Monday, April 27, 2009

Chicago Missing Swaps Swagger, Melamed Vows Comeback

Posted on Bloomberg by Matthew Leising:

Leo Melamed helped create the first contracts almost 40 years ago in what would become the $20 trillion financial futures market. In the 1980s he pushed for electronic trading, propelling his Chicago-based CME Group Inc. to dominate U.S. futures exchanges.

“We think we’re better than everybody else,” said Melamed, CME Group’s Chairman Emeritus.

In the $28 trillion world of the credit-default swap market, though, the Chicago swagger is less certain. Six months after announcing its plan to back credit-default swaps with its clearinghouse, and six weeks after gaining regulatory approval, CME Group hasn’t processed a single dollar of the contracts. It’s losing to the 9-year-old Intercontinental Exchange Inc., which is about to hit the $100 billion mark.

CME Group’s stumble in this new market has forced the world’s largest futures exchange to admit mistakes and change course. Melamed, 77, and his colleagues got fresh evidence of the need to do so last week when the company reported a 30 percent drop in first-quarter profit because trading in its largest contract, interest-rate futures, fell 53 percent.

“We started a little wrong,” Melamed said in an April 22 interview in his office, where photographs of him with Federal Reserve Chairman Ben S. Bernanke and every president back to Gerald Ford hang on the wall. “We said you had to trade with us to go to our clearinghouse. That was wrong. We’ve now adjusted that, and that was a big difference.”

Lehman Fallout

CME Group is battling to penetrate the credit-default swap market where regulators are demanding more transparency after Lehman Brothers Holdings Inc., one of the largest swaps dealers, filed the biggest bankruptcy in U.S. history last September with $613 billion of debt. American International Group Inc.’s bad bets using the contracts led to four attempts by the U.S. to salvage the insurer in a rescue package valued at $182.5 billion.

A clearinghouse that backs the contracts spreads the counterparty default risk among the members that capitalize it by becoming the buyer to every seller and seller to every buyer. It also creates one location for regulators to see prices and positions in the market.

Credit-default swaps are derivatives used to hedge against losses or speculate on companies’ ability to repay their debt. The swaps pay the buyer face value if a borrower defaults in exchange for the underlying securities or the cash equivalent.

110-year History

While clearing credit-default swap trades is a goal of CME Group, the exchange has its eye on the broader over-the-counter business, which is the world’s largest derivative market with a notional value of $684 trillion.

“We think that’s the next frontier,” Melamed said, adding that the CME Group eventually would prevail in attracting customers to its clearinghouse. “If one were to choose where one wants to go with credit-default swaps, how about the place that has a 110-year history without default?”

Intercontinental Exchange, based in Atlanta, is an upstart compared with that pedigree, having begun in 2000 with a system to guarantee over-the-counter energy transactions. The company has since grown to the second-largest U.S. futures market, owning exchanges in New York, London and Winnipeg.

CME Group fell $5, or 2.1 percent, to $234.80 at 12:21 p.m. New York time in Nasdaq stock market trading. Intercontinental Exchange gained $4.02, or 4.8 percent, to $88.41 in New York Stock Exchange composite trading. CME had risen 15 percent his year before today while ICE was up 2.4 percent.

Wall Street ‘Threat’

CME Group has fallen behind its competitor not only because of the initial decision to make clearing customers also trade with the exchange. The Wall Street banks that account for the majority of over-the-counter trading don’t want to give away the lucrative business, said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York.

“They don’t have customers because the street views CME as a threat, not because the CME product is in any way flawed,” said Hintz, who was rated the top analyst covering brokerages in a survey by Institutional Investor magazine last year. JPMorgan Chase & Co. earned $5 billion last year from its fixed-income OTC trading, people familiar with the earnings said last month.

Melamed agreed that banks are wary of shifting over-the- counter business to CME Group. “The majors make a lot of money by not bringing it to us,” he said, referring to the banks.

Fix Needed

Intercontinental’s clearinghouse, known as ICE Trust, has the backing of nine banks including Goldman Sachs Group Inc., JPMorgan, Citigroup Inc. and UBS AG that Intercontinental obtained through its acquisition last year of the Clearing Corp., which the banks owned. The banks receive half the profit from clearing trades on ICE Trust.

