CME Europe, What Went Wrong?

Six years
after launching CME Clearing Europe and three years after launching CME Europe,
the Chicago-based exchange group has announced that at it will shut both operations
at
the end of the year
.

So what
went wrong?

On the
exchange side rather than the clearing side, one issue seems to be that, rather
than offering new contracts, CME Europe was replicating FX contacts that it
already offered via its US infrastructure.

One
derivatives industry expert says that launching the same contracts on a new
venue is always a danger because it threatens to split liquidity, adding that
if you already have a successful contract it’s best to avoid doing this.

This is
consistent with comments from a trader in London who, when asked about the
imminent demise of CME Europe, simply responded that they didn’t offer any new
contracts.

Asked what
contracts they would have liked to have seen CME Europe offer, the trader
suggested that “China/Euro Stoxx or a Russian/Bund” would have been more
different to what was already on offer and therefore potentially more attractive.

“If you
already have something, there might not be a need for another version of it
unless you have a much better mousetrap,” was the verdict of the derivatives
expert.

This being
said, the venture was obviously launched following consultation with clients
and potential clients in region, who apparently indicated that they would like
the exchange to have a separate European presence.

Indeed,
there were logical reasons for CME to launch in Europe, and to do so by
offering FX products. Eurex and Liffe between them have traditionally been the
most dominant derivatives exchanges in Europe, but neither of them offered
currency contracts when CME announced its plans to launch in the region.

CME has
built a strong FX franchise in the US and it certainly seemed reasonable that
the demand for these contracts would be replicated in the UK and mainland
Europe, where traders might prefer the trading hours and regulatory regime
offered by a European entity.

The fact
that Eurex also decided to launch FX products in July 2014, three months after
CME Europe went live with its products, suggests there was perceived to be a
clear gap in the market at that time.

The
regulatory angle, in particular, was one reason why market participants
encouraged CME Group to launch a European exchange and clearing house,
according to one source close to the group, who adds that when CME Europe was
conceived and launched, there were many market participants in Europe that were
concerned that the regulatory environment would make trans-Atlantic trading
more challenging and therefore they liked the idea of being able to conduct
their derivatives trading via a European entity.

Likewise,
when CME Clearing Europe went live it was widely believed that regulators in
both the US and Europe were going to issue a mandate requiring NDF products to
be centrally cleared, and regulators in both jurisdictions could not agree on
equivalence rules for clearing houses, and so firms in Europe apparently wanted
a more local clearing option.

Since then,
says the source, the anticipated regulatory challenges associated with
cross-border trading have not been as great as many firms initially feared,
meaning that CME Europe ended up effectively just competing with the more
liquid FX contracts on CME’s Globex platform, a battle that it was never going
to win.

Meanwhile, in
February 2015
it became apparent that any potential mandate for NDF
clearing was being put on hold in Europe, while in
March 2016
regulators in the US and Europe agreed a substituted compliance
framework for central clearing counterparties (CCPs), meaning that firms in
Europe could continue using CCPs in the US to clear their derivatives
transactions.

Profit & Loss understands that FX volumes on the CME’s US
infrastructure have actually increased during European hours since the launch
of CME Europe, with more European customers using the existing contracts, but
that CME Europe and CME Europe Clearing were loss-making entities and hence the
exchange group made the decision to shut both.

What Next for CME in Europe?

The message
from the source close to the exchange is that CME is down, but by no means out,
in Europe. Although the source claims to be disappointed by the decision to
shut CME Europe and CME Clearing Europe, they point out these were probably the
two smallest entities in the CME Group’s portfolio, which includes Comex,
Nymex, the Kansas City Board of Trade and the Chicago Board of Trade.

The source
also stresses that CME has no plans to significantly decrease its presence in
Europe following these closures, adding the Merc currently has approximately
400 staff in Europe and that this announcement will impact a “small
single-digit percentage” of this number.

For
example, London-based Paul Houston was appointed as head of global FX at CME in
April 2016, but Profit & Loss
understands that he will continue in this position and will not be re-located,
despite the closure of CME Europe.

