The Jury in the CME-Floor Trader Suit Finds That a Deal Is a Deal–Just Like on the Floor

A jury in a class action lawsuit filed by a group of Class B shareholders (ex-floor traders) found in favor of defendant CME Group. The suit claimed that the CME had breached its contract with the would-be Killer Bs, most notably by opening the Aurora Data Center (“ADC”) and providing access to it to non-Class B shareholders. As the Court (Judge Patrick J. Sherlock) summarized it, according to the plaintiffs

the [ADC] is a trading floor within the meaning of the [Class B Shareholder’s] Core Right 2–hence, only members are eligible to exercise trading righs and privileges at the ADC. The CME Class contends that the defendants breached their Core Rights by (a) allowing non-members to trade CME products from the ADCO trading floor, (b) requiring Clas Be members to pay co-location fees from the ADC, and (c collected co-location fees from market participants without sharing them pursuant to the revenue sharing plan with members

The CME Class also contends that defendants breached their contractual rights by allowing non-members to trade at member rates, providing discounts and special rates to large customers that are better than rates available to members, and charging co-location fees to CME Class members by eliminating the benefits of the CME fee schedule.

I can’t say that the verdict was a surprise, mainly because anything can happen in a trial, especially one with a jury. Which is precisely why such large cases never make it to trial.

Although I did not hear all the testimony based on the original complaint and the record in the case (notably rulings on the motion to dismiss and summary judgment) I think that the verdict is correct. There is a yawning gap between specific facts alleged in the complaint and far broader inferences drawn therefrom.

The complaint relies heavily on quotes from Leo Melamed’s book, For Crying Out Loud: this makes for good atmospherics, but it hardly qualifies as a contractual commitment. It also contains a few facts relating to the Core Rights established under the CME demutualization plan. It then draws inferences from these that are, in my opinion, far too broad and unsupported.

It is clear that the Core Rights were focused primarily on protecting the CME floor. This was essential to get the member’s support for demutualization. Section Three of the article related to Class B Shareholders in the revised Certificate of Incorporation that formalized the demutalization is labeled, in all caps, COMMITMENT TO MAINTAIN FLOOR TRADING. It lays out various volume metrics which if met, precluded the exchange from terminating floor trading in a contract.

The CME rules at the time also provided members (who became Class Bs) “GLOBEX Screen Rights” (emphasis added for a reason that will become clear shortly), and guaranteed Class B shareholders would have access to the GLOBEX2 trading system and definted eligibility requirements for access to a GLOBEX terminal. The complaint also quotes Melamed committing that Class B shareholder clearing fees would never be higher than the clearing fees charged others.

And here’s where the yawning inferential gap appears. From these facts, the plaintiffs claim that in demutualizing the CME gave the Class B shareholders the “Right to Best Access and Closest Proximity to the Globex Platform, and to Allow the Class B Plaintiffs to Share in Globex-Related Revenues.” Not from the facts in the complaint, it didn’t.

Granting Class B shareholders the right to trade on Globex did not, when evaluated on the face of it, give them exclusive access. Nor did it give them “best access and closest proximity” under all future technological improvements to Globex. It gave them access. Via terminals (screens).

The plaintiffs attempted to argue that ackshually post-ADC, Globex was the floor, and since they had exclusive access rights to the floor (and nobody else did), they had a right to Globex on the best possible and exclusive terms under all technological conditions. They claim, based on a quote from Melamed, that since “ultimately electronic trade would become the real ‘price-discovery pit'” therefore Globex was a “virtual trading floor.” Since they had exclusive rights to the meatware trading floor, they had rights to the virtual trading floor. QED!

Nice try, but no cigar. The fulsome description of the commitments that the CME made to maintain the floor makes it abundantly clear that, within the four corners of the contract that the plaintiffs claim the CME breached, the floor was, well, the floor. Those cavernous spaces on South Wacker, not a large air conditioned building filled with humming servers.

The contract did not provide exclusive access to the locus of price discovery, whatever that turned out to be, floor, Globex, or mental telepathy. By the understanding of everybody at the time, the floor was the place where guys traded futures contracts and futures options by screaming and making funny hand gestures.

In sum, taking the allegations in the complaint as true, the CME promised to provide access to Globex to the Class B members. It did provide access to Globex, and continued to do so. It did not promise to provide “best and most proximate access” to any trading platform the CME introduced up to the end of time. That’s an assertion made by the plaintiffs that is not supported by actual evidence.

