The Chicago Mercantile Exchange, or “CME”, is a U.S. financial exchange. It was founded in 1898 and for generations was the home for aggressive floor traders dealing with commodities futures (as made famous in the movie Trading Places: https://www.youtube.com/watch?v=RLySXTIBS3c).
Today, the open outcry trading floors at the CME account for a trivial proportion of traded volume. Humans and trading pits have given way to electronic trading in which software programs can be used to place orders for financial products through a financial intermediary’s network.
Financial exchanges are a prototypical example of utilizing network effects to create a sustainable advantage: more buyers and sellers (i.e. more users trying to transact at the exchange) means more liquidity. More liquidity means lower spreads and a higher likelihood of transacting (i.e. lower cost to users). The feedback loop is incredibly strong as user’s choice of exchange is largely determined by pricing and volume. CME has benefited tremendously from operating in a winner take all market. Once the company achieves slightly higher volume than its peers, the benefits to buyers and sellers becomes apparent and network effects kick in.
But not all financial exchanges are created equal. The famed New York Stock Exchange has seen substantial deterioration in its equity trading margins and market share over the last couple of decades. This is largely because equities are fungible across platforms. If you bought a share of company X on the NYSE, you could sell the same security on Archipelago. This allows users to multihome. The rise of electronic trading, high frequency trading, and large pools of available capital have allowed for competing platforms to gain share.
CME has largely avoided this problem because it operates a closed network. Because futures exchanges provide users with clearing services (thereby reducing counterparty risk), contracts that are opened on one exchange are also settled on the same exchange. This eliminates the opportunity for market participants to multihome for a specific type of futures contract. The result is that CME’s margins for futures trading are materially higher than margins for equities trading and largely benefits from a winner take all market structure.
Not all is lost for new entrants, though. Potential strategies for CME competitors could include:
- innovating with new products. The futures market is highly fragmented at the product level. Creating liquid markets for new types of contracts can lead to a first mover advantage.
- competitively price products to attract more volume. Exchanges can provide pricing incentives to customers who prioritize or trade across many products on their platforms. This means that they can subsidize one liquidity pool (in the form of lower spreads) to attract volume for other products on their platform
- compete on quality. Exchanges spend significant capital on improving their infrastructure and ease of trading for users. CME was early to capitalize on the transition to electronic trading and was able to benefit tremendously. Further step change innovations will open the door for new entrants
- push the industry to transition to an open network. Many market participants and regulators believe that spreads would decrease and users would benefit from a move to more open fungible futures market. creating innovative platforms that create synthetic fungibility across exchanges or pushing regulators to adopt openness standards could weaken the network effects that CME enjoys