Streetwise Professor

May 25, 2006

Another Exchange Merger Skeptic

Filed under: Exchanges — The Professor @ 10:12 am

In today’s FT David Lascelles expresses skepticism about the logic underlying exchange consolidations, specifically the NYSE-Euronext tie up. He too seems mystified as to the source of scale and scope economies. He also notes that the cultural challenges facing a merger should not be dismissed:

By the same token, Euronext’s natural partner at the international level is surely Deutsche Börse because of their shared European traditions and outlook. I have seen such an alliance described as a “marriage from hell” because of the number of potential warring parties, but it must have more going for it than a Euronext-NYSE marriage run by the cultures, respectively, of the French énarques (administrative class) and Goldman Sachs.

Another article, this one in Europolitix gives the lie to the idea of “shared European traditions and outlook.” To quote the article:

The EU’s internal market chief Charlie McCreevy has become embroiled in the proposed takeover of France’s Euronext stock exchange by Germany’s Deutsche Börse.

According to internal commission documents seen by German newspaper Handelsblatt, Charlie McCreevy’s department appears to support the French government’s opposition to Deutsche Börse’s proposed takeover of Euronext.

Paris wants the German company to restructure before completing a bid for Euronext, spinning off its clearing and settlement operations that focus on the transfer of ownership of stocks and shares.

McCreevy’s department agrees, arguing that separating the Clearstream clearing and settlement operations from the stock exchange business will create more price transparency and greater competition.

The German paper calls the stance “a full frontal attack on the German stock exchange”.

One can almost imagine the parties facing off across the bargaining table, with the Germans sporting Pickelhaubes and the French kepis. “European Union” is an oxymoron whenever French and German interests clash. They gladly cooperate when they can shaft the British or the Poles, but they fight like in the old days when it’s a French business interest vs. a German one.

Clearing and settlement is ostensibly the key issue in the German-French exchange dispute. The German exchange, Deutsche Borse, has an integrated clearing and settlement operation. Euronext does not. Euronext wants DB to spin off clearing as a precondition to any deal. DB objects. EU competition authorities have expressed concerns that integrated clearing and settlement impedes inter-exchange competition. The economics of this are by no means clear. I plan to give this issue further consideration. Stay tuned for my take.

China & Siberia

Filed under: Commodities,Politics,Russia — The Professor @ 9:49 am

Columbia professor Padna Desai writes about the Russian demographic problem in The Wall Street Journal. Most of the article supports my analysis from earlier posts, but contrary to my speculation that the future may see a conflict between China and Russia over Siberia, she opines:

Some Russians also fear that the Chinese, seeking to increase trade, will come into the Far East and settle down permanently — and that Beijing will then somehow stake a claim on Russian territory! This is nonsense, of course, but I encountered such fevered scenarios of the “yellow peril” even among some liberal acquaintances on my recent trip to Russia.

I certainly don’t view such a conflict as a probability 1 event, but in my view it is anything but nonsense. Nature abhors a vacuum, and if present population trends continue, Siberia will become a human vacuum–but one with vast mineral wealth that China wouldn’t mind having. It is hard to imagine that a depopulated Siberia coexisting side by side with a vibrant, energy hungry, proud, and confident China is a stable long run equilibrium. Moreover, the Chinese have a long historical memory, with a particular talent for nursing historical wounds suffered at the hands of foreigners. Although the Russians do not rank with the British or the Japanese as exploiters of China during its humiliations in the 19th and early-20th centuries, they were not blameless either. As a result, I wish I shared Ms. Desai’s blithe optimism about Chinese-Russian relations over the long term, but I don’t.

Ms. Desai also suggests that immigration is a solution to Russia’s demographic dilemma. Good luck with that. Ask the Western Europeans how the immigration thing is working out for them. And if it doesn’t work in Western Europe–which it doesn’t, pace Paris car burnings, honor killings in Germany, Britain, and Sweden, etc.–it sure as hell isn’t going to work in Russia.