Melamed said CME Group’s bank customers told it that the initial proposal to offer credit-default swaps for clearing only through its CMDX platform wasn’t how they wanted to use the system. The banks wanted to trade the contracts among themselves or with clients and then bring them to CME Group to be cleared, he said.

“They were very frank about it,” Melamed said, adding that the Chicago exchange changed CMDX several months ago to allow that outside trading of credit-default swaps. “We saw it as a legitimate problem that we ought to fix.”

Melamed declined to comment on which banks CME Group is in talks with about joining CMDX, which is a joint venture with Citadel Investment Group LLC, the $13 billion hedge fund based in Chicago.

Olive Branch

ICE Trust has cleared 875 credit-default swap transactions in Markit CDX North American indexes, guaranteeing $98 billion of the contracts, according to its Web site.

“I have to give ICE a lot of credit,” Melamed said. “They came in strong. They are a serious competitor.”

Craig Donohue, CME Group’s chief executive officer, said in an April 22 interview that the evolution of the credit-default swap market will take time. The exchange is working to build trust with the major banks involved in over-the-counter markets, Donohue, 47, said the next day in response to a question on a conference call with analysts.

“We’re modifying our approach to extend the olive branch,” he said.

ICE Trust’s share of credit-swap clearing was minimal, Donohue said in the April 22 interview. “The amounts that have migrated to the clearinghouse are very, very small,” he said.

Financial Futures Founder

The total in credit swaps cleared by ICE Trust comprises 1.5 percent of the investment grade and high volatility CDX indexes, which total $6.4 trillion, according to the New York- based Depository Trust & Clearing Corp., which runs a central registry that captures most trading. Revenue from the business could reach $50 million a year, according to Goldman Sachs. That would boost revenue 6.2 percent at ICE or 2 percent at CME Group based on 2008 sales.

Intercontinental spokeswoman Kelly Loeffler declined to comment.

Melamed is often called the “father of financial futures” for his role in creating the first currency futures contracts in the early 1970s. Along with Richard Sandor, who helped invent interest-rate futures at the Chicago Board of Trade at the same time, Melamed transformed a futures world that had been based on agricultural products such as corn.

Chicago’s financial identity for generations was defined by traders in colorful jackets shouting buy and sell orders at each other in the pits at the CME and Board of Trade.

Culture Challenge

In the 1980s, Melamed challenged that open-outcry culture by spearheading the development of the Chicago Mercantile Exchange’s Globex electronic trading platform against opposition from the city’s floor traders.

Globex now accounts for more than 80 percent of CME Group’s total volume, up from less than 15 percent in 2000. From 2000 to 2007, the number of contracts traded annually rose to 2.8 billion from about 200 million. That growth boosted CME Group’s shares more than 14-fold from 2003 to 2007, allowing it to buy the Board of Trade and another competitor, the New York Mercantile Exchange. CME Group now controls 98 percent of U.S. futures trading.

The $684 trillion notional value of the over-the-counter derivatives market dwarfs the $20 trillion exchange-traded futures market, which doesn’t include commodities, according to the Bank for International Settlements in Basel, Switzerland.

The lack of transparency in the OTC derivatives market allowed banks to make billions in profits from the spreads between offers to buy and sell.

Day to Remember

In foreign exchange markets in the 1970s, Melamed said, the Chicago Mercantile Exchange’s futures contracts reduced spreads to as little as 2 basis points from 20 basis points when the banks traded in the OTC market. A basis point is 0.01 percentage point.

From those days more than 30 years ago, Melamed still trades foreign currency contracts. At one point during the interview in his office, an announcement about a trade in yen crackled over a squawk box.

“I trade, which makes me live,” Melamed said. “I know what’s going on because it’s my money.”

He shows off Chinese, Japanese and Korean translations of his 1996 book “Escape to the Futures” with Bob Tamarkin. On a shelf, a crumpled calendar page from Thursday Nov. 13, 1969, sits in a frame.

Melamed commemorated the date because it was the day he did well enough in the pits to get himself out of debt from trading egg futures. He’d gone broke as a trader twice already, and he promised himself never to do so again.

With that perspective, he said he isn’t overly concerned about ICE Trust taking the lead in clearing credit-default swaps.

“I learned that, yes, there probably is a timeline,” he said, “but it’s much longer than we all intuitively think.”

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