The OneChicago Exchange was created in response to a change in the law. Now the exchange sits in the middle of the SEC and CFTC and has had to fight to respond to regulatory changes. While there are plenty of headaches to be had as Dodd–Frank is implemented, these changes have also helped the OCX stay technologically innovative under the guidance of CEO David Downey. By Anthony Malakian
When David Downey got the call from Thomas Peterffy, the majority owner of OneChicago Exchange, he had already had his next six months mapped out: golfing, skiing, boating, honing his piano-playing skills, and spending plenty of time with his family—the same things he had been doing for five-and-a-half years. What he didn’t have planned was a return to the world of finance.
After cutting his teeth at the American Stock Exchange (Amex) and leaving his imprint at Timber Hill and then Interactive Brokers, Downey abruptly left the business after a tragic car accident took the lives of two of his close friends. Soon after that day, he found himself on the phone with clients in Germany at 3 a.m. working out an issue that seemed all too trivial in light of what had happened.
So, in 2000, Downey quit.
He planned to spend time traveling with his children, mastering Beethoven, and generally enjoying life’s simpler endeavors. A return to the capital markets was not part of the plan. Part of Downey’s personality is a desire—an obsession—to succeed in anything he does, whether in the business world or on the golf course. He knew that a return to the working world would demand almost all of his attention.
Peterffy knew Downey well—their relationship was years old and Petterffy knew how to tap into Downey’s inner competitive instincts. In fact, it took only one sentence from Petterffy to get his friend on board at OCX: “No one thinks it can be done.”
By the end of the brief phone call, David Downey had himself a new job—CEO of OneChicago Exchange.
Downey’s path to OneChicago was far from a straight one. Right out of college, he was offered a job at Goldman Sachs working in the firm’s back office. He turned it down. But what makes the decision to snub the Wall Street heavyweight even more unusual is what he did instead. Downey became a gardener.
Downey went to work for novelist and longtime friend of Ernest Hemingway, A.E. Hotchner, who also partnered with Paul Newman to launch the Newman’s Own food and charity venture.
Hotchner put a small ad in a local paper, which Downey answered. During the interview, Hotchner grinned—no one had ever handed him a professional résumé for a gardening job. Downey explained that he was looking for something temporary until he could find a job he wanted on Wall Street. Hotchner said he’d help open a few doors for Downey if Downey stayed the summer and tended his garden. The novelist remained true to his word and introduced Downey to Arthur Levitt, who at the time was the chairman of the American Stock Exchange and who would later go on to chair the US Securities and Exchange Commission (SEC). Downey was hired as a quote reporter.
After approximately two years, Downey got an interview with Thomas Peterffy, the founder of Timber Hill and Interactive Brokers. (This relationship would obviously prove fruitful in the future.) Once hired, Downey was sent to help break into the Chicago market with Timber Hill’s electronic trading tablets, first at the Chicago Mercantile Exchange. He moved on from Timber Hill to take over the then-startup Interactive Brokers.
Downey says Peterffy was an invaluable mentor in his development. Not only did he admire Peterffy’s leadership abilities, but he learned the importance of technology and building that technology in-house, rather than having to rely on others, which would come in handy later.
From 1985 until 2000, he learned and he grew in his career. He then spent the next six years enjoying the fruits of his labor, but when OneChicago and Thomas Peterffy came calling, he was ready to put what he learned into something that was completely new: a single-stock futures exchange, which was only made possible at the turn of the century with the passing of the Commodity Futures Modernization Act of 2000.
OneChicago Exchange is housed in the architecturally striking Chicago Board of Trade building on Jackson Boulevard. The grand tour of the OCX’s cozy office takes all of a few minutes. The exchange’s IT staff—to use the term “staff” liberally, since the team comprises only two people—sit in the middle of the office between Downey’s quarters and Thomas McCabe, the company's chief operating officer.
But don’t let the company’s modest size fool you—it is a technologically savvy group. OneChicago is jointly owned by CME Group, CBOT, and the Chicago Board Options Exchange (CBOE), as well as Connecticut-based Interactive Brokers Group, which bought a controlling share in the exchange in 2006. While the OCX leaned heavily on its parents for technology when it opened in 2002, when Downey took over in 2006 he demanded that the exchange become IT-independent.
“The first thing I asked when I came in was, ‘Where is your technology?’ They said they didn’t have any,” Downey recalls. “So my first order of business when I took over was to build technology.”
Downey went out and hired a former trader he had worked with in the past to work alongside McCabe. From there, the small team worked to map out how the exchange would build out its infrastructure. “Now our main focus is to build technologies that are robust and that eliminate the need for any human intervention,” Downey says.
Production at OneChicago looks more like an inverse pyramid: They start with a small idea/project and slowly build it out and accelerate it as they become more comfortable with it, customizing the product to fulfill OneChicago’s specific needs.
While the OCX does lease one of its two matching engines from the CBOE for low-latency trading, almost everything else is built internally. And while it’s not at the top of OneChicago’s priority list, the firm is looking to build a low-latency engine of its own, Downey says.
“The CBOE has a terrific matching engine, but I’ve often thought that we should do away with the CBOE lease agreement because we pay more than we receive,” he says. “The CBOE matching engine has to handle millions of messages every hour, whereas our block and Exchange Future for Physical (EFP) trading engine doesn’t have to go anywhere near that capacity. There are plans in the pipeline to build our own matching engine, but it’s not our biggest priority.”
