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Don't Be Afraid of Market Competition
by: Russ Wasendorf, Sr.
SFO Feature Interview: Futures Industry advocate John Damgard talks about challenges of an ever-evolving U.S. futures industry with plenty of competition.
John Damgard, president of the Futures Industry Association, has been around the block a few times, and the block keeps ending inside the Beltway. With nearly 20 years under his belt as top dog and association advocate for the futures industry, he’s watched the industry evolve from agrarian beginnings to a major force on the world’s financial landscape. What used to be a pretty tight “fraternity” now has mushroomed impressively in terms of not only geographic reach but also number and types of market participants. With growth, however, come challenges, and he has sat squarely in the middle of some major controversies revolving around the futures industry during his career – user fees, international competition, market jurisdiction, electronic vs. pit-traded efficiencies and, most recently, workings between the SEC and CFTC to enable trading in single stock futures.
When we originally began this story, we had no idea how interesting Damgard’s background really was. In fact, we had no intention of going back to his roots. But, to understand John Damgard and how he thinks as relates to the industry, we found it interesting to dig into those roots and to see how active politics have flavored his vision. It’s a fascinating story and explains why he has been able to effect the accomplishments he has.
RW – John, thank you for carving out some time from your busy schedule to be interviewed by SFO magazine. How did a nice Midwest guy like you end up in a place like Washington, D.C.?
JD – I grew up in a small Illinois town. My parents felt that a proper education included more than just being a big fish in a little pond, and so I was sent to Deerfield Academy, a boarding school in Massachusetts, and, after graduating, I went to the University of Virginia. After college, I ended up getting married and bringing my bride back to Illinois.
I became interested in politics in Illinois. The Republican candidates were running statewide in those days. I volunteered in both the Richard Ogilvy for Governor and Chuck Percy for Senator campaigns. I got a lot of credit for my work for Percy and Ogilvy, and one day the phone rang and it was John Ehrlichman. Ehrlichman said Richard Nixon was going to need some help in the Midwest primaries, specifically Wisconsin and Indiana. He asked “How would you like to be part of the team for the next President of the United States?” I’d never met Nixon, but I was in my mid-20s and was enormously flattered. I devoted a fair amount of free time and energy to those primaries. I ended up in Miami in the ’68 Convention where I became one of the first front-line advance guys.
After Nixon won the nomination, we all went to advance-man school in New York and then fanned out over the country and took assignments every six or eight days in a new location.
Because I was from near Chicago, I was assigned to be the advance man for Nixon’s first stop in Chicago. You may remember the Democratic National Convention that year because of all the trouble on the streets and the criticism of Chicago’s finest. So right after the Democrats left, Black Jack Riley and Richard Daley were very anxious to improve the image of Chicago. Richard Nixon arrived to a ticker-tape parade, and we had the full cooperation of City Hall. Nixon came out of Chicago with a 33-point lead which, over the next two months, diminished to the point where he only beat Humphrey by a whisker. My own view is that if the campaign had gone on another three or four days, Humphrey would have won.
RW – Is this when you moved to Washington?
JD – No, not right away. After the election, my interest was really on elective politics, so even though Haldeman and Ehrlichman put a high priority on the kind of can-do attitude of most of the advance guys, I turned down every job offer and went back home.
But I found myself doing so many of these political advances after that, that when I got a call in 1970 to come to Washington full-time to be the tour director on the campaign airplane in 1970, I said “okay.” I got to be very, very close to Agnew. He was a good guy. Even after he resigned in disgrace, he’d come back to town and be my houseguest.
After Agnew went down in flames I went to the Department of Agriculture under Secretary of Agriculture Earl Butz.
RW – I was fortunate to work with Secretary Butz on a tour in Europe. He was an impressive guy and his free market approach to U.S. agriculture was broadly applauded among Midwest farmers.
JD – Farmers loved him and, of course, those were the days when we were getting rid of the surpluses and trying to turn agriculture into a market-oriented business. Secretary of Agriculture is a tough job. You have consumers saying, “We want to buy cheap bread.” And you have farmers saying, “These are our soybeans; they don’t belong to the State Department, don’t use them as a bargaining chip.” There were huge fights with the State Department in those days about market-oriented agriculture. The farmers loved the fact that Butz was so feisty.
At Ag, I worked with all the domestic programs, the marketing programs and the regulatory program. One of the regulatory agencies was the old CEA [Commodity Exchange Authority].
RW – The predecessor of the CFTC (Commodity Futures Trading Commission).
