By Laurie Morse

Watch your back, Chicago. Real competition from Internet-based exchanges may be just around the corner.

The Commodity Futures Trading Commission recently announced that it is reviewing its first-ever submission for an on-line, Internet-based futures exchange. In January, Amarillo-based Texas Beef Group submitted an application to open FutureCom, its version of an Internet commodity exchange. And the CFTC is giving the application serious consideration.

While FutureCom plans to offer trading only on cattle derivatives initially, "We think this is the first of what could be a large number of similar applications,” said Alan Seifert, deputy director of the CFTC's division of trading and markets. In fact, some industry lawyers think it is only a matter of time before the largest bank futures commission merchants make their own applications to open electronic futures exchanges.

Ironically, the nascent movement toward Internet exchanges has been fueled in part by the Chicago exchanges' own proposals to lift CFTC oversight over "professional” financial markets, which include provisions to liberalize the definition of an exchange. If Congress approves the proposals, Chicago could be competing against a wave of new "professional” electronic exchanges that perform many of their functions at a tiny fraction of the cost.

The professional market legislation does not apply to agricultural derivatives, so it may be no accident that the first Internet futures exchange submission has come from Texas Beef, an outfit with agricultural roots, and is going through the traditional CFTC contract market-approval process. Cutting out the middleman—in this case futures exchanges that impose hefty fees to support trading floors, staff and clearinghouses—is a popular concept on Wall Street as well as Main Street.

"There is a physical limit to the number of people who can access the market on established exchanges,” says David Downey, vice president in charge of technology at Timber Hill, a Chicago-based futures and options firm that trades only its own money. Timber Hill has been developing its own way to streamline order flow into the world's futures pits, with the goal of cutting trading costs, but its system stops short of electronic trade execution. "Not only that, but the exchanges require you to put a telephone line into a booth by a pit, staff the booth, pay a broker. They say, ‘You must support this huge and inefficient order-routing system and then you have to make the client pay for a whole lot of it.'”

Chicago, meanwhile, hasn't taken the threat lightly. "The Chicago Mercantile Exchange [which has an established live cattle futures contract] has done everything it can to stall our application,” says Bill O'Brien, FutureCom's managing partner. O'Brien notes, however, that the CFTC is basically supportive of the notion of electronic trading, and adds that Texas Beef is willing to stick with the application process for as long as it takes.

Texas Beef, however, has a number of challenges to overcome. O'Brien concedes that Internet security is the top concern for the CFTC. Financial backing is also an issue, since customers rely on exchanges to have deep pockets and procedures for handling defaults. FutureCom is designed to be a price-time-priority trading system with clearing and trading occurring simultaneously. Traders must have margin money on deposit in an on-line bank account before trades are made.

As for deep pockets, FutureCom is taking an innovative approach to financial integrity. It intends to back up its clearing process using re-insurers who offer credit security at a price. At the established exchanges, by contrast, the first line of defense in cases of default are usually the clearing members of the exchange, backed by lines of credit from a bank or banks.

"No one wants to risk trading on a small, undercapitalized exchange,” said O'Brien, "The issue is, what amount of credit enhancement do we have to purchase to make our product viable?” At pennies, or even dollars per trade, FutureCom could offer substantial credit security and still price its services far below established exchanges.

Timber Hill's Downey, meanwhile, doesn't think an Internet-based exchange is the answer. "Texas Beef is picking the wrong medium,” he argues. "They should be shooting for an intranet, not the Internet.” Although he agrees with the firm's basic philosophy, he believes the problem of Internet security could stall FutureCom's application.

CBOT Wins the Dow Derby

The Chicago Board of Trade won out in the much-hyped bidding war to secure rights to trade futures and futures options on the Dow Jones Industrial Average, the most recognized stock market benchmark in the world. However, it remains to be seen how much those trading rights are worth, either to the exchange or to Dow Jones, which resisted associating its name with derivatives for more than a decade.

The Standard & Poor's 500 index is the benchmark used almost universally by portfolio managers to judge their success, making the Chicago Mercantile Exchange's S&P 500 futures pit the busiest in the world. DJIA futures, based on a narrow index of 30 blue-chip stocks, may attract retail investors, but isn't expected to draw institutional traders away from the S&P 500. The CME, on the offensive after being passed over by Dow Jones, said it plans to launch a "mini” S&P 500 contract, valued at one-tenth of its full-sized S&P future, to appeal to retail traders.

Still, the Dow Jones indices could give the CBOT a boost. "This is as significant to the Chicago Board of Trade as the introduction of financial futures,” says CBOT chairman Patrick Arbor. "It gives us entry into a whole new line of products.”

The CBOT hasn't had an equity-based futures contract since it lost the low-volume Major Market Index—a proxy for the DJIA—to the CME four years ago. Arbor said his change will launch DJIA futures as quickly as regulators allow, and then follow up with related indices. Along with the DJIA, the CBOT won futures rights to the Dow Transports, the Dow Utilities, and a host of global, foreign and sector indices calculated by Dow Jones.

The synergies—and spreading possibilities—between these indices and between equities and U.S. Treasury bonds (the CBOT's biggest contract) could generate some volume in these products, CBOT traders say.

Meanwhile, Dow Jones isn't finished with its licensing caper. In the United States, the Chicago Board Options Exchange won rights to trade Dow Jones options, and the American Stock Exchange to offer Dow Jones unit trusts or warrants. However, the three U.S. exchanges' rights apply only to the North American time zone. Dow Jones said it expects to sign additional derivatives agreements—possibly with exchanges in other time zones—in the near future. According to one account, the company has a goal of reaping $100 million annually from derivatives licenses.

CME-DTC up For Sale

For the relatively insignificant sum of $8 million, any bank, brokerage or venture capital firm could own nearly half of the Chicago Mercantile Exchange's Depository Trust Company. Better hurry though—the offer is expected to close sometime in August.

The CME-DTC is meant to be custodian for the billions of dollars of collateral that back swaps transactions by the world's largest banks. Along with custody, the DTC expects to offer netting between counterparties, and margin rationalization between over-the-counter interest rate swaps and CME Eurodollar futures.

First proposed in December 1994, the CME-DTC was designed to be fully owned by the CME, with the exchange acting as vendor, recouping its investment through a complicated schedule of fees. That arrangement foundered last November, when it became clear the DTC—not yet operational—would yield losses in 1997 and 1998. The CME, unwilling to accept new budget strains at a time of weakening volume, decided to shop the venture around.

The exchange is offering 80 limited partnership units for about $100,000 each in the CME Depository Trust. Limited partner investors would get about half of all future profits, and would accept all of the first $8 million of losses. As equity owners, they would also get five of 11 seats on the DTC's board of directors.

At the same time, the CME-DTC's fee structure will be simplified, so all users will be charged the same amount, regardless of equity interest.

John MacPartland, CME-DTC president, says he expects the first banks (all of them in the top quartile of ISDA membership) to begin operating with the DTC in September, and by the third year of operation returns on the limited partnerships should be "spectacular.” He expects five to seven banks to join the CME-DTC this year, and to add 10 banks per year for the next three or four years.