Craig Donohue was the CEO of the Chicago Mercantile Exchange during its historic merger with the Chicago Board of Trade. He also oversaw the CME’s purchases of the New York Mercantile Exchange and the COMEX.
Donohue left CME Group in 2012 and has been the chief executive of The Options Clearing Corporation since 2014.
Business Insider caught up with Donohue and discussed markets, high-frequency trading, blockchain, and his new role.
This interview has been edited for clarity and length.
Jonathan Garber: You’ve spent the majority of your career working around trading floors — what have you learned?
Craig Donohue: I certainly saw firsthand what trading is like, what the risks are, and it’s easier to see that in a trading floor environment than you do in an electronic trading environment. I didn’t have a trading background — I had a legal background — but I spent a lot of time … I also had a regulatory role, so I spent a good amount of time on the trading floors, and it was a great way to really kind of learn the business, learn how markets function, and ultimately to learn, you know, how the sort of mechanisms that are put in place to try to ensure orderly trading and fair trading work.
When I got to the Merc it was on the heels of the FBI investigation, on the trading floors, and they were really scrutinizing very heavily the kinds of trading practices — some of which were unique to a trading floor environment but many of which were not. And being in the legal and regulatory area I was able to sort of ramp up pretty quickly and learn about the intersection between letting markets operate freely and at the same time having the kind of controls that are necessary to avoid wrongdoing.
Garber: How do you think the industry changed when the CME went public in 2002?
Donohue: Obviously I have a biased view, but my general view is I think the transition from mutual membership clubs to public companies has been very positive for the industry. I think that the exchanges were always difficult to navigate in terms of change, and it was difficult in the context of a membership organisation, where everybody has such a different interest, to always try to figure out the right way to move forward.
I had been at the exchange for a very long time, well prior to demutualization and the IPO, and what I generally found is that sometimes we could get to the exact right answer and outcome but almost always it was always a suboptimal outcome because it ended up — good ideas ended up being compromised because of the politics and because of the inherent differences in what floor brokers versus floor traders versus clearing member firms versus end-user customers wanted. And I think getting everybody to a different sort of unified shareholder-value orientation was largely very positive.
The worry and the risk was always that, you know, if you took the exchanges and made them public companies, that they would just become these kind of giant monopolies and they wouldn’t be responsive, and I think that hasn’t been true.
I think that there’s been tremendous growth, tremendous consolidation that we could have never had, which has created enormous efficiencies for the industry because having a currency and a public market really facilitated the types of things that we were able to do and that other exchanges have done — in our case the combination with the Board of Trade and then NYMEX, COMEX. And that did create very substantial efficiencies for the entire industry.
And one of the things that I would like to point out was that from a pricing perspective, you know, our average rate per contract for the decade that I was CEO actually decreased substantially, and so the model enabled us to actually grow and make a lot more money, but at the same time the actual cost of trading at the CME on average really reduced significantly over a 10-year period.
Garber: You were the CEO at the CME when you guys bought the Board of Trade, the New York Mercantile Exchange, and the COMEX. Talk a little about what it was like to see those deals through.
Donohue: For me it was certainly a personal and professional highlight. I like to give us credit as a group for being pretty smart and having made a lot of very good decisions. But I also recognise that I think we were also very fortunate and in many respects lucky because, you know, we had been the first to demutualize and do an IPO, and we had experienced tremendous growth and so we had a great currency and we had already made many of the adaptations that the other exchanges were slower to adopt.
I always give Leo [Melamed] credit for really having had the vision to start Globex and keep fighting for Globex for so many years, and it put us in the position to really capitalise on the whole trend toward electronic trading. And again, at least in the United States exchange context, we were really well ahead of everybody — not so much in terms of Europe, but in the US we were. And the combination of the two things — having a lot of growth from product innovation like the e-mini, electronic trading growth, and then a public currency just kind of put us in the catbird seat to be successful.
Garber: What type of impact do think those mergers had on the exchange business around the world?