Addendum. Apparently the world, Goldilocks-like, is looking for a level of immigration that is “just right.” In the US, many people (arguably a majority) think it is too much. In Russia, too little. A couple of quick thoughts. First, what kind of immigrants are we talking about? Immigrants are not homogeneous. Some are skilled. Many are not. What kind of immigrants is it necessary to attract? How can you attract those immigrants (the skilled ones, presumably) without attracting the less desirable ones? Is immigration consistent with social welfare policy? (One of my intellectual heroes, Richard Epstein, said in a seminar at Michigan in the 90s that his primary objection to the welfare state is that it was incompatible with unrestricted immigration. Like many Epstein positions, not quite in the mainstream, but logically consistent and intellectually serious.) Put differently, how can you attract immigrants without attracting a disproportionate number of “gimmie-grants?” Second, where are the immigrants to Russia going to come from? China–maybe. The Middle East–probably not, and given the European experiences, its arguable that this represents the most desirable source of immigrants. And are people from places where it is routinely 35+ degrees C really want to move to where it is routinely 35- degrees C? Central Asia? Again, the disparity between educational attainment in most of Russia and Central Asia is immense, and it is doubtful that Central Asian immigrants will address the Russian labor problem. Third, the difficulties of assimilating immigrants have proven very difficult in Europe and the US, but they are likely to be immensely more difficult in Russia. Russia has no tradition of accepting immigrants. Russia is historically more insular, and arguably more xenophobic than the US or Western Europe (which is not to say by any means that xenophobia is absent in those places–this is an ordinal statement.) Language will be a barrier.

All in all, saying that immigration is the solution to Russia’s demographic challenge is fantasy. It reminds me of the standard economist joke, of which there are several variations, one of which is: An economist and a physicist are on the 50th floor of a high rise hotel. The fire alarm goes off. The economist and the physicist look out the window, and see that the entire lower part of the building is engulfed in flame. The physicist says–“there’s no way out. We’re going to die.” The economist says–“Don’t worry. We’ll just assume the existence of a 50 story ladder.” Assuming immigration to be the “solution” to Russia’s existential conundrum is no more realistic.

Addendum II. Mark Steyn weighs in:

The answer to many of China’s problems lies just across its northern border: the fast depopulating, resource-rich Russian east, which Beijing will wind up with one way or the other. If you read Mark Bassin’s masterful book Imperial Visions : Nationalist Imagination and Geographical Expansion in the Russian Far East, 1840-1865, it’s hard not to notice that the rationale behind the Russians’ sale of Alaska applies just as well to a big swath of their eastern provinces today. A century and a half ago, Grand Duke Konstantin Nikolaevich, the brother of Alexander II, argued that the Russian Empire couldn’t hold its North American territory and that one day either Britain or the United States would simply take it, so why not sell it to them first? The same argument applies now to the 2,000 miles of the Russo-Chinese border. Vladivostok will return to its old name of Haishenwei before too long.

And, given Russia’s own gender imbalance — between sickly men of low life expectancy and long-lived robust women — it doesn’t take much imagination to see a Sino-Russian union as a marriage of convenience in more than just the geopolitical sense. That’s the key difference between transatlantic Ouija boards on China: as the cannier American analysts see it, Beijing is a threat to Washington not because of its strength but because of its weakness.

As always, Steyn provides an interesting perspective. The Alaska II scenario is not implausible, but Siberia is more of an integral part of Russia–both physically and more importantly psychologically–than Alaska ever was. This makes a transactional transfer of Siberia less likely, and a violent one much more likely.

Addendum III. Richard Posner’s observation on the US & Mexico pertains to the feasibility of immigration as a palliative for Russia’s demographic problem:

As soon as per capita income in a country reaches about a third of the American level, immigration from that country dries up. Emigration is very costly emotionally as well as financially, given language and other barriers to a smooth transition to a new country, and so is frequent only when there are enormous wealth disparities between one’s homeland and a rich country like the United States. The more one worries about illegal immigrants, the more one should favor policies designed to bring about greater global income equality.

Since per capita income in Russia is already relatively low, the differential between Russian incomes and the incomes in possible sources of immigration is already small. Moreover, it is likely that the “language and other barriers to a smooth transition to a new country” are substantially greater between Russia and other countries than between the US and Mexico, requiring an even larger income differential to attract substantial immigration. In other words, large immigration is (not surprisingly) something that occurs in rich countries, and is not a panacea for the labor problems of relatively poor ones (like Russia.)

Russian efforts would be better devoted to keeping its high skill people from going west, to the US or Europe, than to attracting low skill people north or east to Russia.

What, me worry?

Filed under: Military,Politics — The Professor @ 9:26 am

The National Journal carried an article on whether Iran can be deterred. The question immediately arises: deterred from doing what? The article is not explicit, but it is implicit that the NR writer means that Iran can be deterred from using an atomic weapon through traditional MAD logic.

