The CME FCM: Likely Much Ado About Nothing

There is a bit of a kerfuffle in futures world about the CME winning approval from the Natinoal Futures Association (NFA) to operate its own brokerage firm (futures commission merchant “FCM”). The industry is pretty unified in its opposition to this “vertical integration” by the CME that will put it into competition with some of its customers.

(Once upon a time I worked on the 15th floor of the tower on the left).

I think this will turn out to be much ado about nothing. Yes, CME has the right to open an FCM, but whether it will, or how big it will be if it does, is very much open to doubt.

Recall that the CME launched this initiative in response to FTX’s adoption of this model. (The fact that the CME obtained approval almost exactly 2 years after FTX went kaput tells you a lot about the speed at which regulators work). FTX is no more, and no other exchange, crypto or otherwise, has adopted the model. So there’s no perceived competitive threat from an integrated exchange, which reduces (and perhaps eliminates) the CME’s need to bring the FCM to life. It likely pursued the application after FTX’s demise as a precautionary measure.

If that’s right, the FCM will remain on the shelf.

And I think it will because it’s hard to make a business case for it. Let’s consider the various economic rationales for such integration.

One commonly asserted one is to leverage monopoly power. Commonly asserted, and wrong. The one monopoly rent theorem implies that except under very special (and usually quite contrived) circumstances, a monopolist (which CME arguable is in most of its products, and in clearing) can extract all the rents from its market power by pricing its own product, and cannot increase profit be obtaining market power upstream or downstream.

Regulated monopolists have sometimes integrated to circumvent rate regulation. For example, ATT owned its equipment supplier Western Electric. ATT operated under rate of return regulation, but could circumvent that by purchasing equipment from its subsidiary at inflated prices.

That doesn’t apply to CME. It is a regulated monopolist but not subject to rate of return regulation.

Integration can also be a way of circumventing price controls. That’s also not an issue here.

Vertical integration can mitigate transactions costs when there are bilateral monopolies (at least after the “fundamental transformation” that occurs when the upstream and downstream firms make relationship specific investments). The FCM sector is pretty fragmented and competitive, and does not fit this “scorpions in.a bottle” template.

Another reason for vertical integration is double marginalization. This occurs when both the upstream and downstream firms have some market power. Each charges a price above marginal cost, and in general the all in price exceeds the joint profit maximizing price.

Again, the FCM sector, though more concentrated than it was historically, is still highly competitive. It’s not impossible that FCM prices (commissions and data charges) exceed marginal cost, but not by much.

But it is not outside the realm of possibility that CME believes that the more concentrated FCM industry could use a little price competition. An exec at Interactive Brokers apparently thinks so: “If they’re going to undercut our pricing and offer cheaper market data then that will be a problem.” (It’s quite interesting that market data is mentioned. That’s a big deal in the modern electronic world).

Pro tip: “we don’t like the fact that they may compete with us on price” is not a public spirited rationale for opposing a competitor’s or potential competitor’s action.

I consider this to be the most likely reason for CME to activate an FCM and operate it seriously. And that would not be a bad thing. Although the impact on the ultimate customer is likely to be modest because lower FCM prices would permit CME to jack up its price. But the combined CME+FCM price would be lower if there is indeed double marginalization going on. That would benefit the ultimate customer.

Another reason for integration would be for the CME to secure better information on the costs of supply and the demand for FCM services. This could help it optimize its pricing.

The one potential real concern about CME’s move is that it is a self-regulatory organization that polices FCMs, and that it might favor its own or try to raise its rivals’ costs through exercise of its oversight facilities. But note that the NFA, which granted approval, regulates FCMs (under CFTC auspices).

In sum, absent competition from a new integrated FTX copycat, I don’t see a compelling business case for the CME to turn on the lights to its newly approved FCM, or at least to operate one at a scale that would compete seriously with the bank-owned big boys. (Funny how that form of integration gets little comment or scrutiny, eh?). The reason that it might–to stimulate price competition in the FCM space and mitigate double marginalization–would benefit customers, though perhaps not by much. The self-dealing issue is ameliorated considerably by the fact that the NFA regulates FCMs. (Indeed, political economy considerations, namely pressure from other NFA members, might make the NFA be harder on the CME).

So all in all, nothing to get hot and bothered about.