Donohue: It was sort of destiny that the exchange marketplace was going to consolidate rapidly, whether we were or whether we were not. I think electronic trading enabled something that would not have been possible when the whole business model was resident on the trading floor of the Merc or the trading floor of the Board of Trade or NYMEX or COMEX or LIFFE.
As we were all able to move toward the electronic trading model it just facilitated that consolidation, and the consolidation was — while certainly valuable from a shareholder perspective in terms of capital and operating efficiencies — it was as valuable or more valuable for clearing member firms, in terms of reducing their operational costs and their clearing capital costs, and it was extremely valuable for the end users as well.
So I think it introduced a whole new type of efficiency, and I think it also kind of accelerated the globalization of the market as well, because for the first time you had exchanges — less so from CME’s perspective but certainly other exchanges had a different consolidation strategy, and many of the consolidations were more international in nature, and so the old, arcane differences that used to exist at the different exchanges have become somewhat more homogenized as a result of some of that cross-border activity. So I think it’s had a huge impact, including in the way that regulators even approach regulation of exchange activity.
Garber: You left the CME and you moved over to The Options Clearing Corporation, where you’re now chief executive. Will you explain a little bit about what your company does?
Donohue: Sure. The Options Clearing Corporation is the clearinghouse for the entire US options industry. We operate as an effectively open, horizontal clearing house, and every options exchange in the United States — and there presently are 14 — all clear through The Options Clearing Corporation. Which is very large-scale enterprise, in many ways akin to the scale of CME Group from a clearing perspective. We have 115 global clearing firms — we clear approximately 16 to 17 million options contracts daily. We hold roughly $100 billion in customer margin collateral. And we have a guarantee fund of approximately $8 billion.
So in many respects a lot of what we do is very similar to CME, at least in the clearing context. We’re systemically important to financial market utility, so we’ve been designated by the Financial Stability Oversight Council as systemically important. And I would say the big change in our business since the enactment of Dodd-Frank is the level of regulation and oversight for central counterparty clearing — I mean, we’ve experienced a sea change. It’s a much differently regulated business than before. And we were already quite heavily regulated, but I always like to say we’re regulated today more like you would regulate a large, global bank.
Garber: And what type of impact has government regulation had on your business from a profit standpoint?
Donohue: Well it’s been quite significant. In very broad brushstroke terms I would say operating expenses are somewhere between two and three times what they have been historically, and the capital necessary to provide sufficient default capital and liquidity facilities and guarantee facilities are probably two to three times what they were. So it’s material.
I think the biggest issue that we face as an industry is a couple of things. One is that since Dodd Frank and the enactment of a lot of the rulemakings underneath them, including the Basel III Capital Accord, I mean it’s just become a very, very capital-intensive business, and many of the capital rules that had been implemented initially are ones that absolutely need to be adjusted in certain respects, because it’s made exchange trading central counterparty clearing much more expensive.
And ironically I think in some of the implementation of what has been done, I think they have actually worked at cross-purposes to the initial ambition of Dodd-Frank. If you stay current with some of the recent research and analysis that people are talking about, it’s becoming clear that central counterparty clearing is in some respects now more expensive than bilateral trading between counterparties, and that is absolutely not what was intended by Dodd-Frank, but even the government’s own analysis research is beginning to tell us what we’ve been saying for a while, which is some of the implementation of this is just wrong.
One of the unfortunate things that I think is happening as a result of Dodd-Frank is they were trying to solve too-big-to-fail problems, but, in some sense, I think they have made things even bigger, certainly from the bank perspective.
But one of the other unfortunate things that I think is happening is, you know, when you look back at the financial crisis, the exchange markets that were centrally cleared function very, very well — you know, we did not have gridlock. And people were still trading with each other, there was still abundant liquidity, and in many respects that was happening partly because people had confidence in the post-trade clearance and settlement system, because positions were margined, and you knew what people’s exposures were, and you could look to the clearing house to assure and guarantee performance.