This is a reasonable proposition, but largely beside the point. The main danger is not that Iran will use a nuclear weapon as a sword, but that an atomic arsenal is a powerful shield behind which an aggressive Iranian state can conduct low and medium intensity and asymmetric warfare against its neighbors. Iran clearly has large regional designs, and also fancies itself as the vanguard of a campaign to bring down the United States. Indeed, from the time of Khomeni Iran has viewed itself as the successor to the USSR as the main adversary of the US. Although the author of the article, Paul Starobin, and most of these he quotes, point to the example of the operation of deterrence during the Cold War as an illustration of the efficacy of MAD in preventing the offensive use of nuclear weapons, this view neglects that the 1945-1990 period was one of low and medium intensity armed conflict around the globe. MAD deterred the Soviets, Americans, and Chinese from using nuclear arms against one another, but fear of nuclear war also made it much more difficult for the West to confront Soviet aggression, roll back the Iron Curtain, and achieve decisive outcomes in Korea and Viet Nam. Millions died, and millions more lived lives of misery under Communist rule in large part because nuclear weapons served as a shield behind which the USSR (and to some degree China) were able to wreak havoc.

If Iran goes nuclear, it too will gain a substantial increase in its freedom of action–and its freedom to exercise its malign influence beyond its borders. This is hardly a pleasant prospect, and although it pales in comparison to nuclear conflict, given the strategic importance of the Middle East to the US and the West–not to mention the human misery that will result from Iranian mischief–it provides a powerful motive to prevent Iran from getting the bomb.

There is also considerable room to be skeptical whether the lessons of the Cold War are fully applicable to Iran. Educated Westerners have a tendency to misjudge messianic individuals with an intense will to power–such as Lenin or Hitler. The tendency to project our rational templates on to such people is very strong, and has led to complacency, with disastrous results. I see the same tendency in the conventional reaction to Ahmadnejehad. Methinks that he should not be dismissed so readily, and that the logic of deterrence is less comforting when dealing with someone like him and the regime he represents than with the Soviets.

Addendum. There are a couple of other dubious contentions in this article. For instance, Starobin says “[t]he world’s biggest nuclear arsenal did not keep the Soviet Union from imploding — and is of little benefit to today’s Russia, which under Vladimir Putin is attempting to regain its global clout by becoming an energy superpower.” Somebody should tell Putin. One of the uses to which Moscow is putting the revenues that flow from energy superpower status is to upgrade the Soviet military–and most notably, its strategic nuclear forces. As this piece from MissileThreat documents, Russia has put considerable effort into upgrading its Topol-M (NATO designation SS-27) ICBM to allow it to defeat any missile defense, and is proceeding rapidly with its development of the SL version of the Topol-M, the SS-NX-30 Bulava. Despite the collapse of the USSR, and despite its massive endowment of energy, Russia still considers nuclear weapons to be the cornerstone of its strategic power. Even with energy, without nuclear weapons Russia is what Bismarck said it was in the 1860s–a geopolitical void, a nullity. (His quote was, in the French that was the diplomatic language of the age, “La Russie, c’est le neant.”) Putin and the Russian establishment recognize this, and are acting accordingly. Iran has the same understanding. A massive endowment of energy resources is not sufficient for that country to achieve its rulers’ broader geopolitical ambitions. Hence their determined–indeed hell-bent–effort to acquire nuclear weaponry. They are not spending massive resources on something that is useless. Even if never used, nuclear weapons can be quite useful indeed.

May 21, 2006

Russian demography, cont.

Filed under: Politics,Russia — The Professor @ 12:14 am

A good article from The Christian Science Monitor on Russian demography that echoes the points made in some previous posts. The key point: “[c]ritics point to the high male death rate, a problem Putin barely addressed. Men’s ranks have been decimated by alcoholism, war in Chechnya, AIDS, and accidents. ‘Male life expectancy is less than 60 years,’ says &Yevgeny Gontmakher, research head of the Center of Social Studues, an independent Moscow think tank. ‘Trying ot stimulate the birthrate is pure populism; it’s naive to think a demographic revolution can happen.” Regional Development Minister Vladimir Yakovlev noted that at current trends (always a dicely assumption) in a mere 19 year there will four dependents for every Russian worker.

To reiterate my earlier contention, Russia needs to solve the male death deluge before it can alleviate the birth dearth. This is a historically unprecedented challenge, although in some way it echoes circumstances in American inner cities, where male populations are disproportionately ravaged by drug abuse, criminality, and poor education, and where many women despair of finding a marriagable man. Given the depressing lack of success that the US, a vastly wealthier country than Russia, and one that has experienced nearly 25 years of almost continual GDP and job growth, has had in addressing these problems in a relatively small portion of its population despite more than 40 years effort, one cannot be too sanguine about the prospects for curing a condition that afflicts an entire nation spanning two continents that is just emerging from a lost decade of economic catastrophy.

