Chicago Mercantile Exchange Holdings Inc.
Chicago Mercantile Exchange Holdings Inc.
Founded: 1898 as The Chicago Butter and Egg Board
Sales: $732.5 million (2004)
Stock Exchanges: New York
Ticker Symbol: CME
NAIC: 523210 Securities and Commodity Exchanges
Chicago Mercantile Exchange Holdings Inc. is the parent company of Chicago Mercantile Exchange Inc. (CME), which specializes in the trading of futures (contracts to buy or sell something on a specified future date) and options on futures. At its core, the CME, also known as "the Merc," plays an important role in global risk management. It is involved in four major product areas: commodities, the CME's original focus; foreign exchange; interest rates; and stock indexes. The CME is famous for its hectic trading floors where "price discovery" is pursued by traders practicing the open outcry system, shouting out prices and quantities and also using hand signals to make themselves understood over the din. The system has been abused in the past, resulting in a major Federal Bureau of Investigation (FBI) sting operation in the late 1980s, but traditionalists cling to open outcry nonetheless. In recent years, however, the method has been undercut by the rise of electronic trading, including CME's Globex round-the-clock electronic trading system. Many traders now trade electronically as well as in the pits. The CME is a public company listed on the New York Stock Exchange.
The Merc: An Outgrowth of Chicago's 19th-Century Rise to Power
The opening of the Erie Canal in 1825 not only transformed New York City into the United States' commercial and financial capital, it gave rise to the country's "Second City." Chicago, advantageously located on the shores of Lake Michigan and, later, a major railroad hub, became the bridge between the farm products of the Midwest and New York and the other major cities of the East Coast. In the mid-1800s Chicago emerged as the country's largest market for corn, wheat, lumber, and meat. It was through the grain market that the futures market became a key factor in the city's financial system. Because transporting grain from the farm to the city was dicey, with rain in the summer and snow in the winter often making country roads impassable, Chicago sometimes found itself bereft of grain or glutted with it. The result could be economic chaos. If there was no grain, livestock could not be fed, resulting in meat shortages and people going hungry. If there was an overabundance of grain on the market, prices would plummet, farmers could not buy equipment, manufacturers faced bankruptcy, and workers were laid off. Forward contracting was a way to instill some certainty into the market to level off the peaks and valleys that could have such a devastating effect on the economy. Chicago's grain traders began using forward contracting in the early 1830s. In 1848 the Chicago Board of Trade was formed, providing a place, an exchange, where buyers and sellers could negotiate prices on the future delivery of grain, as well as a forum where business issues could be resolved.
Far less prominent than grain, livestock, or lumber, the butter and egg business also found its center in Chicago in the 1800s. This sector was served by the Chicago Produce Exchange, founded in 1874, but the butter-and-egg dealers grew dissatisfied with the exchange and the way it allowed its secretary to determine prices by querying merchants in a haphazard way. In 1895 they formed the Produce Exchange Butter and Egg Board as part of the Chicago Produce Exchange, its only purpose being to provide a better way to determine butter and egg prices. But in the next couple of years the exchange suffered from a civil war, as the butter merchants battled with their hated rivals, the margarine men or oleo faction. The butter merchants tried to use the exchange to influence state legislators to limit the sale of margarine in Illinois. The oleo producers thwarted them, and so in February 1898 the butter-and-egg men walked out, forming their own organization: The Chicago Butter and Egg Board, destined to one day become the Merc.
Launching the Merc in 1919
The board was part trade association, part marketing. Initially its members were not overly enamored with the concept of egg futures, instead preferring the cash market. In 1915 the trading of futures contracts was banned for a brief period, then limited for the next year before the progressives prevailed and time contracts were restored. Government restrictions due to the United States' entry into World War I soon resulted in the suspension of time contracts in butter and eggs, however, and normal trading was not resumed until 1919. It was also in 1919 that some egg dealers banded together to look deeper into the idea of futures trading. They then convinced the Butter and Egg Board to amend its rules book to include organized futures trading and permit a new organization under the rubric of the board to engage in futures trading. Because the members expected to deal in commodities other than just butter and eggs, the unit took the name of the Chicago Mercantile Exchange. In October 1919 the Chicago Butter and Egg Board went out of existence, and the next day the Chicago Mercantile Exchange (CME) was launched, although it would not be until December that it actually began trading in butter-and-egg futures, when three contracts were traded in less than an hour. At the end of the first week, only eight contracts were negotiated.