After a major technological revolution, the CME provided a new type of access–co-location, with higher fees for shorter cables. In my view, the plaintiffs made a completely unsupported, an extremely large, logical leap to assert that the access rights granted with demutualization necessarily conferred preferential access rights to the new technology.

And technological change is the crucial issue here. What this all comes down to is a failure of imagination by all concerned–including Leo Melamed. Specifically, a failure to imagine the emergence of HFT, and algorithmic trading generally. Trading that was not only not face-to-face, but was untouched by human hands via keyboard, mouse, or touch screen.

At the time of demutualiztion, computerized trading was screen trading–and it was often referred to as such. Indeed, even by the standards of screen trading as it became, 1999-era computerized trading was cumbersome. Not until TT screens were introduced (along with copycat products) in the early-2000s did screen trading become user friendly and fast. But in the minds of virtually everyone in the industry at the time, “computerized trading” meant “a human inputting orders to a computerized limit order book via a screen/terminall/keyboard/mouse.”

I was an early and pretty lonely predictor that computerized trading would eventually displace the floor, yet I did not foresee how computerized trading would evolve. My predictions were mocked when made in the mid-1990s: when I released a study (done under the auspices of Deutsche Terminborse, later Eurex) finding that liquidity on computerized and floor markets was approximately equal, the late Robin Wigglesworth, then Chairman of LIFFE, ridiculed me on the pages of the Financial Times as an ivory tower academic who had no clue about the real world. I restrained myself from gloating (publicly, anyways) when Eurex nearly killed LIFFE in 1998, and LIFFE shut its floor and went electronic.

So it’s fair to say that I was more foresighted about computers v. floor than most, and especially most actually in the industry, when I predicted the eventual triumph of electronic trading. But my foresight was far from perfect, as I did not foresee how electronic trading itself would evolve.

In other words, a lot of history was packed into the 12 years between demutualization and the opening of the ADC. The CME responded to the technological change by introducing a new form of access that was tailored to market participants who had virtually (no pun intended!) nothing in common with the Class B shareholders. The new system catered to those who specialized in virtual markets.

If the CME had not done so, it would have breached its duties to the Class A shareholders and perhaps doomed the exchange to oblivion.

The mismatch between the human capital of the Class Bs and the heaviest users of the ADC is massive. The Class Bs did not have the skills or knowledge necesssary to produce value by trading on Globex via co-lo.

Here’s what likely would have happened if the CME had provided access on the basis the Class Bs claim they were promised. Since they could not exploit the nature of the ADC themselves–most couldn’t even make the leap to screen trading–they would have arbed by selling or leasing their access rights to those who could. Or the CME would have bought out Class B shares. And what a negotiation that would have been, given the vast difference between the value of co-location to the typical Class B and its value to the Virtus and Jumps of the world (and hence to the CME). That and the personalities of the Class Bs–personalities suited to the no-holds-barred bargaining on the floor.

In the event, CME concluded that it did not owe the Class Bs anything more than providing some access to Globex (basically on the terms shaped by 1999-2000 technology) and keeping the floor open unless and until the computers killed it. As they eventually, and arguably inevitably, did.

Class B shares did plunge post-ADC. But that’s because the real value of the Class B shares was driven by the exclusive right to access the floor, not by rights to access CME trading platforms by all means imagined or unimagined. ADC at most accelerated the demise of the floor, and recognition of that dynamic cratered the value of floor trading rights, which foreshadowed the closure of the floors (for futures and many options) a few years later.

History did not work out well for the Class Bs. Like 18th-19th century weavers, they were overwhelmed by technological change that they did not anticipate, and which was not anticipated by those who displaced them. They bargained for a demutualization deal predicated on their beliefs about computerized trading technology–as did the CME. The technology changed in ways that few if any even dreamed of. This made their deal far, far less favorable than they had anticipated. In 1999-2000 they hit their drive–right into a sand trap they didn’t see.

So they wanted a mulligan, and the lawsuit was their way of demanding one. But a jury found that they got what they were promised, and a mulligan was not among the promises.

Watch the movie Floored and you can have some sympathy for this particular group of individuals who like many before were rendered obsolete for technological change. The potential for such sympathy is why I thought a jury might find for them, despite their weak legal case. But the jury instead apparently went with the principle that a deal is a deal, even if the deal doesn’t work out they way you like.

Which, ironically–was the way the floor operated.