I have been called today by several reporters about membership procedures and processes at $CME. The trader that was fingered for the Flash Crash was a B-3 Member. I don’t own a membership today, and I don’t own stock in CME. I have owned each class of membership at one time or another.
I want to compare, contrast, and make a suggestion. First assumption is that there is no good or bad here, it is just what is. Open outcry markets are different animals than electronic markets.
I Co-Chaired the Membership Committee from 1999-2001. I also Co-Chaired Arbitration, Pit Supervision, and was on the Budget and Strategic Planning Committee of CME. That’s what board members did in those days-we ran the exchange. We were paid by the membership to do it, $35,000 a year plus parking. Board members today do less, and make four times the money or more.
The process was this in a nutshell:
- Buy or Lease a membership
- Appear before the Membership committee
- Be indemnified by your clearing firm
- Get fingerprinted at the National Futures Association and have a background check run
As long as you were approved by the committee, and there were no skeletons in your closet that the NFA turned up you were good to go. It was extremely rare that anyone got black balled by the committee, but it happened. I chaired a committee proceeding where a member had been previously kicked out. The committee decided to let him back in, but we debated it.
People could be blackballed because they were a known bad character. Maybe another member knew them from a different business-so they would speak up. It was important to the membership where the code was “My word is my bond” that stand up guys became members. Being a member was like being accepted into an exclusive club. When I appeared before the Membership committee in May of 1988 I was sweating like a whore in church. I was nervous.
The membership process today is different. I believe the current process is appropriate for the way CME operates today. I think it would be beneficial to the market if more participants leased seats and were equity members. Here is how today’s process works.
- Buy or Lease a membership
- Get approved by the Membership department
- Be indemnified by your clearing firm.
- If you want to go on the floor, get fingerprinted and approved by the NFA
In the old days, there was intense peer pressure put on members by other members to toe the line. Sure, shenanigans happened. But, it was out in the open and there were several disciplinary committees that oversaw the action. Your peers were the people that wrote up the fines. Your peers were who you appeared before when you went before an Arbitration committee. You had an economic incentive basically behave.
As we know from things like high school, Twitter and Facebook, peer pressure can be extremely powerful. Members had a vested interest in protecting the integrity of their markets, and the integrity of the membership. Today, that’s changed. I wouldn’t want to see it go back to the old way because the old way would be far to cumbersome to administer. Membership is international now, and it should be.
At the same time, if an organization like the CFTC steps in and starts writing regulatory edicts on who and who can’t become a member at an exchange it would be detrimental to the marketplace. I also don’t want them to start writing edicts on order types and other practices that should be taken care of by the self regulatory power of the independent exchanges. I don’t see how CME could be more diligent. In an electronic marketplace, if you have the dough you should be able to play. Very different than a human marketplace.
The question becomes, how do you bring the “peer pressure” aspect to the marketplace and who can do it?
The only answer I have is to put it to the electronic trading community. They have an economic incentive to be the policemen of the market and enforce best practices. Only they have the expertise to see when it happens. They also don’t want their own orders picked off. There needs to be a system in place where when they see it happen, they can report it to an exchange and an exchange has the authority to level a penalty without everything winding up in court.
I don’t think this can be handled through the NFA, or inside exchanges. They just don’t have the level of sophistication and intelligence that the electronic trading firms have. It would take them far too long to get up to speed.
One solution is to make a bid or offer stick longer in the book. But, that creates other problems and while it stops spoofing, who knows what else might be different? Without doing a lot of due diligence and thought, it’s hard to know if that is the best solution. But, in things like this you start with gut feel.
Leo Melamed cleaned up the open outcry markets back in the day. The marketplace flourished. Markets were better and they performed their function so hedgers could transfer risk, and speculators could earn a living off of it. Much of that basic function is broken across several marketplaces today. Instead of human members looking out for and policing markets, we are left with big banks, hedge funds, algo and HFT traders. They don’t have an incentive to think about the broader market because they aren’t on the hook for it. Some of them are more concerned with lobbying government ($GS, $MS, $BAK) to create an edge rather than finding one in the marketplace.
I think that it’s much better for electronic traders to begin setting standards for themselves, and enforcing those standards before someone else that is unsophisticated does it for them. All the regulators and exchanges will do is increase the paperwork, increase the cost of doing business and block innovation in the name of preserving a marketplace. The real reason they are doing it is to cover themselves and protect from lawsuits.
On another note, maybe if the CFTC didn’t have such an arduous expensive process (minimum $350k in legal fees and 18 months) to set up a new regulated exchange, we’d have more competition. Competition has a way of allocating assets and resources so that the best marketplaces win.