Derivatives Exchange Gets Approval As Trading Brokerage
Chicago Mercantile Exchange raises conflict of interest concerns
By Andrew Park
The Chicago Mercantile Exchange (CME) has just gotten approval from the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) to become the first exchange to buy and sell commodities with and for the same customers who trade on its exchange. Exchanges should be neutral venues where willing buyers and sellers meet and agree upon prices. The exchange acts as a platform that facilitates the trades and enforces the exchange rules, but does not participate in them. The notion that exchanges act as impartial market facilitation platforms may soon become outdated as the CME may soon also be able to trade against its customers and charge customers to trade on its exchange, raising deeply troubling vertical integration and conflict of interest concerns.
In late October, the NFA, a derivatives industry self-regulatory body, approved the CME’s application to become a Futures Commission Merchant (FCM). And CFTC Chair Benham waved the approval through without any notice, even — as far as we can tell — to fellow commissioners. FCMs act as broker-like intermediaries between buyers and sellers of commodities, futures, and financial derivatives like interest rate swaps. This includes charging fees to execute trades, maintain margin accounts, and facilitate the delivery of assets. FCMs are capital-intensive businesses that are required to constantly adjust how much in margin they collect or send back to their customers. FCMs also benefit from earning interest on the cash they hold from customers’ margin balances.
The NFA’s approval will transform the CME from an independent exchange to an exchange and giant commodity firm that will place orders for clients on its own platform as well as have the ability to make its own trades on its exchange, essentially placing its own bets against rival traders. This vertical integration creates significant conflicts of interest between CME’s trading brokerage and the rival brokerages and customers that place trades on the CME exchange. It is similar to the saying “the house always wins,” because the CME trading arm would have the incentive and ability to profit from giving its trading clients preferential access, information, terms, or prices to the CME exchange. And placing its own trades would amplify these conflicts by operating a market regulator, clearing firm, and trading operation that disadvantages its customers and other market participants.
These conflicts have serious consequences to market integrity and systemic risk. For example, how would the CME exchange prevent information from leaking to benefit its FCM business, similar to the benefits high frequency trading firms (HFTs) Virtu Financial and Citadel Securities, purportedly to receive from purchasing order flow from retail brokerage firms through a controversial practice in the equity market known as payment-for-order flow. Moreover, this kind of vertical integration could concentrate risk that could easily spread throughout the financial system. The CME is a systemically important exchange that many financial firms actively participate in and rely on, but if the CME’s trading arm were subject to large, sudden losses, it could compromise the stability of the exchange itself.
The collapse of FTX and its affiliated Alameda Research trading arm demonstrated the problems with allowing one company to control multiple functions of exchange trading — trading, settlement, intermediation, and market regulation. CME’s own chief executive officer criticized FTX’s combined crypto and commodities clearing and trading at a 2022 House Agriculture Committee hearing because there were so few safeguards to protect customers from the obvious conflicts of interest.
The CFTC, which regulates commodities and derivatives exchanges, should never have outsourced or permitted critical regulatory decisionmaking to self-regulatory industry bodies like the NFA. Some have suggested that the CFTC establish conflict-of-interest rules to provide safeguards to address the problems posed by vertical integration, but the structural problems could not easily be remedied by conflicts-of-interest rules unless they set clear parameters for illegal coordination, strong enforcement tools to delve into the interrelation between the related business functions, and powerful penalties requiring the immediate divestiture of vertically integrated functions.
The real solution would be for the CFTC to establish strong rules that prohibit one firm from becoming vertically integrated to combine multiple but distinct functions of trading, intermediation, and market regulation that pose conflicts-of-interest risks to customers, market integrity, and the economy. The Financial Stability Oversight Council (which includes CFTC as a member) should immediately assess how the CME’s new, broader reach across the commodities and derivatives market poses risks to the broader financial system.
Andrew Park is AFR’s associate director for private equity and capital markets
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