It was the best of times and it was the worst of times; it was a time of historic exchange consolidation; it was a time of tremendous exchange disintermediation. Oh, but how can both of these times coincide? Well they did on August 18th as two historic exchange transactions on the very same day.
First BATS, the upstart equity ECN out of Kansas City, received exchange status. Second, the CME, the largest global derivatives exchange, and the NYMEX, the energy and precious metals exchange, finally agreed on merger terms.
These landmark events mean very different things for not only their respective industries (equities and derivatives), but their regulators (SEC and CFTC) and the exchange industry as a whole. BATS' exchange status signals an escalation of the equities exchange wars, promoting efficiency through competition. The CME / NYMEX merger is about consolidation and global efficiencies through scale. These are two very different strategies but will they converge or will they continue to run in parallel?
The thought of BATS becoming an exchange should send shivers up the spines of existing equity exchange executives. BATS, the upstart ECN, will now have the same status as the NYSE and NASDAQ. While they will need to play out of the same rulebook as other U.S. Equity Exchanges and come under much harsher SEC regulatory oversight, being an exchange provides BATS with significant benefits.
First, BATS will be able to tap directly into the market data rebate pool. Second, becoming an exchange provides BATS with direct access to the central clearing facilities of the DTCC allowing BATS to reduce their clearing fees. Both of these combined could mean an additional $30 to $40 million a year in revenue/cost reductions. This means a lot to an exchange that continues to be run out of a small office park in Kansas City.
In addition, being an exchange enables BATS to post their quotes directly to the market, bypassing the ECN order delivery process, so their quotes are not traded through. Since BATS operates at low milliseconds/sub-milliseconds, the delay in exchange quote posting, and having the liquidity taker respond via the exchange, can be longer than the life of the quote. Being able to post directly to the tape, and hence reducing the latency of the quoting process will theoretically increase BATS execution rates and market share.
The bottom line—in receiving exchange status BATS will have a greater war chest, and more direct access to threaten the existing players in the currently very local U.S. Equities market.
The CME/NYMEX merger however is on a completely different scale for a very different market. While equities are locally traded by a host of individuals and institutions, futures are global products traded primarily by professionals used by institutions to hedge their underlying exposures to financial, physical, and weather-related shocks.
To overly simplify, the combination of the CME (financial), CBOT (agricultural), and NYMEX (energy and metals), gives the CME Group a global futures franchise that is second to none across all major exchange-traded derivatives sectors.
Combined with its vertical clearing arm, the CME Clearing House, the CME Group is squarely positioning itself to leverage their scale to be the largest, most efficient, and well-respected derivatives exchange. This is a very different strategy from an upstart ECN trying gain a bit of status and market share from its local competitors.
While both of these transactions are very different, in a way they mean the very same thing—the exchange sector is still in flux and the "correct" model is still not apparent.
Will the small and nimble strategy work to provide BATS with the credibility and war chest to challenge the exiting U.S. Equity exchanges or get tied up in SEC red tape?
Will the tightly and vertically integrated CME strategy of being the largest global player in an increasingly global market play out, or will Project Rainbow or ELX the upstart broker-led futures initiatives gain share, or will the CFTC take the unlikely step of forcing the CME to divest its clearing arm?
While it may be the best of times and the worst of times, it is also the most uncertain of times and that is what makes a great story. Just ask Dickens.