And in contrast, as you’re well aware, you know, the over-the-counter market seized up, because nobody would trade with anybody, and people wouldn’t exchange collateral, and nobody knew who was going to survive and who wasn’t going to survive. And so in recognition of all that, one of the big international policy mandates coming out of the G-20 and then implementing into things like Dodd-Frank in the US and the corollary of Dodd-Frank internationally, was, let’s move more things to central counterparty clearing and let’s go so far as to mandate that highly liquid standardised swaps be centrally cleared because that system works better.
But the sad thing is, as I was just pointing out earlier in the conversation, that we’re now seeing that it’s more expensive to clear through a central counterparty than it may be to maintain a bilateral credit exposure between two financial institutions. And I think that in many respects it’s because they have gone too far.
I’m actually pro-regulation, and I think some of these create scrutiny and regulation of central counterparties is actually good for us, but not to the extent that we’ve basically subverted the policy goals of the international regulatory community and the outcome is sort of upside in the way that I’ve described.
Garber: OK, and it seems as though technology is becoming more and more important in the industry. How is OCC evaluating blockchain technology?
Donohue: Well, we’re paying very close attention to, firstly what other people are doing. We are also doing our own work internally to adopt what we call use cases where we can try to see in discrete parts of our business where distributive ledger principles could potentially be applied, in a way that could be beneficial to either how we operate or how our clearing member firms would benefit.
There’s no doubt in my mind that I think blockchain principles will become much more significant in financial markets and certainly in clearings and settlements.
Any kind of large-scale chain is likely some number of years off, but yeah there’s a lot of potential value and efficiency that can be created. I mean I don’t want to say it’s exactly like the movement from floor-based trading to electronic trading, but I think there is a parallel and I think that many people, if you go back 20 years, were somewhat sceptical that floor-based trading would really give way fully to electronic trading.
And so at least at OCC I try to remind my colleagues that I think there’s very definitely the potential for blockchain to become a meaningful part of what we do. And our job is to be innovative and embrace change and look for ways to be part of that, versus try to find reasons why it can never happen.
Garber: What would some of those benefits of blockchain be?
Donohue: There’s certainly the value of immediacy. You know as you’re probably aware, through blockchain you can have an instantaneous confirmation and finality to a transaction as well as the funding and settlement of a transaction. And depending on which part of the exchange marketplace you’re talking about, you might have a daily settlement or you might have — in the case of the cash equities market currently, T plus 3, hopefully soon becoming T plus 2 — but blockchain principles, if they were successfully applied, could create instantaneous finality and settlement and funding of obligations within immutable records.
And so right now financial markets are very complex and they’re wired together in very, very complex ways with lots of different systems. And blockchain has the potential to create an almost perfect and irrefutable sort of record of every transaction that has ever occurred.
When we’ve had instances, like say for example the Flash Crash — now the futures markets in this regard are much better, by the way, we have an almost instantaneous and perfectly demonstrable audit trail in the futures market, but in the cash equities markets that’s not true. And as you may recall after the Flash Crash, the FCC that it would spend I think 3 1/2 to 4 billion in year one and then likely, you know, 1 1/2 to 2 billion dollars a year each year thereafter trying to build a kind of audit trail that would allow them to actually understand what happens when market disruptions like that happen.
That’s very expensive and very difficult to do given the way that the industry has evolved and how complex that wiring is. Blockchain can solve those kinds of things, or at least let’s say it has the potential to. So those would be some of the examples I would give.
Garber: What about disadvantages?
Donohue: Well I think the primary disadvantage that I see at the moment is striking a balance between innovation and security and the regulatory framework. And, you know, regulations — and we have, obviously, a large panoply of regulations that has built up over many, many, many decades, but they’re all around, effectively, in the current business system and how it operates, so to the extent that blockchain or distributed ledger were to become a significant new way of doing things, regulation would really, really have to adapt.
Regulators want to be able to get the information they need when they need it. I’m not sure it’s a disadvantage — I just think it makes it difficult until we can try to have regulation mirror and capture what’s being done.
It’s really the same thing with electronic trading in some respects. Electronic trading introduced new and different kinds of problems, and regulators are still trying to grapple with those, even though it’s now been several years since we really moved away from floor-based systems, so that does present something of a disadvantage.