Russia doesn’t have 40 years to experiment. Absent a reversal of these trends, in 40 years Russia will have barely 100 million souls–as compared to its current population of 145 million–and many of them (perhaps a majority) will be aged and infirm. Is such a geographically immense state even viable with such a low population? Will a strong and energy-thirsting China attempt to wrest away Siberia, with its mineral wealth that is the primary (and arguably sole) prop of the Russian state? China and Russia are currently cozying up out of a perceived mutual interest in impeding the US, but the longstanding rivalry between the two will soon reassert itself, and Russia’s demographic weakness will only hasten the day when things come to a head. Given that both nations possess nuclear arsenals, this is a chilling prospect.

May 20, 2006

What She Said

Filed under: Exchanges — The Professor @ 1:36 am

The IHT and NYT ran a very sensible article on the “bourse merger stampede” by Jenny Anderson (with contributions from Heather Timmons). Anderson, and the people she quotes, express considerable skepticism over the economics of exchange mergers, especially cross-border mergers. Anderson says: “[w]hile the Big Board and Nasdaq are excited about global consolidation, neither has made an effective case for how to accomplish such a merger and what it offers, beyond diversification.” Here, here!

Anderson states that Nasdaq’s CEO, Robert Greifeld, believes that a merger with the LSE would allow creation of a single system with lower costs. Where are these savings to come from? LSE and Nasdaq already have trading platforms up and running. Is one going to replace the other? If so, there will be some significant costs to be incurred upfront by the exchange whose system is replaced, and perhaps more importantly, by its customers. There will be savings in development costs down the line, but it is by no means clear how big these savings will be. Moreover, there will be other costs. Furthermore, and perhaps most important, cultural and regulatory differences may make a Nasdaq-LSE tie up very expensive and cumbersome.

As for a combination of NYSE and a European exchange (with Euronext being the likeliest candidate at this round of speed dating), the most commonly cited benefit is “diversification.” Run, don’t walk, away as quickly as possible when managers justify a merger through its diversification benefits. That’s what equity markets are for–to allow investors to diversify so that firms don’t have to do it through acquisition. Moreover, it is arguable whether a purchase of a European stock and derivatives exchange really generates much diversification. The correlation between trading volumes across equity markets is pretty high. And there are downsides to geographic and product line diversification, most notably the cultural and regulatory factors alluded to earlier.

Several hedge funds, most notably Winchfield Holdings are hot for Euronext to merge with DB. This suggests that they see some cost savings, and indeed this may be the case for an intra-European combination. Next week’s non-binding Euronext shareholder vote on this merger will provide some indication of whether this is a commonly held view.

May 18, 2006

He Who Laughs Last

Filed under: Derivatives,Exchanges — The Professor @ 8:56 am

Articles about the energy futures and grain and oilseed futures markets make it abundantly clear that the ultimate dominance of electronic trading is drawing nigh. The commodity markets have been the last bastions of open outcry, but soon the largest of them–at NYMEX and the CBT–will begin side-by-side electronic and floor trading. If the experience in other markets is any guide, volume will move inexonerably to the electronic platform.

Although one can sympathize with the NYMEX floor traders quoted in one of the articles, realistically speaking they are whistling past the graveyard. Those leasing seats have no ownership in the exchange, and will thus have no vote and effectively no voice in the exchange’s future direction. They have no legal claim to any proceeds from the IPO. They are no different than renters of real estate with no control over the sale or conversion of their apartments.

And one piece of free advice–don’t strike, as the article suggests that some NYMEX traders are threatening. Learn from the French–as shocking as that sounds coming from me. The floor traders at MATIF (the French futures exchange that is now part of Euronext) tried that when that exchange introduced side-by-side trading in 1998. All this did was accelerate the movement towards electronic trading and led to the closure of the floor in weeks, rather than months. The striking traders exchanged a shrinking fraction of something for 100 percent of nothing. Not a good idea. The floor will continue for awhile even after the screens go live during regular trading hours. For most of the seat renters, it’s better to hang around and get some business than strike and get nothing. Moreover, seat lease prices will decline as the electronic system gains market share. Those that stick around will make a fair return on their capital. Those that strike won’t.

Although electronic trading currently has an aura of inevitability–and indeed obviousness–that wasn’t always the case. I’ve been around since the conventional wisdom in the futures markets–and the securities markets too–was that open outcry is inherently more efficient and liquid than electronic trading. Indeed, I played a role in challenging and changing that conventional wisdom. In so doing, I was subjected to scorn from some important people in the business, but as the the expression alluded to in the title says–he who laughs last laughs best.