JD – Right. This was at a time when there was a scandal brewing in California. People were still blaming gyrations in the market on Billy Sol Estes, who was borrowing money on empty grain bins. The public felt that government ought to have more power and greater oversight over the entire market, not just watching over the rule making of the SROs (Self Regulatory Organizations) — the futures exchanges.
The creation of the CFTC was under way when I got there, but I became the Administration’s point man for the creation of the CFTC and advocated that there should be exclusive federal jurisdiction over the regulation of futures. Double regulation, state and federal, doesn’t make good sense to me. Exclusive federal jurisdiction is probably the single best thing that’s ever happened to futures markets.
RW – Let’s talk a little about the transaction fee. It’s part of George W. Bush’s budget this year.
JD – Every President’s budget has, at one time or another, included a futures transaction fee, going back to the concept of user fees.
RW – Are you able to get Congress to understand what little sense a user fee makes for the futures industry?
JD – Yes. Thanks to clear thinkers like Iowa’s Jim Nussel, who chairs the Budget Committee.
RW – Congressman Nussel is from my District in Iowa. Many of us in Iowa are very happy with him.
JD – He’s a good man. He understands that adding additional cost to the transaction simply makes the market less efficient. I claim the phrase “tax us on the money that we earn — not on how we earn the money.” If the federal budget is unbalanced, they ought to go out and adjust whatever they need to adjust. But don’t go after the mechanism; it’ll only make our markets less efficient and more costly than markets elsewhere, and we’re already fighting that battle.
There are very, very fine futures markets all over the world. And those markets do not have this tax.
RW – Yes, and those “fine futures markets” are very competitive with the U.S. markets. Do you get the sense that the U.S. exchanges are falling “behind the curve” and are becoming less competitive?
JD – I‘ve been critical of the speed with which U.S. markets have moved toward electronic trading. I know that’s very controversial in Chicago, but as long as customers have to bear the cost of maintaining side-by-side trading when one is, frankly, more efficient and cheaper, they run the risk of allowing an all-electronic marketplace somewhere else in the world to introduce the same products. With new products in particular, the advantage of electronic trading is important.
RW – In the interview with Jack Sandner, in last month’s SFO, he and I talked about the U.S. actually exporting its innovation in futures due to our slowness in approving new markets and regulations.
JD – The Chicago exchanges used to be light years ahead of everyone else. Yet Eurex, which is just 12 years old, is now the largest futures exchange in the world. Prior to the emergence of Eurex and others, if you wanted to do risk management, you had to come to the United States. There weren’t any barriers in those countries that prevented people from accessing U.S. markets. Now turnabout should be fair play. U.S. clients ought to have the opportunity to access trading markets outside of the United States. If, in fact, we continue to believe in the free market system — if we believe that if somebody makes a better widget in a global business such as futures, that widget ought to be available to every potential customer. What kind of television do you think Jack Sandner watches? Does he watch one made in the United States? I think we can’t any longer look at our business as strictly U.S. Besides, competition is healthy!
That’s one of the reasons we worked so hard on the legislation— to make sure the exchanges could compete fairly against other exchanges around the world in terms of not having additional regulatory costs. But U.S. exchanges run the risk of waiting too long to match the efficiency of those other exchanges. I testified before the CFTC not long ago about how expensive it is to trade a stock index futures contract in the United States versus what it costs to trade a similar stock index—and I used the Euro Stoxx 50 stock index on the Eurex as an example. It costs 27 cents per contract for a customer to trade Euro Stoxx 50 compared to $1.14 to trade the e-mini S&P 500 and over $2.00 for the pit-traded S&P 500. That’s significant.
RW – What’s the rationale for prohibiting U.S. traders from trading the LIFFE universal futures contracts, London’s version of single stock futures?
JD – U.S. customers ought to be able to trade any market anywhere as long as the difference in the “safety net” is properly disclosed and there is a sharing of information between markets and regulators when “look alike” contracts are offered. My view is that disclosure is the name of the game. I think that the CFTC is on top of that issue. We have gone through quite a process with the securities industry in terms of getting rules ready for single stock futures, and I think they have listened and tried to make fair and rational decisions about the U.S. trading rules. The next step is to open the door for the foreign markets.
I think it’s been educational for a lot of people in our industry to work as closely as we have with the securities industry on security futures. The clearing model in securities is very attractive. The clearing houses gain their strength and operate the way they do because of a mutual collateralization of risk provided by the deep pockets of the clearing members. And, as a consequence, the securities clearing house governance structure recognizes the important role of the clearing member firms. They have elected to run clearing as a utility. I believe a clearing house that is captive of an exchange and using the capital of the clearing member firms to give it its financial strength is an unsatisfactory model to the member firms.