I don’t really want to get too much into high-frequency trading, but, you know, I think if you look over the last couple of years, it’s clear that at least many people believe there may be an imbalance between how well we regulate and how well we understand high-frequency trading, automated trading. There’s I think no doubt that electronic trading has been very positive for the marketplace, but there will be some who disagree with that and say, “Well I’m not so sure, because I’m not sure we know how to regulate it.” So I think the same thing could be true of blockchain, at least until the regulatory framework adapts.
Garber: Do you think that high-frequency trading presents any risks?
Donohue: It’s impossible to say that they don’t present any. You know I think that they’re certainly not the villains that they have been portrayed to be, and they are obviously a really critical ingredient into the successful functioning of our financial markets today. I mean all you have to do is look at the percentages of high-frequency trading in cash equities or listed options or futures and options markets, and you can easily see that, you know, they’re a very significant and important part of how our markets function.
But like anything there will always be areas where, you know, problems can arise, and there will always be areas where regulation will have to adapt. I think we’re going through that process right now. But the whole focus on “these are bad because they’re fast” I think is silly, and the idea that some people in financial markets will have advantages over other people in financial markets is silly too.
You know, you’ve spent time on the trading floors and you know that people who are taller might have had an advantage over people who were shorter, and people who had a certain spot in the pit might have had an advantage over somebody who had a less-good spot. And so that’s just always going to be true: No matter the nature of the market structure or the market model you can’t create anything that’s perfectly even.
And so you have to strive for overall fairness and overall market integrity, and I think the electronic market, in many respects — and people forget, when people are critical of high-frequency trading — you can’t have that conversation in a vacuum. You have to have that conversation relative to other alternatives, and I mean certainly many people felt that the trading floors themselves lent themselves to gross inefficiencies, significant risks of errors, and also trade practice abuses that were unique to the trading floors.
And so that was not a perfect system either in the same way that electronic trading and high-frequency trading is not a perfect system either. We just have to evolve to things that work on balance very well, and where we find things that don’t work well we have to fix them and we have to address them.
Garber: Do you think there’s any market that’s not suited for electronic trading?
Donohue: That’s becoming less and less the case, but I mean, certainly it seems to me that markets that are very illiquid or markets where either the products or the trading dynamics are very, very complex, they don’t lend themselves particularly well to electronic trading.
I’ve been away from it for a few years, but at least during my time I think we certainly saw that electronic trading in our more complicated options markets were I think significantly more difficult to achieve than in the futures markets, where you just had fewer instruments, concentrated liquidity in, but, you know, like in the listed US equity markets, for example, it’s a somewhat different picture, because you have so many different options theories, and it’s a more complicated market.
So I think the answer is yes — I think there are some areas where it doesn’t necessarily have as compelling of a value proposition as it might in a deeply liquid, highly concentrated market.
Garber: Do you think that we’ll ever see the floor trader again?
Donohue: I’m not exactly sure. There’s still some residual floor trading in pockets, and again we do see that in the options markets and options on futures, but, you know, I don’t think it’s ever going to be the force that it was. I just think technology has taken us beyond that.
Garber: And last question: What’s something we’ve lost with the demise of the trading floor?
Donohue: One of the things that I think — I don’t know if it’s lost or it’s just harder to find, but I think that when you have a coalescence of people in a physical environment, like we did on the trading floor, we had — it had more of a feeling of community, and I don’t mean that just in terms of camaraderie, although there was certainly that, but I think it was a community that was physically proximate, and so you lived and worked among all those people all day long, and I think when there were problems in markets or when there was a need to address customer needs or evolve and change or innovate, I think it was easier to collaborate, partner, and communicate with people in the so-called trading community to come up with solutions.
And I think now everybody’s off in the ether, you know, and it’s much harder to bring people together in a way where there’s that sort of closeness, if you will, where people can talk about things, fight about things, debate things, and come to the conclusion and then more forward. So I’m not sure how to — it’s like a diffusion effect, and I think that does hurt us. I think it makes it harder for us to know where to come out on a lot of these market structure kinds of questions, so that centralised community benefits from the trading floor community I think is lost, and that’s a shame.