By Robert Hunter

On paper, the Cantor Exchange looks like a stroke of genius. Cantor Fitzgerald, the biggest cash Treasury dealer, has created, for the first time anywhere, an electronic trading system in which cash Treasuries and Treasury futures—among other things—can be traded on a single screen. “Instant hedging!” proclaimed CX enthusiasts when the system was launched in September 1998.

When the Chicago Board Brokerage, a similar system created by the Chicago Board of Trade, crashed and burned earlier this year, it seemed as though the CX was in position to steal a huge chunk of the CBOT’s Treasury futures franchise.

But a funny thing happened on the way to world domination: Nobody showed up. By Labor Day of this year, the fledgling exchange had managed to steal only a tiny crumb off the CBOT’s heaping plate. In August, while the CBOT’s Treasury pits racked up 14 million futures trades, the CX had a paltry 14,861.

Now, after a year of pathetic trading volumes, the CX is getting more aggressive. In September, the exchange announced two bold moves to bring in more futures business: It would allow cross-margining between cash and Treasury projects, and it would apply for regulatory approval of block trading.

The cross-margining deal is the first of its kind. In order to pull it off, the CX had to strike an agreement with the Government Securities Clearing Corp., which guarantees trades among the big cash Treasury dealers. In the agreement, the CX’s clearing facility will share information with the GSCC about the positions of companies that clear through both entities, and reduce the amount of margin put up by 75 percent whenever the cash and futures positions cancel each other out.

The benefits of cross-margining are clear: Less capital devoted to margin makes for more capital that can be used in trading activities—and a better use of a trading firm’s resources. Notably, the GSCC has had discussions with the Board of Trade Clearing Corp. and the Chicago Mercantile Exchange about similar initiatives in the past, but neither could be persuaded to strike a deal.

The CX’s block-trading proposal is another bold move. The concept of block trading is straightforward: Major market-makers strike private arrangements for big trades away from the exchange, and notify the exchange after the fact for clearing and settlement. The notion has languished on U.S. exchanges’ back burners since 1989, when various initiatives were rejected by the Commodity Futures Trading Commission. But Liffe dusted off the idea and began offering it in March of this year, and in June the CFTC opened the door for U.S. exchanges by announcing that it “stands ready” to consider new block-trading proposals.

Under the CX’s proposal, submitted in September, trades of 50 contracts or more can be executed directly between designated market-makers and other qualifying firms. The facility will allow participants to access the market after-hours, with counterparties reporting all trades back to the CX to ensure price transparency. The exchange would then clear and settle the trades. The result for participants: guaranteed execution of big trades at favorable prices.

The exchange is betting that block trading will lure players that otherwise would have used the over-the-counter markets. Its big selling points: OTC markets don’t provide the clearing and settlement services the CX can provide, or the cash-and-futures synergism. But the exchange wants to make sure block trading doesn’t sap the main market’s liquidity. That’s why it’s stipulated that, once a block trade is executed and reported, a counterparty cannot hedge the deal directly with another block trade. Rather, the market-maker must go back to the regular CX market to offset the position—thus maintaining liquidity in the primary market.

Will it fly?

Despite the big moves, however, some doubt they’ll amount to a spike in volumes. “The system itself isn’t the problem,” says a former broker. “The problem is, people aren’t willing to trade in a closed market that’s completely run by one counterparty.”

How, then, could the CX change things? “If Cantor wants to be a success,” says the broker, “it needs to open up its market. It would be better off by selling shares in the exchange to three or four big counterparties or investment banks, or possibly even dividing up shareholding much more broadly. That way, the people dealing in the market wouldn’t feel like captive clients of Cantor Fitzgerald in one way or another. But I think it’s going to be difficult for Cantor, which has always had a somewhat monopolistic view on how to approach bond broking, to relinquish any amount of control over its project, even though in the long term it would do the exchange more good.”

The Cantor Exchange and the Chicago Board of Trade declined to comment.

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