Jim McNulty, the president and CEO of the Chicago Mercantile Exchange, is one of the first exchange leaders to come from the OTC side of the business. He is a former general partner at O'Connor & Associates, the pioneering futures and options trading firm that was purchased by Swiss Bank in 1992. At Swiss Bank, he was responsible for designing risk management tools used to advise multinational clients and investment managers. After the UBS/Swiss Bank merger, he served as a member of Warburg Dillon Read's corporate finance technology committee, where he helped launch the firm's global corporate finance web portal. He spoke with editor Joe Kolman in October.

Derivatives Strategy: Unlike most people in the exchange world, you've spent all your time in the over-the-counter market. How have your feelings about exchanges changed in the last few months? How did you view exchanges before you took this job, and how's your understanding different now?

Jim McNulty: When I was at O'Connor, Swiss Bank and UBS Warburg, the exchanges were a big part of how we acquired positions and laid off risk. They were important because they offered a very capital-efficient way for us to grow our business. I think the banks also realized that it was a capital-efficient way for them to manage the risks of their business without incurring BIS capital charges.

If you look out five years or so, you'll see exchange clearinghouses becoming increasingly important. They have been performing a very effective capital-cost controls function. The next stage for exchanges would be to turn clearing firms into universal clearers, where they do clearing outside of the traditional exchange products and even help some of their clearing members in swaps or other product areas.

DS: That begs the question of why it didn't work the first time round. As you know, there have been at least a couple of failed attempts to perform the functions of the OTC market. For some reason, the OTC dealers weren't on the bandwagon.

JM: The Chicago Mercantile Exchange, actually, made one of those attempts. The CME-DTC [CME Depository Trust Co.] effort was based on the concept of swaps collateral management. A lot has changed from even five years ago. The new-economy model that has allowed staunch competitors to suddenly devise collaborative commerce initiatives could be the same new-economy philosophy that will allow them to do something like I just mentioned—a collaborative clearing effort, this time to bring down costs.

DS: Why did the CME decide to demutualize?

JM: A little over a year ago, the membership decided they wanted to be one of the exchanges that survived and prospered. To that end, they started the process toward demutualization. They wanted streamlined governance, they wanted the ability to develop new revenue streams that may or may not be on the floor, and they wanted the ability to have continued growth, either through acquisitions, technology development or other strategic maneuvers.

In the past, we made decisions to create big daily profit opportunities for the members, but in the future we will have to create long-term cash flow for the exchange and its shareholders.

When you go from a mutual organization to a shareholder organization, it becomes important to put metrics in place to create shareholder value and to help us make decisions and grow the business. Here's a simple version. One way to look at it is to take the Gordon growth model, which is net operating profit after tax, divided by the cost of equity, minus the growth rate of net operating profit after tax. This formula should approximate your market capitalization. So when you go from a not-for-profit to a for-profit company, you have to create a profit, manage your risks to keep down the cost of equity and find new revenue growth opportunities.

My management team and I are obsessed on a day-to-day basis with these two things—the net operating profit after tax and the growth of that into the future.

DS: Well, that's a challenge, because profitability obviously wasn't the key thing for the first 102 years of the exchange.

JM: That's correct. So what it means is shifting to a longer decision-making time frame. It means being able to move swiftly once we make decisions, and to create opportunities in the future based on the strength of the 102-year-old assets. In the past, that was always done to create big daily profit opportunities for the members, but in the future we will have to find other profit opportunities that may or may not affect the members on a day-to-day basis, but will create long-term cash flow for the exchange and its shareholders.

DS: Where do you think your long-term growth will come from?

JM: If you take a new-economy view of the CME, what we have are various verticals matching peoples' trades in the equity sector, in interest rates, in currencies and in agricultural products. But we also have a horizontal infrastructure in place, which allows us to clear the trades from our verticals, to settle the trades, to develop new products, to make sure that those products pass through the proper regulatory framework so they can be put up on a regulated exchange. We do dispute resolution, clearing, settlement and management of collateral. As we begin to change some of the processes here and to grow our electronic business, we think that the verticals will grow.

Another area of growth lies in extending this platform that has been clearing, settling and delivering products in an exchange format for 102 years. We can apply the CME infrastructure to the business-to-business marketplace. The first example of that is the announcement we made in September with CheMatch.com in Houston. We will co-develop and co-brand chemical contracts with that marketplace. There will be links from our Globex2 trading platform to the web site of CheMatch.com, so people will be able to trade the cash product, as they traditionally do through CheMatch.com, and the futures product on the same screen. People will also be able to trade futures on these products the way they normally do through Globex2 or through their futures commission merchant.

DS: In the past, the Merc has tried—unsuccessfully—to develop contracts for all sorts of products, such as wood, paper and God knows what else, within the exchange structure. Now you're trying to do it in a new environment. What about this new environment do you think is going to make this effort successful?

JM: I think this concept of the marriage of the B-to-B marketplace with the traditional exchange actually creates a synergy that has never existed before. The B-to-B value proposition says if you combine content and domain expertise, a community will form. And from that community, commerce will take place. But that value proposition has proved disappointing—you could see it in many of the B-to-B valuations, starting last March. Their front-end systems were very useful, but they lacked the efficient process of clearing, settlement and collateral management that you find in the traditional exchanges.

DS: So that's one of the assets as an exchange. Most of these other exchanges have not even tried to set up clearing structures. They hand off the trade and that's the end of it as far as they're concerned.

JM: I think different exchanges bring different pieces to the party, but it's probably best for me to talk about the CME. Our operation is well-integrated in terms of product design, product regulation, straight-through product clearing, settlement and collateral. If you are a B-to-B exchange, I think that kind of integration can be very helpful if you're trying to build liquidity.