I have followed developments in electronic trading since Globex’s development was first announced in 1986 (I was working at an FCM in Chicago at the time). Although Globex has become the orb-straddling collosus that its name connotes, it wasn’t always that way. I followed the system’s checkered early years, which were beset by disputes between the (then) partners in the endeavor, CME, CBT, and Reuters, and the opposition of many members of CME and CBT who viewed electronic trading as a threat. I remember when MATIF did the most business on Globex.

I wrote my first working paper on electronic trading in 1991 or 1992. The paper analyzed the potential efficiencies of electronic trading, emphasizing the ability of computerized markets to reduce the costs of access (thereby likely leading to higher volume) and to reduce error costs. The early paper also compared liquidity supply on electronic and open outcry exchanges. I didn’t reach any definitive conclusions on liquidity because there appeared to be potentially offsetting impacts. This was essentially an empirical issue.

I had the opportunity to begin an empirical examination of liquidity on electronic and open outcry exchanges in 1994. I was retained by Deutsche Terminborse to determine whether it was advisable for the exchange to create a new class of members analogous to locals on open outcry exchanges. DTB had heard ad nauseum that the open outcry LIFFE was inherently more liquid because of its individual market makers–locals. To determine whether DTB really needed electronic locals to allow it to compete more effectively with its London rival, I decided on a novel approach–to look at the data. The data showed that if anything, DTB was more liquid and deep than LIFFE.

Although DTB had originally intended to keep the report private and use it for internal decision making purposes only, upon seeing the results (subsequently published in a peer reviewed journal) the exchange released them publicly. The reaction was swift, and decidedly negative from some quarters–notably LIFFE. LIFFE’s CEO, Daniel Hodson, insinuated that a pointy headed academic shouldn’t be taken seriously–everybody KNOWS that open outcry is more liquid. (I’m looking through my clip files to get the exact quote from an old FT article–will update when I find it.) Other industry people were equally critical.

It therefore took some restraint on my part to avoid gloating when less than 4 years later DTB routed LIFFE in the Bund market, and Hodson was forced out as CEO. DTB used my study as part of its marketing blitz in 1997-1998. It’s fair to say, however, that LIFFE’s near death experience was more attributable to its own complacency than any academic study. When making its concerted attack on LIFFE, DTB cut prices aggressively and the British exchange did not respond until it was too late. In less than a year the Bund futures market–the largest in Europe and one of the largest in the world–had tipped from an open outcry exchange to an electronic one. No one would ever sneer at computerized markets again, and from early 1998 it was abundantly clear that the future was electronic and that open outcry markets were fighting a rear guard action.

Another working paper of mine presents a theoretical framework that helps illuminate why electronic trading has prevailed in the end. Open outcry advocates focused on two things that were right before their eyes–the pool of liquidity provided by locals on the floor, and the evident information advantage of those on the floor. Although these are features of open outcry (though the information advantage of floor traders may be exaggerated), in emphasizing these aspects, the floor partisans overlooked another important fact–the huge latent liquidity pool upstairs. The time and space advantages of those on the floor make it difficult for upstairs traders to supply liquidity in competition with the locals, especially in very volatile markets. The time it takes to send and revise orders from upstairs makes those trying to trade via limit order from off the floor vulnerable to being picked off. This taxes upstairs liquidity supply.

Electronic markets annihilate the floor’s time and space advantage–they eliminate the tax on supplying liquidity from upstairs. The dramatic reduction in the cost of accessing electronic markets has unleashed a flow of liquidity supply from what might term the “globals”–as opposed to the locals. The liquidity on the floor was visible–one could see the locals. In the floor era, the potential liquidity supply from off the floor was effectively invisible–since it was largely untapped, it was hard to understand how big it could become if the costs upstairs traders incurred to access the market were to fall dramatically. My 1994 DTB report hinted at the potential for alternative liquidity supplies, but in all honesty I too am surprised at the torrent of liquidity that computerized trading has loosed. In some respects, therefore, the skepticism about electronic trading that was so common in the 1990s was due to a failure of imagination–a failure to imagine how technological change would alter fundamentally the economics of liquidity supply.

