Closing Up Shop Due To High Fees

Yesterday, legendary market maker Blair Hull announced publicly he was hanging it up.  Hull was a tremendous trader. One of the originals at the CBOE.  If you watch this documentary on the Crash of 1987, they give the credit for stopping the fall in the market directly to Hull.  He walked into the Maxi pit at the CBOT and started buying.  I remember that day well.

I make the distinction that he was a market maker.  A lot of people call themselves “traders” when in fact they are merely brokers.  Market makers take risk and actually make a two sided buy or sell market.  There is a huge chasm between them and “traders” or “brokers”.  Most people in the markets are brokers.

I didn’t know Blair personally.  I was a CME guy and it was rare for guys from exchange to exchange to mix back in the day.  We were hyper competitive.  Today, that’s not the case.

I think it’s important to think about why he is closing.  It’s the ongoing costs to run a firm, and the trading fees charged by exchanges for data.

Taking a step back, when we envisioned computerized trading back in the mid-1990’s, we envisioned it using the constructs of the pit/open outcry environment that had been used for time eternal.  Shame on us for not seeing it.  After all, we had people on trading floors spending money on lifts for their shoes to be taller and buying flashy colored trading jackets to be noticed.  We all knew that the top step was more valuable than the next step down.  That was the “co-location” in its day.

Today, small and mid-size firms cannot compete with the scale of the big firms.  Big firms can spread out the data costs among a larger base of traders, and contracts.  They are much more efficient at deploying capital.  Smaller firms cannot afford to match them on speed so they have figured out different ways to compete.

One way to compete is find a niche and trade it.  However, there are no real secrets in trading.  Once someone starts making money some where, other firms will sniff it out.  Electronic trading allows firms to go after smaller niches than they would have before so finding niches takes time.  When you tell that to a trader, it means they are likely to lose money before it’s good.  This is sort of like the VC that doesn’t invest in small markets.  The risk/reward isn’t there for smaller and mid-size traders.

On the broader policy side, the federal government has a regulatory moat against starting new clearinghouses and exchanges.  Conservatively, it would be a startup cost of $100MM to get a new futures clearinghouse going. Once you made it over the regulatory hurdles, there is no guarantee that there would be anything for your firm to clear.  Today there are four places to clear futures contracts; CME, ICE, MGEX, and the OCC.  On the SEC side, clearing is a commodity and not a strategic advantage.

On the exchange side, it can take years to get through the hoops to become a designated contract market or anything else.  The legal fees can eat up all the capital, not to mention all the capital you have to put up in escrow just to prove financial viability.

Of course, there are permutations between the SEC side and the CFTC side of the business, but the overriding sentiment is that there are enough regulatory and capital investment hurdles that it’s very hard to get a new competitor off the ground.

Because of this, existing incumbents can charge higher fees than they might charge given a very competitive environment.  Fees are a huge revenue driver.  When I was on the CME board’s budget committee, I was surprised at the number.  It’s a lot larger today.  We were really sensitive to fee revenue, but we always increased it at the margin because we knew the elasticity of demand was pretty benign.  We could almost charge whatever we wanted because firms had to have data if they wanted to be in business.  That’s true more today than it was back in the day because of the nature of electronic trading.

Those of us that were open outcry traders were put out of business by co-location and the premium put on speed artificially created by exchanges because they found something new they could charge for that wasn’t based on volume.  Smaller and midsize electronic traders are feeling the same pinch because of fixed costs that are essential and cannot be avoided.  In many ways, this mimics other industries where big huge businesses can scale costs across a large organization and smaller players are stuck with it.

If we want this to change, I believe there have to be changes at the government policy level.  Change the anti-competitive and highly regulatory policies, and you will see more competition.  Of course, that isn’t without its own risk and rewards.  I do think we need to move sooner rather than later.  Having lots of market participants from all over that can compete is better for a market than having just a few competitors.