RW – What do you think is the best model for a futures clearing house?
JD – I think the BOTCC [Board of Trade Clearing Corporation] model is a good model—an independent clearing house with a board comprised of members who have their money on the line. The CME has a fine clearing house, but is not the right model. There’s the temptation, particularly when you’re going for profit, to bundle the fees so that it is difficult to distinguish clearing and execution costs. Why run the clearing house as a profit for everybody instead of the clearing member firms who put their capital at risk? After all, what does a local trader have to do with the clearing process? He comes to work everyday, he uses the market, he goes home even, and he provides liquidity for the transactions. That person shouldn’t benefit from profits derived from the clearing process.
We came very close to building a kind of an irrevocable partnership with the exchanges some time ago. Common clearing in Chicago would have forced the clearing members and exchanges into a partnership that would have lasted forever.
But, no matter which way you slice it, the fact that all market participants are forced to put money up in a number of different clearing houses in order to use the products at different exchanges adds to the inefficiency of the futures business.
RW – Well, if common clearing is an important efficiency issue, isn’t fungibility also an important issue, especially in dealing with single stock futures?
JD – Yes, and I think it’s a fair question to ask. We have seen a lot of new entries in the marketplace since we have passed the legislation of lowering the barrier to become an exchange. But not one of the new exchanges has entered into competition with established exchanges on existing products. All of the new exchanges are there to compete for the new marketplace—single stock futures. Why hasn’t the Chicago Board of Trade introduced the Eurodollar? Why hasn’t the CME introduced a competitive product to the CBOT’s ten-year note?
RW – Why do you think?
JD – I think it has a lot to with the uniqueness of the product, and they are not sure they can win the business. But I do think Tom Donovan’s (past president of the CBOT) idea of competition was, “have we traded more volume this month than the Merc?” I believe you’ll only have competition when somebody introduces your product line and you have to compete on a head-to-head basis. The FCMs (futures commission merchants, futures brokers) understand competition. They compete by offering the very same service to the very same customers on the very same products. There are a lot fewer FCMs today than when I started in this business. The business is probably about 20 times larger today than it was when I started this job, but we have one-half the number of firms.
RW – As you say, the volume has increased 20-fold, and there are less than 200 firms. The business mix also has changed dramatically. Years ago, futures trading meant soybeans, corn, cattle and an occasional cotton trade. The business was a few individual speculators, a small group of floor traders and small and large hedgers. Today, much of the trading volume is coming from institutional investors trading financial markets, and single stock futures will be thrown into the mix soon. How do you think they will fare?
JD – I believe that single stock futures will be an enormous success. I think the timing of their introduction would have been better in the days of the bull market. Today there are some enormously attractive values on Wall Street, but people aren’t quite sure if they should invest. They have lost a lot of money during the last couple years. The fact that single stock futures will be there for people who want to protect themselves by shorting a single stock will enable investors to invest with greater confidence.
RW – Let me give you some interesting tidbits about single stock futures we discovered recently. As you know, we have been able to trade simulated single stock futures since June of last year. We have more than a year of simulated trading history already. In May, we conducted a trading contest, trading only simulated single stock futures, and they were given $50,000 in “play money” to invest. During the month of May these contest participants traded, on a simulated basis, nearly as much volume as the LIFFE exchange. There is a lot potential in single stock futures if volume like that can be created with a small universe of traders.
JD – That’s a lot of volume, but naysayers will argue that it wasn’t real money.
RW – Well, that’s true, but it was real traders making real trading decisions based on real market price movements. It is, unfortunately, the only single stock futures game in town — the only opportunity traders have to test their skills in these new markets.
JD – But back to SSFs, I agree with you. I think it’s a huge market. Most firms have not recognized how large the single stock futures market is going to be. My view is that single stock futures, options and cash transactions are going to bring liquidity to each other, and this will be very, very good for equities. And, the fact that the CFTC and the SEC have tried as hard as they did to come up with rules without taking sides. It’s been an incredible challenge, and I have great respect for Harvey Pitt and Jim Newsome for the job that they’ve done. It’s remarkable and we owe them both our gratitude.
RW – Why has it taken so long? You can easily develop the opinion that the regulators are not doing their job.
JD – Well, you’ll recall that the industry actually supported the agencies in their request for more time. Originally the law said they had a year to do it—a year that included some pretty dramatic changes in those agencies. Getting new teams in place obviously delayed the process and everybody knew it would. Nobody predicted September 11. Nobody predicted Enron. Nobody predicted all of the other things that the SEC has had to cope with. Nobody predicted the market slide. Obviously, everyone that has a stake in this new market would have liked the process to move more quickly. I think that the industry needed time, and so did the government, so I’m not sure that the timing hasn’t been appropriate.