DS: One of the things that creates liquidity in international markets is the combination of hedgers and speculators. In most B-to-B exchanges, there hasn't been that speculative component. Is that something the Merc's membership can bring to bear on some of these new initiatives?

JM: That's a great question. I think there are all kinds of B-to-Bs—let's call them exchanges. Some of them are not really exchanges the way we would think of exchanges. You have few-to-few, you have few-to-many, you have many-to-few. We think we add value to the B-to-B environment where there's a fragmentation between buyers and sellers in the many-to-many area and where the products can be standardized.

The next stage for exchanges is to turn clearing firms into universal clearers, where they do clearing outside of the traditional exchange products.

If the trades can be simplified or standardized to a point where many people can usefully buy and sell them, you end up creating an interesting marketplace for people other than just buyers or sellers. You create room for hedgers and you also create an opportunity for speculators to express an opinion. Once you do that, you open the door for arbitrage—doing statistical arbitrage with options and then hedging in the underlying, or maybe doing arbitrage on the spot vs. forwards and essentially creating a type of fixed-income instrument.

DS: You say your biggest value is in fragmented markets, but the financial markets are the opposite of fragmented. There are maybe a couple thousand names that do the greatest percentage of the trading. What are the Merc's plans for that side of the market?

JM: It's actually not as simple as what you just stated. Some of our markets are highly fragmented—for example, the Nasdaq and Nasdaq E-mini contracts. There are many investment managers, but also many retail players. We do a great deal of one-lots every day, but we also do some very large lot sizes—because we have a true fragmentation in the kinds of users of those products.

DS: A few years ago, you launched the Standard & Poor's E-mini, an electronically traded version of your S&P futures contract, geared to retail investors. This contract now attracts a lot of interest from market-makers and institutional investors who don't want to trade through the floor. Is it the bellwether for the movement from an older type of trading to a newer type of trading?

JM: Basically, a very large portion of the market wants to have a what-you-see-is-what-you-get experience. We think that's a growing portion of the market.

DS: Do you think you'll increase interest from institutional investors if you take the trading limits off?

JM: We're taking the limits off—that should happen sometime in the near future. At the same time, we're expanding capacity on the Globex2 system, and we've seen an increase in volume since we made those announcements.

DS: The financial press has always looked at the exchanges in terms of open outcry vs. electronic. The exchanges are trying to present a more complex picture. How do you see the relationship between open-outcry and electronic exchanges in the future?

JM: It goes back to the value proposition. In the B-to-B world, people talk about creating content, which they hope will create community, and then from community there will be commerce. We already have the community here, on our floor. Our member population is a tremendous trading community. But we also know that some portion of our end-users want this what-you-see-is-what-you-get interface and environment, and want to sit in front of a computer screen, click a mouse, enter trades, close trades and take profit.

Ten years from now, it will be difficult to differentiate between securities exchanges, derivatives exchanges and B-to-B exchanges. And they will be linked on a cross-border basis.

What we need to do is make sure we maximize the value of our community at the same time as we meet the end-users' needs. Some of those needs have to with open outcry and some have to do with the electronic platform. What we've done at the CME is create what we call "the third way,” where we have our community, we have open-outcry activity in most of our products, but those pits are surrounded by people who are trading electronically and can arbitrage the open outcry against the electronic marketplace. These people are essentially performing that third-way arbitrage function, which is creating the highly liquid, electronic marketplace that you see in the E-mini S&Ps and the E-mini Nasdaq.

DS: There are some who say that the growth in electronic trading is inevitably going to come at the expense of open outcry. There may be a third way right now, but inevitably those open-outcry pits are not going to be there.

JM: That's a possibility, but I think it will be the customers who tell us that.

DS: We haven't talked about global linkages at all. You haven't brought it up. Do you have a game plan?

JM: Absolutely. The drivers of the marketplace are globalization, deregulation and rapid advances in technology. And globalization, I think, will lead us to a much more streamlined picture 10 years from now, when it will be difficult to differentiate between securities exchanges, derivatives exchanges and B-to-B exchanges. In other words, the exchanges will—one way or another—be linked on a cross-border basis.

The CME already has established numerous global alliances. The Globex Alliance includes the CME, Singapore Exchange, ParisBourse, BM&F in Brazil, Montreal Exchange and MEFF in Spain. The CME separately has an alliance with Liffe and recently announced plans to pursue a global alliance with the Tokyo Stock Exchange.

DS: A year or two ago, Leo Melamed said that he thinks there will be two exchanges left in a few years. I don't know if he still thinks that now, but is that anything like what you think will happen?

JM: I don't think that will happen in two years, but I think Leo's overall direction is right. There may be hundreds of specialty exchanges in a few years—I think four specialty exchanges a week are opening at this stage in the B-to-B development. But in terms of where the actual liquidity is being developed, where you see hubs of growth, I think it's going to be on a cross-border basis and also on a cross-regulatory basis. The big exchanges of the future will be international. They will be crossing the boundaries of securities, derivatives and B-to-Bs.

DS: It seems to me that in the future institutional investors are going to have so many choices about where to transact their business. They'll have different electronic communication networks, they'll have different alternative trading systems, they'll have different exchanges. They'll probably have 50 to 100 icons on their desktop. Do you see some way to unite all these disparate trading vehicles?

JM: I think the marketplace will do it. Basically, people want to have the right products, they want to have the right efficiencies, and they want to have the right processes supporting them. They want liquidity and a consistent product—and one that's credit-worthy. There's not enough liquidity, credit-worthiness and consistency in the world for a thousand exchanges.