The Risk Man
One piece of in-house development that Downey is particularly proud of is the firm’s risk management platform, dubbed Risk Man. In late 2010, the SEC adopted rule 15c3-5, which requires “brokers and dealers to have risk controls in connection with their market access,” according to the regulator.
Since OneChicago trades security futures, it developed a solution for the exchange’s block EFP trading system that stops every trade to monitor for risk allowances. While most trades are stopped and examined electronically for a very brief period, some are stopped for a few minutes if a red flag goes up.
“This stops fat-finger traders from executing trades that the firm cannot back up,” Downey says. “The firms are generally very happy with it; the traders sometimes get upset with it, but that’s what it’s supposed to do—it stops them from trading in excessive sizes and makes them go back to their risk department.”
The SEC, according to Downey, told OneChicago that Risk Man meets the spirit of 15c3-5 and customers that access OneChicago’s market are meeting the requirements of the new rule. OCX is still awaiting official documentation from the SEC so that it can officially advertise this in writing to the Street.
Where the SEC and CFTC Meet
Since OneChicago deals in listed security futures, it is regulated by both the SEC and the Commodities Futures Trading Commission (CFTC). Earlier this year SEC chair Mary Schapiro told Waters’ sibling publication Risk that the SEC and CFTC could deviate on certain rules when implementing the Dodd–Frank Act because “[securities and futures] are different products that trade differently.”
This is a true statement for most, except for OCX, which trades security futures.
There are massive challenges—and headaches—that have been brought about as regulators grapple with how to best implement Dodd–Frank. “I’ve spoken with many people who have been in this business for a long time and even they can’t paint a picture of what this is going to look like down the road; it’s only now beginning to form,” he says.
Downey says even the SEC doesn’t know in any great detail how Dodd–Frank will impact the US trading landscape. The CFTC, meanwhile, has been pressing forward and prescribing rules as though it knows what the end picture will look like.
“The SEC has chosen to let the markets begin to evolve and then moderate its regulation if it thinks the market is going in the wrong direction,” Downey says. “The CFTC has bitten off an enormous piece of the pie.”
Part of the problem is that while the SEC has more experience in dealing with member firms of the trading community, the CFTC has rushed into this and may not have the staff size and experience it will take to deal with the new rules it is implementing.
“We try not to overreact when the regulators ask for an opinion, but we put our two cents in,” says Downey, who meets with regulators on a weekly basis. “We understand our responsibilities as a designated con- tract market, and we understand that we’re a self-regulated organization that has to watch the activities that go on in this place. Nobody knows how to create a compliance system better than I, because I was a trader, I ran a brokerage operation, I traded futures, I traded stocks, and I traded options. I know how people cheat, I know how people steal—it’s subtle. If you’ve never been in a pit, I don’t think that you can possibly know how that happens. When I built our compliance system it was based on all the knowledge I had accumulated throughout my years of experience,” he adds.
The SEC and CFTC are not the only forces behind the development at OCX. For example, Downey points to an in-house reporting system the exchange built to help its members comply with Order Audit Trail System (OATS) requirements released by the Financial Industry Regulatory Authority (Finra).
As the OCX’s EFP product suggests, the exchange switches a trading firm’s physical position for a future position, and that stock transaction is posted on Nasdaq, and as such, all of the OCX’s customers have OATS requirements that must be met. Since the OCX is an order-sending organization, it can transmit those OATS reports directly to Finra. So to streamline the process for its customers, the OCX developed an in-house reporting system that captures the OATS information from inbound orders, formats that information, and produces a report for the exchange’s customers, which is then transmitted back to Finra at the end of the day.
“As a regulated entity, and as customers, brokers, dealers, and member firms interact with us, they have to comply with an ever-larger burden of regulatory reporting,” Downey says.
Buy vs. Build
The OCX is a self-regulating institution, and has built its own in-house compliance system that looks at all the data passing through the exchange in real time. The exchange is also improving its front-end EFP trading system so as to streamline the process as new rules surrounding swaps come to light and make users more comfortable with how the data is presented.
When asked why his exchange builds most everything in-house rather than tapping into the vendor community, Downey says that one lesson of many that he took from Peterffy, his mentor at Timber Hill, was that you have to be innovative in order to separate yourself from your competition.
“One of the things he taught me was: If it’s really a novel idea, no one’s thought about it; if no one’s thought about it, no one’s built it,” Downey says. “If you’re just buying something that everyone else has, how can you really differentiate your services from the others?”
While the OCX will occasionally contract a vendor, it is traditionally only used for very specific work that are one-off situations. These aren’t mission-critical projects, but usually low-priority patchwork. “The beauty of building versus buying is that when the thing breaks, the person who built it knows exactly which line failed and can fix it on the fly,” he says. “You don’t have to pick up a phone and get in on someone else’s agenda.”
And perhaps most importantly, most of the projects undertaken at the OCX have to do with compliance in one form or another—as such, you don’t want to risk your reputation on someone else’s work, Downey says.
“The blackest eye you can get as an exchange is to have people doing bad things in your house and not catching them,” he says. “We spend an enormous amount of time on that.”
After all, Downey says, “That’s my reputation on the line.”
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