In the old days, those on the floor were able to profit from their time, space and information advantage. Seat prices capitalized value of these advantages to the marginal exchange member–inframarginal members (the better traders, the more risk tolerant, and better capitalized ones) earned even more. The rents accruing to floor traders have disappeared as computerized markets take over, but the skyrocketing valuations of exchanges with publicly traded stock indicates that the pool of potential rents is even bigger in an electronic environment. Computerized trading, with its lower access costs, has driven substantial increases in volume. Seemingly small (but supercompetitive) fees on each trade generate large revenues for exchanges. Again, this was unimaginable only a few years ago, but now seems almost self-evident. It obviously wasn’t though. Even though I was an early supporter of electronic trading, I didn’t buy CME at the IPO or shortly thereafter. If I had only put my money where my mouth was;-)

May 11, 2006

Great Minds, Part Deux

Filed under: Military,Politics,Russia — The Professor @ 9:09 am

I must have been channeling Vladimir Putin while writing my “Great Minds” post yesterday evening. Therein I mentioned two glaring Russian problems–demographics and military weakness. So what should I find in my morning stroll through my usual web news sites? Two stories reporting on Putin’s State of the Nation speech in which he emphasized that Russia had to address two major issues: its pressing demographic crisis and its perceived military weakness. Where have I heard that before?

Putin talked about “stimulat[ing] the birth of a second child” and noted that “concerns about housing, health care and education are prompting many families to stop at one.” Increasing the birth rate is clearly important, but as I noted parenthetically in the earlier post, there is room to doubt whether this is an easy thing to do in a post-modern world, especially one in which women are highly educated and have high paying professional careers.

Relatedly, Putin mentioned the high death rate in Russia–this is the thing that distinguishes his country’s demographic dilemma from that of Italy and Spain, for instance, where both birth rates and death rates are low. This also suggests a tension. The horrific rate of early male mortality increases economic opportunities and wages for women, thereby increasing the opportunity cost of childbearing. It also raises the uncertainty that women face; they must confront the significant probability that they will have to support their children on a single income, or that a premature death of a spouse (even after children are grown) will reduce future household income and raise the cost of interrupting a career to have several children. This is a further dis-incentive to have children. Therefore, these problems are linked: unless something is done about male mortality, it may be very difficult to raise the birthrate.

The press coverage I read did not indicate that Putin made any concrete proposals to bring down mortality. Since it is likely that it will be difficult to bring up the birth rate without bringing down the death rate, there is little reason to be sanguine about Russia’s prospects for addressing its demographic challenge. It is interesting, however, that Putin is so open about this and at least is attempting to do something about it. I doubt that the Soviets would have been similarly frank. As twelve-steppers say, the first step towards solving a problem is admitting it, and Putin deserves credit for doing so in such a forthright way.

With respect to the military dimension, Putin is also facing a difficult challenge. Russia is attempting to professionalize its armed forces through the creation of a volunteer force as was done with in the US in the 1970s. The current conscript-based force is plagued by low morale (exacerbated by brutal hazing of recruits by NCOs) and low investments in the human/military capital of conscripts. Changing the military culture and increasing the professionalism of the NCOs and private soldiers and sailors will not be easy. Moreover, Russian equipment and doctrine are obsolete. They have good designs for many weapons–and are selling them around the world, especially to China–but it will be quite expensive to bring the Russian military up to American standards. And American standards are a moving target; American technology and doctrine are advancing at a dizzying pace. Trying to keep up with the Americans ruined the Soviets, and could well ruin Russia too.

The WSJ story also contained a delicious quote regarding Gazprom. Putin touted the growth of the company’s market cap, and noted “[t]his didn’t happen by itself . . . but as the result of certain actions by the Russian government.” You don’t say. Or, more crudely, NSS (for No [synonym for jive], Sherlock.) Though it is certainly the case that this isn’t the only thing that drove up the company’s stock price–the spike in world energy prices had something to do with it too.

Exchange Speed Dating

Filed under: Exchanges — The Professor @ 4:39 am

My head spins trying to keep up with all of the rumors of this exchange talking to that exchange about a merger. Everybody seems to be talking to everybody else in very rapid succession–hence the analogy to speed dating, events where busy and available singles serially interview potential partners.

Ms. LSE seems particularly popular, but somewhat coy. Mr. CME has money falling out of his pockets, but really wants to find Miss Right. Herr Deutsche Borse got badly burned in his courtship of Ms. LSE, and is making overtures to the girl next door–Mlle. Euronext.Liffe, who wants things definitely on her terms or not at all, and seems to have major reservations about Herr DB. Ms. CBOE needs to get completely moved out of her dad’s (Mr. CBOT) house before she can commit. The mature bachelor freshly on the market–Mr. NYSE–appears a little unsure on what to do, but seems to be looking for someone who is very different.