The reason
for this being that, although the European customers have shown a clear preference
for the US infrastructure and liquidity, the US listed derivatives market is
more mature than the European one and subsequently the client growth is
stronger in Europe than the US.

With CME
Europe shutting its doors, eyes should turn to Eurex, which has “re-launched”
its FX derivatives contracts since acquiring 360T in 2015.

When Profit & Loss interviewed Carlo
Koezler, CEO of 360T Group and global head of FX at Deutsche Börse Group in
September 2016, he said that the firm had re-launched these contracts because
they had not been very liquid previously.

The full
interview can be accessed here,
but when Koezler was pressed on why Eurex hadn’t gained any traction on its FX
derivatives contracts the first time round, he responded: “There are a few
reasons. One is simply that there was no FX DNA within the Deutsche Börse
Group. There was no franchise, no existing FX customer base, it was a global
product only trading during German hours and, ultimately, there was an
alternative product available and there wasn’t enough justification for another
similar contract.”

Again, this
last point is clearly the same problem that CME Europe ran into – there was
already an alternative product with liquidity, so what was the incentive for
firms to trade this new contract?

When asked
what he thought would be different this time round with the re-launch, Koezler
claimed that “a lot has changed” since the German exchange group acquired 360T,
pointing to the FX expertise and clients that it gained in the
transaction. 

“Deutsche
Börse now has 220 people within the group that are FX specialists. They now
have a franchise of 2,000 customers that could be potentially interested in the
futures and options,” he said.

Interestingly,
Koezler sees a regulatory environment that is making trading more fragmented
along geopolitical lines, not less.

In the
interview he claimed that “firms are now looking for a European FX futures
contract because regulations have caused liquidity pools in the US and Europe
to separate from each other. European corporates and asset managers
increasingly prefer to trade with a European entity rather than a US one so
that they don’t tap into another regulatory environment”.

Further,
the Deutsche Börse strategy focuses on becoming a venue that can provide all
the different OTC and listed products and services that firms need to execute
FX in one place. To this end, the exchange group is developing and launching
new hybrid products that contain attributes of both OTC and listed products.

“360T/Deutsche
Börse Group are currently in the process of launching different products and
services that will lead to the truly hybrid offering of both OTC and
on-exchange FX trading. As one of those components the upcoming launch of
Rolling Spot Futures on the Eurex exchange will enable 23 hour trading of a
true synthetic OTC FX spot equivalent,” the exchange operator says in a
statement issued to Profit & Loss.

The
statement continues: “There is a completely different dynamic in the market
today, compared to when discussions about a rolling spot product and additional
on-exchange products first started in Europe some years ago. Even though the FX
market is still currently very much “under-Futurised” in comparison to other
asset classes, based on contracting prime broker capacities and higher costs
for bilateral credit as well as the trend towards transparent and “stamped”
execution, the interest in listed FX products is strongly growing.”

But the
experience of CME Europe illustrates the uphill challenges associated with building
liquidity on new derivatives products. That particular exchange group doesn’t
lack FX expertise, it has significant resources at its disposal and it
supposedly had clients in Europe telling it that they would be in favour of a
separate entity for trading in the region.

It’s a
truism that liquidity begets liquidity, and it seems that CME Europe never
quite took off because it couldn’t effectively differentiate its offering from
its other, more liquid one, on Globex.

Similarly,
Deutsche Börse will have to demonstrate to the market how its offering is
different if its FX derivatives products aren’t to go the same way as CME
Europe.

“360T/Deutsche
Börse Group will be the one-stop-shop where clients can take advantage of the
broad choice of FX products and trading styles to help them always get the
trade they need,” according to the statement from the German exchange group.

This is
part of the “FX 2.0” strategy, as
outlined by Koezler
, which focuses on providing market participants with a
one-stop-shop for trading FX, where it can offer pre-trade, execution and
post-trade services across a complete range of OTC and listed products. And it
seems to be that Deutsche Börse plans to differentiate its listed FX offering,
by offering it as part of a much broader suite of FX products and services.

Is this a
better mousetrap? For now, it remains to be seen.

galen@profit-loss.com

Twitter @Galen_Stops

Twitter
@Profit_and_Loss

Colin Lambert

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