What do airlines, farmers and bank lenders all have in common? They all have exposure to an underlying commodity or asset class that they would ideally like to hedge to minimise price risk. At a derivative exchange, this group, known as commercial hedgers, use derivative contracts to eliminate price risk arising from their exposure to commodities like jet fuel, soybeans, or interest rates, to name a few. Speculators like hedge funds, proprietary trading firms and retail traders make up the other side of the equation, providing critical liquidity, and making “bets” in which they hope to profit from. Together, these two groups of participants provide the supply and demand for derivative contracts across exchanges around the world.
CME Group, the world’s largest exchange by market capitalisation, is a central location for the interaction between commercial hedgers and speculators, facilitating the trade of interest rates, equities, energy, agricultural commodities, metals, and currencies. They are perhaps most well-known for their Eurodollar and Treasury contracts. In this article we will focus on the Treasury contracts – futures contracts based on differing tenors of US government debt securities.
US Treasuries are the most liquid assets in global markets, backed by the US government such that their rates are widely used as a proxy for the risk-free rate. Due to their low risk, these securities are used as collateral by the primary dealers to facilitate interbank lending globally. Like WD-40, these securities smoothen the creation of credit around the world via the elimination of credit risk. Given their global relevance and importance, it is certainly a head-scratcher that only a single venue exists in which market participants can trade futures on these assets – CME Group.
“A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity.”
There is an aphorism amongst derivatives markets participants that “liquidity begets liquidity”. When starting up a derivatives exchange, speculators and hedgers are attracted to liquidity which results in tighter spreads, lower cost-to-trade, and better price discovery. However, this is a classic chicken and egg problem, whereby to attract liquidity, an exchange must already have liquidity. Typically exchanges attempt to circumvent this issue by offering volume discounts to market makers and banks, incentivising them to trade on their platforms. Despite these strategies, it is often extremely difficult to steal market share, or liquidity away from an incumbent exchange within certain products, due to the strong network effects associated with liquidity. For example, in 2007 ELX markets began trading Treasury contracts via its electronic trading platform. ELX, a new well-capitalised competitor, was created by a consortium of major banks and market makers, looking to steal share from CME by undercutting them and offering the same products. At the time CME’s market share was 99% of the US Treasuries, however over the next 5 years ELX’s market share peaked at 4% whilst it continued to incur significant expenses associated with discounts. Following the failure of a key partner, volumes at the ELX subsided and today sit at less than 1%.
As many major market participants observe minimum liquidity thresholds, significant adoption friction is created for new exchanges looking to build up liquidity within their products. For example, XYZ Capital may not be able to trade on an exchange with less than $20bn average daily volume. Hence, other funds of a similar size or larger than XYZ Capital may not be able to trade on the exchange, which has a flow on effect reducing the liquidity of products and increasing bid-ask spreads. As bid-ask spreads widen, other participants are deterred from using the exchange due to the greater cost to trade. Hence, the newly started exchange is unravelled, or fails to generate enough momentum to succeed, due to negative network effects.
In the absence of a Black-Swan-like event, it is difficult to see the global relevance and ubiquity of US government securities waning. Each year, we believe investors globally will continue to speculate or hedge their underlying interest exposures using these futures contracts. With this thought in mind we ask our readers, given liquidity begets liquidity, is CME Group a monopoly, and if so, what is the right price to pay for such a firm?
Phill Namara is a Research Analyst with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.