At the end of the night, who will end up with whom? Beats me, but here are a few thoughts.

First, don’t be surprised to see a few mistakes made, as is wont to happen when there are strong expectations that one should really be married by now. Some exchanges are swimming in free cash flow, and it is well known that this sometimes leads to ill-advised purchases. Marry in haste, repent in leisure.

Second, look for economies of scope and scale. As noted in the just-previous post, NYMEX-CME makes sense. CME-Euronext.Liffe also has some attractions given their complementary derivatives products–both are strong in short term interest rate (STIR) products. But both have good technology platforms, so it’s hard to see what they gain from the pairing on that front. And inter-cultural marriages are always a challenge. The scope economies between derivatives (especially futures) and equities don’t strike me as compelling, but I could be wrong. There is a superficially plausible case for combining an exchange that offers individual equity options with an equity exchange, but again I don’t find it compelling. There are potential advantages to trading equities that are currently traded on different exchanges on a single platform, so an equity exchange + equity exchange merger (e.g., NASDAQ+LSE, NYSE+Euronext) may make sense, although they may face some daunting issues regarding integration of their trading platforms. In futures, the big savings come from the clearing side, and potentially the technology side. CME and CBOT have already combined clearing, so a merger between them doesn’t bring a lot of savings on the clearing end. Moreover, there may be some nettlesome legal issues involved in integrating clearing for a US and a European exchange.

In brief, nothing jumps out at me as a no-brainer. Hence, as I’ve often said in the past, don’t believe stories of exchange marriages until you see the rice fly.

May 10, 2006

Merc + Merc

Filed under: Commodities,Exchanges — The Professor @ 11:41 pm

After earlier negotiations went nowhere, the Chicago Mercantile Exchange and the New York Mercantile Exchange entered into an agreement whereby NYMEX contracts will be listed on CME’s Globex system and traded side-by-side with the NYMEX open outcry markets. This followed a brief interval in which NYMEX tried to convince an apparently skeptical (and probably justifiably so) marketplace that its legacy electronic systems (Access and ClearPort) were up to the task of staving off ICE’s challenge.

As I noted in my February post “Whither NYMEX,” the NY exchange was vulnerable due to its technological weaknesses, and viewed in that light the deal makes perfect sense. I surmise that NYMEX played hardball in the initial negotiations, and the CME walked. CME then played its cards perfectly, announcing that it intended to offer energy futures of its own on Globex. Already having its hands full with ICE, NYMEX was in no position to tangle with the biggest kid on the block, so it did the prudent thing and combined with the CME.

NYMEX did what it had to do, but the deal is a coup for CME. It gets a nice revenue stream (with very little additional cost) from an established franchise, whereas competing with NYMEX would have been expensive (with marketing expenses, likely fee waivers, etc.) and of uncertain outcome.

Is this the end of the story, or just the beginning? Methinks the latter. There is a potential double-sided opportunism problem here. CME has the technology. NYMEX has the contracts. They have entered into a contractual relationship whereby they share these assets. If Globex trading of energy contracts takes off, as is reasonably likely, each party is in a position to hold up the other. It is very possible that we will see haggling over fees, threats to walk from the agreement, and so on.

How can these problems be forestalled? Merger. A combination would economize on the transactions costs inherent in the double-sided holdup problem. It could also result in some cost savings, especially on the clearing side.

Whether or not this will occur will depend on how electronic trading fares. If my conjecture that electronic trading of NYMEX energy contracts will take off is correct, the deal is almost imperative. Moreover, such a development will undermine the strength of the floor community who might otherwise oppose the deal. The deal will also be easier to consummate after NYMEX has an IPO.

If things play out this way, then the question will become: Whither ICE? That’s a post for another day.

Great Minds

Filed under: Uncategorized — The Professor @ 9:04 am

Apropos my last post re Rosneft, yesterday’s London Times reports:

Mounting disquiet among Western investors surfaced in the City last month in a backlash against plans for a $10 billion ( £5.4 billion) flotation on the London Stock Exchange of Rosneft. Some Western institutions might be have been content that this Russian oil giant was created mainly through the controversial state seizure of the assets of Yukos, the energy group once controlled by Mikhail Khodorkovsky, the jailed oligarch. Others were not so sure.

F&C, a leading UK fund manager, delivered a bold denunciation of Russia’s dubious corporate governance regime. So long as this remained opaque and incomprehensible, investors ought to steer clear of the unacceptable risks posed by taking any stake in Rosneft, F&C said. George Soros, the billionaire investor, weighed in with a warning that the float would “raise serious ethical and energy security issues” and risked legitimising Moscow’s expropriation of key parts of Russia’s oil and gas industry.

