(Bloomberg) — While CME Group Inc. makes most of its money charging the people who use its markets, the worlds biggest futures exchange captures a sliver of sales with a little-known group that trades directly with those customers.
The GFX Corp. unit, which has been disclosed for years in regulatory filings, generated about $9 million in revenue last year, or 0.5 percent of CMEs total, according to spokeswoman Anita Liskey. GFX makes markets on the exchanges electronic trading system to stimulate volume in new or underused futures tied to currencies, interest rates and equity indexes, according to filings.
U.S. regulators have recently increased their scrutiny of programs designed to spur buying and selling at exchanges, such as incentives provided to some firms, though theres no indication theyre looking at GFX. Trading units are unusual for a market owner, whose primary business is hosting places where others buy and sell. CME risks diluting its valuation if GFX grows too large compared to its traditional business, said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York.
The fundamental question is, as you roll out new products, out of necessity will you have to make this thing bigger? said Hintz, who has covered CME since 2007 and wasnt aware of GFX until this month. He said GFX could be considered training wheels for new contracts, but if it gets too big, people will begin to ask, Whats going on, he said.
Liquid Markets
CME Chief Operating Officer Bryan Durkin serves as president of GFX. The business employs 11 traders covering three shifts throughout the day, according to Liskey.
CME Group is committed to providing deep, liquid markets that allow our clients to meet their risk management needs, Liskey said in an e-mailed statement. While it is not material to the company, GFX provides an important service to the users of our markets.
GFX was created in 1997 to facilitate overnight electronic trading in currency futures on the exchanges Globex system. In 2011, CME notified the U.S. Commodity Futures Trading Commission that it was expanding the unit to trade any future, option or over-the-counter contract backed by the companys clearinghouse.
Craig Pirrong, a finance professor at the University of Houston, said its understandable though rare to see an exchange run its own market-making unit. While it may be necessary to boost trading in new or underused contracts, CME may be cannibalizing its own business, he said.
Unusual Arrangement
It is unusual, he said. In some respects, its competing with its customers. Programs to help early trading in contracts also have a way of never going away once the contracts are successful, he said.
They take on a life of their own, Pirrong said.
Futures traders, whether they are employed by an exchange or not, must go through a broker that executes transactions and serves as the gatekeeper to an exchanges clearinghouse. In the case of GFX, its broker was a unit of MF Global Holdings Inc. until 2011, when the firm headed by former Goldman Sachs Group Inc. Co-Chairman Jon Corzine collapsed, resulting in $1.6 billion in missing customer money, including $15 million of CME collateral.
MF Globals failure was the first time a futures brokerages collapse led to the loss of customer funds, which are supposed to be segregated in separate accounts, according to CME Chairman Terrence Duffy. In Senate testimony in 2012, Duffy called the loss of customer money at the brokerage unlawful.
New Brokers
CME, like the other MF Global customers, eventually recovered its money. GFX now uses Newedge USA LLC and Mizuho Securities USA Inc. as its futures brokers, Liskey said.
The chance that CME is on the other side of transactions on its own platform has drawn criticism over the years, said John Lothian, a Chicago-based futures professional who publishes industry newsletters.
In one sense, they are curtailing opportunities for other potential market makers, which probably pisses people off, said Lothian, who for 14 years was president of the electronic trading division at the Price Futures Group. In the other sense, theyre providing liquidity so other people in the markets can participate.
Its a tough balance for CME, according to Lothian. Traders say there are all sorts of conflicts of interest in this situation and CME is impeding their interests, he said.
Exchanges efforts to encourage trading are being examined by regulators. The CFTC is looking into how the U.S. futures markets it oversees reward traders with incentive programs, a person familiar with the matter told Bloomberg News in May. In the stock market, Senator Carl Levin joined critics this year in saying the rebates paid by exchanges to traders should be abolished to improve confidence in the financial system.
Trading Lubrication
Donna Faulk-White, a CFTC spokeswoman, declined to comment on the CME trading unit.
GFX makes sense as a way to keep trading lubricated, according to Rich Repetto, a New York-based analyst for Sandler ONeill & Partners LP whos covered CME since 2005.
This is somewhat in a gray area between the no-risk, purely intermediary model and the need to provide customers liquidity, he said. However, the amount of trading and volume that GFX is engaged with is very small.
Traders at GFX have access to some of the largest asset classes offered by CME. The fees the company charges to trade futures based on interest rates, equity indexes and currencies made up 47 percent of its revenue in the second quarter, CME said last month.
Not Unprecedented
Its not unprecedented for a trading firm and market to share a connection. Bats Global Markets Inc., one of the three big owners of U.S. stock exchanges, was founded by Dave Cummings, who also formed high-frequency trading firm Tradebot Inc. Cummings is chairman and chief executive officer of Tradebot, which owns a 4 percent stake in Bats, according to Bats spokesman Randy Williams.
GFX limits risk in the markets it trades in by hedging its futures trades with offsetting transactions in the spot and forward markets, according to CME filings.
Various types of proprietary trading faced scrutiny after the 2008 financial crisis. The worlds largest banks, brokers and financial companies needed more than $330 billion in government bailouts stemming in part from their principal trading in mortgage bonds and derivatives that went bad. The Volker Rule, part of the U.S. Dodd-Frank Act, restricted bank prop trading in response.
CME isnt covered by the Volker Rule because it doesnt hold federally insured deposits. Yet its ownership of one of the worlds largest derivatives clearinghouses resulted in it being designated as systemically important by U.S. regulators in 2012. As such, it has access to emergency funds from the Federal Reserve in certain circumstances.
While it appears the positions taken by GFX are very limited, its possible you could see some application of the Volker Rule on these types of operation for exchanges, Repetto said. It would depend on whether regulators view this as pure proprietary trading or a hedged trade to provide liquidity.