In the beginning CME relied on a chalkboard method, with offerings on one board, bids on another, and the final transactions listed on the sales board. Traders worked off of the posted information to negotiate the deals, with the market sometimes closing in a matter of minutes after its 10 a.m. opening. The blackboard method was far from satisfactory but it was the standard for an entire generation, not replaced until 1945 when the trading pit was introduced. In addition to eggs and butter, by now the CME was trading in potatoes and onions and, occasionally, involved in frozen eggs and cheese. It even tried a contract in animal hides as a trial.
The CME struggled to survive the war years 1941 to 1945, barely able to pay its mortgage, as a planned wartime economy handcuffed the country's futures exchanges. In eggs, for instance, there was no trading in futures in 1942 and 1943, and only minor business during 1944 and 1945 due to an imposed price ceiling. The exchange's leadership took the time to plan for the postwar period, installing new leadership that would seek to add new commodities to the trading mix. Shortly after World War II ended in 1945, the CME added a turkey contract. In 1949 it began trading in apples and dressed poultry. But just as it appeared to be gaining momentum the CME took some backward steps in the 1950s. Price supports ended futures trading in butter, then in 1958, after pressure was brought to bear on Congress by disgruntled onion growers, the practice of futures trading in onions was banned. Onions were the CME's second most heavily traded futures contract. Its loss meant that the Merc was essentially a one-commodity exchange, trading in eggs.
As the CME entered the 1960s, its prospects appeared bleak, especially since the exchange's attempts over the years to trade in other products, including apples, potatoes, turkey, hides, cheese, and even scrap iron, had never met with a great deal of success. The potato business was meager and the egg business was no longer a seasonal business conducive to futures trading, the result of modern technology that offered a consistent supply of eggs year-round. The CME was on the verge of closing its doors, but discontent among the membership led to some changes and the exchange introducing three successful new contracts between 1960 and 1966. In 1961 the exchange added a frozen pork belly (used to make bacon) futures contract, a major innovation since it was the first futures contract related to frozen, stored meats. Few of the members knew what a pork belly was, and fewer investors, so that it was not until 1965 that the business took off, resulting in a significant rise in the price of a CME membership, from $3,000 in 1964 to $8,500 a year later. (In 1968 the price climbed to $38,000.) Another important contract also had been launched in 1964, a live cattle futures contract, notable because it was the first futures contract related to a nonstorable commodity.
Broker's Club Taking Charge in 1968
A group of CME's younger traders, who had forced the Board of Governors to take action in the beginning of the 1960s, were still not satisfied with the direction the Merc was taking. The group, known as the Broker's Club, launched a revolt in 1967 to force the board to be more responsive to the desires of membership. A showdown between the old guard and the dissident traders resulted in the latter winning the day, and in January 1968 a new chairman was installed and the CME entered a new era, governed by new bylaws. The dissidents also would spearhead the move into the financial markets that would transform the old Chicago Butter and Egg Board into a global exchange.
Since 1919, when it evolved into the Chicago Mercantile Exchange, the Merc has traded futures on over 50 products, from frozen pork bellies and live cattle to Eurodollar and index futures.
Always on the lookout for an opportunity, the CME found one in foreign currency in the early 1970s. It engaged the services of economist Milton Friedman, who wrote a paper on the possibility of doing business on foreign currency futures. Not only was there money to be made on money, he argued, the ongoing growth of foreign trade actually required a futures market in which currencies could be hedged and risk managed. Thus in 1972 the CME introduced the first financial futures market, involved in futures contracts on seven foreign currencies. The exchange's International Monetary Market would soon add gold, other precious metals, and Treasury Bills to the mix of financial instruments in which it dealt.
As a result, the CME was poised for a period of explosive growth in the 1980s. In 1981 it introduced CME Eurodollar futures, a highly successful market. A year later the CME S&P 500 Index futures contract was first offered, and it too attracted a great deal of interest. The 1980s was a period of innovation for the exchange on other fronts as well. The CME began developing an electronic trading system to operate when the trading floors in Chicago were closed, mostly to benefit the Japanese. According to Euromoney, "When originally announced in September 1987 this system was hard to take seriously. Even its name, Post-Market Trading, or PMT, was a joke: the initials PMT are more frequently used in the English speaking world to signify Pre-Menstrual Tension." The idea of electronic trading also met with opposition from old school Merc members who were worried that the venerable outcry system of trading would be imperiled. The new high-tech system would take years to develop, however. In the meantime, the CME had to contend with a scandal that not only called into question the outcry system but sullied the reputation of the institution.