As distasteful as it is to agree with George Soros, he’s right. (I prefer to think that he is actually agreeing with me–which he would also probably also find distasteful if he knew me from Adam’s Off Ox.) In any event, it is gratifying to note that there is increasing recognition that it is imprudent to plunk down good money in the Russian energy sector. Further, yesterday’s WSJ contained another article indicating that western investors are becoming somewhat chary of plunging into Russian equities due to concerns about transparency and buying a lemon.

Investor disquiet is playing out against a background of growing tension between the US, eastern Europe, and Russia. VP Cheney gave a blistering speech in Vilnius castigating the Russian use of energy as a weapon. Poland has expressed considerable unease at the Russian stance–and is clearly dismayed at German participation in a gas pipeline project that will bypass Poland, thereby ensuring German gas supplies while making Poland (and other EE countries) more vulnerable to Russian extortion. It brings to mind the words of the wise old Pole, Joseph Conrad, who in his perspicacious essay, Autocracy and War, wrote: “The common guilt of the two Empires [Germany and Russia] is defined precisely by their frontier line running through the Polish provinces.” Given the grim history of Poland since the early 17th century, it is not surprising that the Poles are nervous as cats when the Germans and Russians get together and pointedly leave the Poles out.

The western Europeans are also slowly coming to the realization that it is one thing to be an energy importer, but quite another to be an energy importer increasingly beholden to a state monopoly that is as much a political entity as an economic one. Gazprom is attempting to gain ownership and control of gas distribution networks in western Europe. This would put them in a position to impede entry of competitive sources of gas into western Europe, thereby enhancing Gazprom’s market power. Now of course this would also make Gazprom vulnerable to expropriation if it were to act too clumsily–those pipes in Italy and Germany are not going anywhere. It is a safe bet, however, that Gazprom investments in the EU are much less vulnerable to expropriation than western investments in Russia. The EU legal system would (rightly) make it difficult for European states to expropriate. Moreover, it is to be doubted whether any European government would have the stones to act in this way. Thus, the threat of future expropriation is not a credible response to any future attempt by Gazprom to squeeze the Europeans. To keep their strategic options open, Europe should be very leery about creeping Gazprom access and influence today–as they are unlikely to be able to resist it tomorrow. (It probably grates on them, but Ronald Reagan warned them of energy dependence on Russia in the 1980s!)

This said, it is worthwhile to remember something else that Conrad emphasized in Autocracy and War: Russia is never as strong as she looks. Right now, Putin has one card–energy–and he is playing it to the hilt. Sad to say for the many fine Russian people (friends and colleagues) that I know, Russia is painfully weak on every other dimension. It is living a demographic nightmare. Its birthrate is extremely low, and its death rate is astronomically high. Although the former may–emphasize may, as birth rates have remained low in many western European countries (e.g., Spain) despite robust growth–increase in response to the country’s emergence from the calamity of the 1990s, the latter problem appears intractible. The death rate among men in particular is beyond belief–and far outside historical experience for any developed country. The eastern part of the country–the heart of energy production–is depopulating rapidly. Overall, population is contracting at about .5 percent per year. Most economic growth is in the energy sector alone. Energy now accounts for 30 pct of GDP, and this fraction is growing. The rest of the economy is stagnating. The energy boom enriches the state and a few favored oligarchs, but has only limited benefits for the remainder of the populace. The Russian military is a hollow shell.

Putin is playing very aggressively right now, but his hand is not a strong one. Perhaps he can bluff his way to winning a big pot–the western Europeans are particularly likely victims of a bluff. But if they exhibit a modicum of backbone, and the US stands forthrightly by the eastern Europeans and facilitates the development of stronger energy ties with the central Asian republics, Putin and Russia risk another epic humiliation if they continue this strategy.

And another thing. Energy prices go both ways. Things now are similar to circumstances in the early 80s, when everyone predicted that energy prices would only rise. Within a very few years, they had collapsed. Fundamentals are different now, and I don’t forsee an imminent price collapse, but markets do correct. High prices induce entry. They may actually provide a welcome jolt of reality to nitwit Congressmen and parlimentarians and get them to remove self-imposed obstacles to enhancing energy supplies. With such an inelastically demanded commodity, every little bit can have an appreciable price effect. Betting everything on high and rising prices –as Russia is doing–is a sucker’s wager.

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