Exchange Consolidation

The business model for futures exchanges has come a long way...


Back when I started trading in the early 1980's, the membership collectively owned the futures exchanges. Anyone who owned a seat, or the right to trade on an exchange, owned a piece of the institution itself.

In those days, there were different exchanges that specialized in different products. The COMEX traded metals like gold, silver, and copper. The New York Mercantile Exchange (NYMEX) traded energy commodities as well as platinum and palladium.

The Chicago Board of Trade (CBOT) traded grains while the New York Board of Trade (NYBOT) traded soft commodities such as coffee, sugar, cocoa, cotton and orange juice. There were so many exchanges trading commodities and financial products it was hard to keep track of them all. For example, three different types of wheat traded on three different exchanges- the CBOT, the Kansas City Board of Trade (KCBT) and the Minneapolis Grain Exchange (MGE). All of these exchanges had the same basic business model and the Commodity Futures Trading Commission (CFTC) in Washington, D.C. regulated them all. Then there were foreign exchanges like the International Petroleum Exchange (IPE), the London Metals Exchange (LME) and the London International Financial Futures and Options Exchange (LIFFE) in London.

Each exchange was a center for price transparency and price discovery. The producers, consumers, speculators, arbitrageurs and investors who came to these markets to transact business could do so without credit risk.

In each case, the clearinghouse of the exchange became the buyer to each seller and the seller to each buyer. Buyers and sellers of futures contracts posted original market, which acts as a performance bond. Each day, based on settlement prices, those with long and short positions settle up- they pay or receive market differences.

If the amount of margin drops below maintenance margin levels, the party is required to post more margin. It is a great system that works for all involved- trading take place without the worry or hassle of counterparty risk.  The popularity of trading futures contracts, which allow market participants a great deal of leverage, grew, as did the volume of futures and options traded on the various exchanges. As volumes grew, exchanges and their respective clearinghouses had to invest more capital in computer systems and infrastructure to handle the ever-increasing flow of business. As the need for capital grew, some of the exchanges began to merge with one and other.

On August 3, 1994, the COMEX and the NYMEX merged- operating as one exchange resulted in tremendous cost benefits. The appearance of the Intercontinental Exchange (ICE) on the scene in 2000, added a new dimension to futures trading. ICE was an all-electronic exchange- there were no floor brokers and its original mission was to develop a transparent marketplace for over-the-counter energy markets. However, ICE quickly got into the futures business in 2001 when they acquired the IPE in London. The pace of mergers and acquisitions picked up steam when one of the world's largest exchanges, the Chicago Mercantile Exchange (CME) went public in 2002 becoming the first public futures exchange with its shares listed on the New York Stock Exchange.

A frantic period of consolidation and mergers followed. The CME eventually purchased the NYMEX, ICE purchased NYBOT and eventually in 2013, ICE acquired the NYSE/Euronext. Now, few if any independent commodity exchanges operate in the United States or around the world for that matter. Those that do are targets for the huge futures empires created by the CME and ICE.

The reasons for the fast pace of consolidation of the various futures exchanges was a result of both growth in the industry and the availability of capital. As the expense of operating a modern futures and options exchange grew, it made a great deal of sense to merge. Mergers created economies of scale- it became cheaper and more efficient to operate one large multi-dimensional clearinghouse and regulatory framework than to operate many small ones.

Additionally, these exchanges make money on the fees that they charge for trading as well as for the data that many market participants are willing to pay for. Therefore, listing companies like CME and ICE on equity exchanges attracted many investors who wished to own shares in these profitable entities. Today the market capitalization of the CME is over $31 billion and ICE has a market cap of $26.75 billion.

Exchange consolidation has created efficient publicly traded companies. These companies have the capital to handle the ever growing demand for financial and commodity futures and options products.