In January 1989 federal agents surprised 40 CME and Chicago Board of Trade traders with subpoenas, the culmination of an undercover sting operation conducted by the FBI to determine if traders had defrauded customers. Four agents, wired with tape recorders, had infiltrated the Merc's trading pit, befriended traders, and recorded them both there and at places where they socialized. As Time explained, "Federal law requires that traders and brokers must try to get the best possible price for their customers when executing trades. But because the deals are conducted orally, illegal trades are difficult to catch." A "typical shady deal," according to Time, was the "'bucket trade,' in which a broker slices an extra profit margin by buying a contract from a confederate at a bit more than the going price in the pit, or selling one for a bit less. For example, if a customer asks the broker to sell a soybean contract of 5,000 bushels and the market price is $7.50 per bushel, the crooked broker may sell the contract to a colleague for $7.40. That gives the colleague a discount of 10 cents per bushel, or $500, some of which he kicks back to his partner. The customer probably cannot challenge the price because there is no record of precisely when the deal occurred." Scores of traders and brokers would be indicted, and over the next two years the vast majority would plead guilty and the rest go to jury trial.
The CME spent much of the 1990s trying to rectify the damage caused by the FBI sting. Reforms were introduced, as was Globex, the CME's renamed electronic after-hours trading system, which made its debut in 1992. A virtually round-the-clock electronic trading system, Globex2, was introduced in 1998. Another innovation from this period was the CME E-mini S&P 500 contracts, electronically traded products that were much smaller than the standard S&P 500 Index futures, the first product of its kind to trade during regular trading hours on a U.S. exchange. It also opened the way for other E-Mini products, such as the E-mini S&P 500 futures and the E-mini NASDAQ-100 futures contracts.
As the 1990s came to a close, the CME unveiled a new strategic plan. It introduced more electronic order routing to the trading floor and approved side-by-side electronic and open outcry trading of Eurodollar contracts, a bid in large part to fend off the challenge of foreign exchanges that were dropping actual trading floors for cheap, electronic ones. The Merc also decided to become the first U.S. financial exchange to demutualize in order to become a public company, raise money, and invest in the kind of electronic infrastructure that would be a key to the exchange's future growth.
In 2000 membership shares in the CME were converted into shares of stock, which could be bought and sold apart from trading privileges. A year later a parent company was formed, Chicago Mercantile Exchange Holdings Inc. The stock of this holding company was then offered in an initial public offering in December 2002, raising $191 million for the CME and other selling stockholders. The stock then gained a listing on the New York Stock Exchange, as the CME became the first publicly traded exchange in the United States.
The Merc was on the verge of a new era in the early 2000s. Although many of its members were loath to give up the open outcry system, it was clear that the exchange was moving toward a totally electronic system over the next few years. Such a move, according to Institutional Investor, "likely would make for cheaper, more efficient trading for the exchange's 6,000 customers, speed new product development and allow the CME to market more aggressively across borders for new customers, leading to volume gains and bigger profits." When, if ever, open outcry would be eliminated was far from certain, because in the end customer preference ruled the day, and many of the customers still found a great deal of value in the old system, especially when it came to complex deals. The Merc was also in the market to grow in other ways. In the words of Crain's Chicago Business in 2004, "Flush with cash, Chicago Mercantile Exchange Holdings Inc. will consider acquisitions, joint ventures and other partnerships in a consolidating futures industry." Given its history of a willingness to adopt to changing times and an eagerness to seize opportunities when they presented themselves, there was every reason to expect the Merc to find a way to prosper for many years to come.
- The Chicago Butter and Egg Board is formed.
- The Chicago Butter and Egg Board is dissolved; the Chicago Mercantile Exchange (CME) begins operations.
- The trading pit is introduced.
- The trading of pork belly futures is introduced.
- The world's first financial futures are traded.
- FBI sting results in the indictment of CME traders.
- The Globex electronic trading system is introduced.
- The CME is demutualized.
- The CME is taken public, listed on the New York Stock Exchange.
Chicago Mercantile Exchange Inc.; GFX Corporation.
CBOT Holding, Inc.; Deutsche Börse AG; LIFFE (Holdings) PLC.
Abbott, Susan, and Giner Szala, "How FBI's Sting Has Changed Pit Life," Futures, June 1991, p. 46.
Gorman, Christine, "Crackdown on the Chicago Boys," Time, January 30, 1989, p. 52.
Lewis, Janet, "Up from the Pits," Institutional Investor, December 2004, p. 78.
McWhirter, William, "A Bid to Salvage a Go-Go Legacy," Time, February 6, 1989, p. 52.
Osborn, Neil, "Running Scared in Windy City," Euromoney, February 1989, p. 38.
Strahler, Steven R., "Cash to Spare, Merc Intends to Spend," Crain's Chicago Business, April 26, 2004, p. 26.
Tamarkin, Bob, The Merc: The Emergence of a Global Financial Powerhouse, New York: Harper Business, 1993.