, it was eggs and butter, then cattle and pork bellies. The Chicago Board of Trade across town, once the more successful exchange, dominated trades in wheat and corn. The two did not really compete because product-oriented exchanges in particular benefit from strong “network effects”. These mean that more members are better: the more trades exchanges handle, the more liquidity they can provide and the more activity they attract.
The CME managed to benefit from the same virtuous cycle in futures. It was not the first to offer contracts on currencies, but it had the best timing. Leo Melamed, the Chicago Merc’s chairman from 1968 to 1973, had learned firsthand about the value of currency trading from the black markets in Tokyo, where he lived briefly as a refugee from Nazi Germany. When the Bretton Woods system of fixed exchange rates fell apart in 1972, CME was quick to offer currency futures. Contracts tied to the London Interbank Borrowing Rate (LIBOR) and the Standard & Poor’s 500 index followed.
This allowed CME to lead the creation of an entirely new class of securities, explains Michael Gorham of the Stuart School of Business at the Illinois Institute of Technology. Between 1972 and 1982 futures, which once locked in prices only of physical commodities, were increasingly used for financial products. These types of futures have since experienced staggering growth and today makes up more than 80% of the business.
The CME also negotiated the shift to electronic trading better than its competitors. It was not particularly quick to convert, but it did move once it faced a genuine threat from European competitors. Other American exchanges, such as the once larger Chicago Board of Trade (CBOT) and the NYMEX, which then dominated energy trading, were slower to change. They were taken over by CME.
Leading the pack, the CME was able to benefit from powerful network effects, just as it did in its old business of handling trades in cattle and pork bellies. These effects are even stronger in the case of futures tied to copyrighted indices such as the S&P 500 and because of “proprietary clearing”, meaning contracts initiated on one futures market cannot be transferred to another—much as apps written for the iPhone only run on Apple’s devices. In contrast, options and equities can be traded on any exchange. This explains why the NYSE’s share-trading franchise has many rivals and lost much of its value.
Ordinarily, a big market share supported by strong network effects—which help deter competitors—would attract the wrath of trustbusters. But CME has been left alone so far. In fact, it may now benefit from new regulation, passed in reaction to the financial crisis. Clauses in the Dodd-Frank act require more products to be cleared on exchanges, which will push business CME’s way.
CME does face long-term competition: others may innovate around it. But, as in the case of Apple, the CME’s main problem is to develop new markets. It has begun offering niche products tied to areas like a single harvest or debt with an unusual term structure, such as four years rather than five or ten. That may seem trivial, but such iterations add up to something bigger: CME is evolving into an ever more sophisticated institution that plays a key role in many sorts of financing. If tourists want to get a glimpse of the inner workings of capitalism, they now have to make a trip to the lovely city of Chicago.
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