RW – How much longer do you think it will take to write the rules for single stock futures?
JD – I think on October 1, we’re going to see these products trading. Maybe September 1, but my guess is October 1. I had a long talk with Bill Rainer [CEO, OneChicago] yesterday, and he thinks September 1. I said, “Bill I think that’s a little ambitious.” Because it does take the SEC longer to get their rules into the Federal Register. But, I think we’re very close.
RW – Does it look like the margin rules are going to be 20 or 25 percent?
JD – Twenty percent right down the line. That was sorted out a long time ago. It’s the other technicalities that will take all the time.
RW – What are some of the technicalities?
JD – Fungibility — you mentioned that earlier. In the options business, the regulator forced multiple listings and, in the beginning, the CBOE (Chicago Board Options Exchange) was the beneficiary of that. But now, there’s competition and that’s healthy. The regional exchanges as well as the International Securities Exchange are doing a heck of a job on the other options exchanges’ market share. One would argue that it’s because the other exchanges continue to cling to the mechanical transaction on the floor versus cheaper electronic order matching.
There may be markets where it’s terribly important to have a pit for the purpose of providing liquidity, but it’s my observation that in some of these highly liquid exchange-traded derivatives markets, some of these pit traders have gone “upstairs” and provide the liquidity just as easily as in the pit. The screen plays no favorites. The pit trader’s competitive advantage over the public goes away in a pure electronic environment. The real question is, does that harm the liquidity to the point where the market becomes less efficient and the bid/ask spreads widen?
RW – I don’t think that has been the case in recent history. A market like the S&P 500 is just as popular and liquid as a screen-traded market. But U.S. exchanges have a huge investment in bricks and mortar. They appear to be keeping the open outcry pits alive with artificial respiration.
JD – The last remaining argument the open outcry guys seem to cling to is … “We’ll give the customers the choice. ” They say, “Traders can either trade A/C/E or trade on the floor. Look what’s going on. More business is going to the floor.” Well, yeah, if you shut down the electronic trading system during daylight hours, your pricing favors the open outcry pit. You’re not really creating a fair contest.
RW – What it appears to come down to is that screen-traded markets are a buyer’s market, and pit-traded markets are a seller’s market. In a pit-traded situation the public customer either plays by the rules given to him by the floor or they don’t have access. Every active trader has been exposed to fast market conditions, when the floor suddenly claims that orders are “not held” or pit brokers are not accepting stops or limit orders. The rules in a seller’s market exist to benefit the seller; the seller is actually the trading facility, the “trading engine.” Screen-traded markets put the power in the hands of the public traders instead of the trading facility. Until customers had access to an electronic engine, they never understood the disadvantage they were exposed to.
JD – They didn’t used to understand it.
RW – Now, they understand it.
JD – Now, they understand it.
RW – Screen-traded markets can also provide true real-time quotes. For the first time, quotes are coming to traders electronically, and they’re seeing the quote at the same time as everyone else in the world. If you have watched a pit-traded market, you’ve seen the price quote displayed 15-20 seconds after the transaction in the pit, even longer in some instances. Exchanges are charging public customers for real-time quotes that aren’t real time. I suppose if I had the rules of the trading facility bent in my favor, and I had the advantage of seeing “real” real-time quotes, and I could see order flow that the public cannot see, I would be slow to embrace change, too.
JD – Imagine if the people on the board at Boeing were all in the propeller manufacturing business and the CEO says, “We’re going to design a new airplane called the 707, and we’re going to use jet engines, and we’d like a vote of the board.” And every guy on the board is making propellers and they’re thinking, “It may be good for our company, but it ain’t good for me, so I think I’m going to vote against the jet airplane.” That’s what is going on at the exchanges. People who have a stake in preserving the old way of trading have dominated their governance.
From my bully pulpit, I continue to urge the Chicago exchanges not to be afraid of that competition. They can do a better job.
RW – Let’s jump to a different issue. A few years ago, Jack Sandner introduced a concept he called the “Super Regulator” to the FIA and last month I interviewed Jack on this concept for SFO magazine. We have revived the Super Regulator Congress recently as everyone is talking about regulatory reform. What do you think the possibility of such a dramatic reformation of regulations flying in Washington?
JD – Not good.
RW – Not good, why?
