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Shawn Baldwin from CMG at the CME in Chicago on CDS’s

Shawn Baldwin from CMG (Chicago) in 2009 for the Critical Capital Management Series

Shawn Baldwin from CMG at the CME in Chicago on CDS’s

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The Chicago Mercantile Exchange (CME) is the world’s largest futures exchange with 9.5 million contracts in commodities traded in a single day. The CME was the first publicly traded (CMG participated in that IPO transaction!) financial exchange in the world focusing on futures contracts and options on futures contracts. The CME provides both a marketplace, and the back end financial infrastructure for administrating and settling financial instruments. The highly acquisitive organization bought its long time LaSalle Street rival the Chicago Board of Trade (CBOT) and also acquired the New York Metals Exchange (NYMEX) leveraging its publicly traded structure and currency of shares. The resulting consolidation of these entities made it the most powerful commodities exchange on the planet.

 

The CME essentially has a monopoly in the U.S. futures trading. The spectrum of commodities traded there range from Treasury bonds and interest rates to the $900 high hitting gold, (silver, platinum and copper trade there as well) along with the highly liquid S+P 500 (Spoos), pork bellies and Foreign Exchange (ForEx).

 

Today CME announced their focus on the over-the-counter market (OTC) derivatives. The move is seen as a conciliatory effort for collaboration to Wall Street and the banks with the CME as a central counter-party for clearing for OTC trades. Unfortunately, the CME reported a 30% drop in the first quarter earnings of $199.1 million, down $3 a share from $283.5 million or $5.25 a share last year on 33% less volume in contracts. The strongest source of income has been the interest rate contracts which have been systematically reduced in importance as index futures have increased. The interest rate contracts represent roughly 45% of the average daily volume which was down from 60 %.

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I have a particular fondness for the CME because it has been an integral part of my career at (3) three critical times I reflected on this when I decided to come to the CME early this morning as I walked into the old members club. I was flooded with memories from the early days of my career as a senior vice president for an investment research house that provided research to sophisticated global commodities sales and trading desks.

 

In the early 90’s, I ran the US and UK business for Foreign Exchange, Treasuries and Interest rates along with volatility and options business. I convinced the CME to partner with our firm for a joint marketing effort (we supplied over 70% of the research to their traders) and they allowed us to link to their site.  This was a very big deal at the time because back then, they allowed absolutely zero third party connections. This was a huge deal for me because it was my first transaction with global ramifications and it allowed me to travel to London to do the same with the London International Financial Futures Exchange (LIFFE) where many U.S. units were setting up operations there to run effective trading strategies. The world has changed dramatically since then.

 

Whether you are in Chicago, London or Madrid for that matter, your physical location will not give you any advantage in the new nanosecond trading environment.  There also have now been many third party connections — we did have the distinction of being first and I am particularly proud of that moment.

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In the early part of 2000’s, the CME came under the stewardship of the trading legend from CRT, Jim McNulty—the architect and engineer of the CME’s IPO and Jim could never receive enough credit for his work. The majority of observers did not believe that a CME IPO would be possible, due to the history of the somewhat heavy- handed members who enjoyed love/hate relationships with each other that was bounded by avaricious eyeing of Profit and Loss statements for trading accounts. Jim and his CFO Dave Gomache allowed my investment bank to participate in the IPO in 2002 and the several follow on offerings. These deals were very prestigious, coveted offerings and CMG was honored to be in the transactions, especially since the IPO was our third as a new firm. I am eternally grateful to both Jim and Dave for the opportunity. Thanks guys, I will never forget it.

  

In December of 2004, the current CEO Craig Donohue met with me for breakfast and agreed to allow me to host one of CMG’s Economic Conferences at the exchange. The conference held in January of 2005 was keynoted by the President of CalPERS, the largest plan sponsor in the United States and helped to institutionalize our firm. I am indebted to Mr. Donohue for that.

 

After that somewhat lengthy reminiscing, I will press for the reason for my arrival today. Information. The CME has created a clearance mechanism for Credit Default Spreads (CDS) instruments–which makes it integral for the market place in terms of clearing for the instrument which has defined the 2nd best call of my career– the collapse of the US stock market on September 30th which I called on September 18th. The CDS instrument was used as an instrument to create almost limitless, risk less leverage as amplification for short positions.

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Before we begin dissecting the mechanism, you might ask yourself why were they created and what exactly is the function of a Credit Default Swap (CDS)? These instruments were designed to transfer the credit exposure (read risk) of fixed income products between parties. The mechanics are that a CDS is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults. 

1)      The buyer of a credit swap receives credit protection

2)      The seller of the swap guarantees the credit worthiness of the product.

 By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap. The buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, if the bond defaults in its coupon payments.    

The Securities and Exchange Commission (SEC) granted approval for the Chicago Mercantile Exchange to operate as a clearinghouse for CDS transactions which are traded over- the- counter (OTC) in a private market anonymously.The CDS clearing will work in functionality like the OTC market operates or what is affectionately called the Pink Sheets. The pink sheets list the bid and ask of more than 6000 stocks in an electronic trading platform. Firms open up accounts with a clearing firm that has a line of credit—this insures transparency of who bought what, which is very important. Credit default swaps are traded in a much similar fashion.

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The market makers have typically been banks who have extensive inventory of CDS instruments. JP Morgan Chase example has an inventory to $87.7 trillion dollars of swaps. Each market maker will now need to open an account with the CME entity and establish a line of credit with them. This was not the case prior to, which resulted in less back office clarity.

The CME clearing entity will do all back office work of accounting and clearing trades along with generating the confirmations daily.So in essence, what the CME will do is keep track of who’s who and provide transparency, which means that there will be a record of all the trades. The clearinghouse at the CME, also monitors the accounts of all the players to be sure that they maintain enough money in the account to cover their trades at all times. If there is a chance of default, the CME clearinghouse will immediately determine if the parties have the money to cover all losses. This is critically important.

I believe that some one toppled a number of stoic institutions in something that I will refer to as an analogue of the creation of a black hole–in the process of a sun going supernova the mass greatly accelerates and then dramatically contracts and all mass is condensed creating a black hole from which nothing can escape. This is what happened on September 30th 2008.

The Supernova market was turned into a Black Hole that no one could escape. It is my belief that this was done intentionally by some people who became unbelievably wealthy by being on the correct side of the trade that they influenced and accelerated with the CDS instruments. I will detail this trade at another time.You can now understand why knowledge of this mechanism is highly important.

Only time will tell if the transparency aids in reducing risk. Please connect to the following links to get a greater understanding of the migration and clearing mechanisms for the CDS instruments in this market. This knowledge will be highly critical if you are going to participate in trading this enormous market. It will continue to be a huge factor and whether you trade it or not, you would be wise to know how it is functioning as was evidenced by the 4th quarter 2008 crash.

I will report Monday from Beverly Hills at the Milken Global Conference at which I am speaking and share with you the perspectives of the top investment minds and billionaires attending. I will even take pictures so that you feel that you are there too! Bon Soir!  

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About the author

Shawn D. Baldwin is Chairman of the AIA Group (AIA), an alternative investment and advisory firm based in Chicago.

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