JD – The possibilities are not good for a number of reasons. The main reason is that futures deserve a different kind of regulation than securities. It has become woefully apparent during single stock futures rule negotiations between the CFTC and the SEC. In reform efforts to build the so-called level playing field, we might actually be burdening futures products with inefficiencies and make them uncompetitive against the same markets overseas.
RW – The competitive environment appears to be heating up for futures but not so much for the security exchanges.
JD – The U.S. securities markets don’t need to worry so much about competition from foreign markets. The New York Stock Exchange is the Big Kahuna. If you want to trade 100 shares of Sears, you go to the New York Stock Exchange. The U.S. is essentially the only place you can make the trade. The securities markets are more insulated from international competition than futures markets. The nature of the products we trade makes us more vulnerable.
If somebody wants to trade oil at a London or Singapore exchange, the New York Mercantile Exchange has to be cognizant of the competitive threat, plus there’s a huge OTC (over-the-counter) market.
RW – My firm has a popular electronic platform called Best Direct, and we are seeing a spectacular shift of business from pit-traded to trading online. We also see online traders becoming electronic locals, replacing the pit-trading locals. They are providing a service similar to what traditional locals provide by scalping the market, [scalping is to take very short-term positions in the market, a strategy of taking many small gains during a trading session]. Personally, I’ve tried throwing huge volume at the e-mini market just to see how bad the fill will get and invariably orders are filled within a narrow bid/ask spread. It’s absolutely amazing.
JD – And that’s a huge testimonial to the potential success of the single stock futures business.
RW – Another thing that we’ve seen is a recent jump in e-mini volume—not a small jump but a 50-percent increase—while the stock market is having a pretty ugly time of it. Literally on the first day of June, volume among retail traders began growing, and it has remained at these higher levels ever since. There’s been an attitudinal change among these investors. They’re back and they’re back in a very major way.
JD – But they may be back on the short side?
RW – They appear to be trading both sides of the market. I think stock index futures were a major contributor to the 20-year bull market in the stocks.
JD – Absolutely, and I think that every economist would have to agree with that. Even the ones that at the beginning said, “Oh no, they’re just gambling devices!”
RW – The success of stock index futures and their importance in the economy has surprised everyone including the SEC.
JD – Interesting that the SEC had no interest at all in futures regulation during the creation of the CFTC. The SEC said, “you take care of your product, and we’ll take care of ours.” It wasn’t until the beginning of equity trading that the SEC said, “Wait a minute, that’s our jurisdiction.” The CFTC promptly pointed out, “We have exclusive jurisdiction.” Then came the Johnson-Shad Accord.
As regulations are negotiated, I always have been concerned about that fact that the futures industry is much smaller than the securities industry. I feared that decisions would always be made on behalf of the securities industry when there was disagreement.
RW – Is that what’s going on now as the CFTC and the SEC try to hammer out a compromise for security futures?
JD – I think because of Harvey Pitt we are doing an exceptional job of getting very reasonable regulations. Harvey Pitt is the most qualified chairman of the SEC in my memory.
RW – You have expressed how impressed you are with Harvey Pitt. What is your impression of James Newsome (chairman of the CFTC)?
JD – Fabulous job! He is the free market, pro-competition guy who worked closely with Bill Rainer—and we all thought that Rainer did a good job. The FIA endorsed Jim as chairman because the agency really needed continuity and someone over there that had been through all the discussion on the CFMA and single stock futures. Jim has done a spectacular job.
RW – Let’s change topics for a minute. There is a so-called Wagner Patent Suit raising eyebrows in Chicago. As I understand it, owners of the Wagner Patent claim that they own exclusive rights to electronic futures order-matching and are suing the CME and others.
JD – I think there are two schools of thought. One school of thought is that the patent should never have been granted. It was granted for the wrong reasons, and it’s way too broad. The other school of thought is that there has been no infringement on the patent. Perhaps a third school of thought is, “Where were the Chicago exchanges when they were offered the deal to buy the patent?” My own view is that the FIA probably ought to join with the exchanges or at least provide an amicus brief to the court in Texas. We adhere to the theory that the patent ought not be granted in the first place.
RW – Certainly a loss in this case would be very damaging to the current evolution toward electronic trading.
JD – I worry that this plays right into the hands of those on the Chicago exchanges, the locals who want to use this as yet another argument to inhibit the advancement of electronic trading.
RW – John, I think that you and I agree that there are a number of challenges ahead for the futures industry, and some important decisions down the line will have a bearing on the continued health and growth of the U.S. portion of that business. I hope we will both be around to see it make the giant strides we think are possible. It’s been fascinating speaking with you. On behalf of SFO magazine and the entire futures industry, I’d like to thank you.