Streetwise Professor

Well, it finally happened. The CME and CBOT have announced their intention to merge. On the one hand, it’s not a surprise–this tie up has been mused about for years, and there were talks of a combination in the runup to the CBOT’s IPO not long ago. On the other hand, the timing of the deal was a surprise. There was no serious uptick in rumors or conjectures about an impending deal in the days leading to the announcement.

The economics of the deal are perfectly sensible–as they have been for years. When each exchange was a membership organization, however, politics and rent seeking stood in the way of the combination. As I noted in my 2000 JLE piece on exchanges, the members of exchanges are heterogeneous, and there is considerable disparity in the rents accruing to different members. Thus, any major policy change–including a major merger–is likely to have important distributive effects that raise the cost of implementing this change even if it enhances total member wealth. Indeed, the infamously Byzantine nature of member-owned exchange governance structures is a sensible way to control rent seeking–even though it slows decision making and impedes major strategic moves.

Electronic trading eroded the rents that exchange members–notably the locals and floor brokers who dominated exchange governance–earned from their special skills. As I predicted in my JLE article, the move to electronic trading completely undermined the rationale for the not-for-profit form and member ownership. In the early 2000s, the CME and the CBOT went for profit, and had IPOs. Distributive considerations were muted as a result. The exchange owners became much more homogenous–they were all essentially residual claimants to the stream of rents thrown off by the electronic trading system. All had a common interest in maximizing the share price. This reduced the political opposition to any deal, and made the CME and CBOT owners interested in maximizing the size of the pie, rather than fighting over the division of the pieces. Under these circumstances, the compelling economics of the combination finally prevailed.

What’s next? The exchanges are publicly confident that anti-trust review will not cause problems. Perhaps that’s the case, but I would expect the deal to get some attention from DoJ. It’s a big deal, and those tend to attract attention. Moreover, exchanges have attracted little anti-trust scrutiny in the past, but with sea change in the industry, the tendency towards concentration in trading, and the prospect for further consolidation, that may change. DoJ will recognize that this deal will establish a precedent for future mergers in derivatives, equities, and options, and will likely want to make sure that it is comfortable with it.

The key will be market definition. If it’s an individual futures contract market (e.g., Treasury futures), then there’s no problem–the deal won’t increase concentration as the exchanges don’t compete head-to-head in any contract. If it’s the derivatives markets (including the OTC derivatives market), no problem–because the futures markets are small relative to the overall derivatives markets. If it’s the futures markets (i.e., not individual futures markets, but something like “interest rate futures”)–then there could be a problem.

Economically, I think that the first two are more economically sensible than the third. The third market definition presumes that different futures are close substitutes for one another. This is problematic. Different futures–even relatively related futures such as Eurodollars and Treasuries–are not very good substitutes for hedgers. They may be substitutes for some speculators, but I am doubtful that the relevant cross-elasticities are very high. Moreover, some pairs of contracts are actually complements for some speculators. For instance, traders who spread Eurodollars and Treasury note futures, or corn and live hog futures, consider these contract pairs complements. Thus, there is not a strong prima facie case that “futures” is the appropriate market definition.

The deal also sparks additional speculation about what will happen with other exchanges. As I’ve said before, it makes sense to combine NYMEX and CME. Indeed, NYMEX has some of the same attributes–and weakenesses–as the CBOT. NYMEX has a strong slate of contracts, but like the Board, does not own its trading technology. Moreover, there is another benefit to adding NYMEX to the mix–the economies of scope in clearing. Clearing NYMEX, CME, and CBOT contracts together would be cheaper, and economize substantially on margin, relative to clearing NYMEX separately from CME/CBOT.

Beyond that? CBOE+CME+CBOT? There is already cross margining on index options and index futures, so that limits the potential margin savings. Also, CBOE clears through OCC, and there will remain advantages to clearing options on individual stocks that are traded on multiple exchanges through OCC. CME+CBOT+NASDAQ? That is intriguing, and I’ll give it some further thought.

In the meantime, as a Chicagoan, and a student of exchange history, the merger is somewhat bittersweet. The CBOT has been around since 1848, and has been a world leader in futures trading since the Civil War. There aren’t a lot of American business institutions that have been around for 150+ years, let alone world leaders for over 140. The Board was the scene of many important economic events, the birthplace of many important financial innovations, and the stomping grounds for many colorful, illustrious, and sometimes infamous, characters. The CME is also a storied institution with a distinguished past, but it only came into its own in the 1960s, and particularly the 1970s and 1980s. Indeed, the CME almost died when Congress outlawed trading of onion futures–the exchange’s leading contract–in the 1950s. Thus, this represents the passing of an age, and the passing of the torch from a venerable pioneer to a relative newcomer.

Fortunately, the combined entity will utilize the CBOT’s beautiful and historic building at LaSalle and Jackson (depicted in the background wallpaper of this site), so there will be visible and enduring evidence of the Board’s contribution to the city, and a reminder of the exchange’s glorious past. Moreover, the combination will ensure that Chicago will remain the dominant force in derivatives trading for years to come. So though the name “Chicago Board of Trade” will no longer live on, its legacy will. Modern futures trading was born in Chicago. In the last 20 years the futures industry has grown dramatically around the world, but for the foreseeable “future” its home address will continue to be 141 West Jackson Boulevard, Chicago, Illinois, 60604.

Today the UN Security Council passed tepid sanctions against North Korea in response to its (alleged?) nuclear test. Not surprisingly, Russia and China led the opposition to tougher sanctions. This follows repeated Russian calls for caution in responding to NoKo actions, and is of a piece with Russia’s persistent opposition to sanctioning Iran for its nuclear program, and its former intransigence on taking action against Saddam’s Iraq.

I am sure that Moscow’s constant calls for cautious, level-headed diplomacy to deal with international tensions are of immense comfort to the denizens of the Republic of Georgia. Russia’s solicitude for the sovereignty of North Korea, Iran, and Iraq must be very reassuring. Russia’s reluctance to impose sanctions on aggressive, lunatic, and totalitarian states must imply that it would never resort to such measures when small, poor, and passably democratic nations are involved.

Oh wait, I forgot. Russia is mightily exercised at Georgia’s temerity in asserting its independence–de facto and de jure–from Moscow. It is livid at Georgia’s Rose Revolution, its desire to join NATO, its opposition to the presence of Russian troops within its borders, its desire to maintain control of Abkhazia and South Ossetia, and its outrage at Russian espionage. And perhaps most importantly, Russia is determined to stop the construction of oil and gas pipelines across Georgian territory, pipelines that would undercut Russian control over energy exports from the Caspian region and Turkmenistan. So Russia has unilaterally (no UN monkey business for Vlad) slapped punitive sanctions on the tiny Caucasian republic, using Georgia’s detention of 4 Russians on espionage charges as the pretext. It has implemented a virtual blockade of Georgia, and is beginning to round up Georgians living in Russia. The Russian economic measures go far beyond what Moscow would even contemplate imposing on Iran.

The rhetorical contrast is particularly rich. When lecturing the world on NoKo, Iran, Iraq (and Sudan, for that matter), Putin and Foreign Minister Sergey Lavrov speak in measured, diplomatic tones. Butter wouldn’t melt in their mouths. Threats are counterproductive, don’t you know. Precipitous, punitive economic actions–not to mention military force–are beyond the pale. When the subject is the “near abroad,” however, the language is blunt, brutal, threatening, and anything but diplomatic. The specter of military force is palpable.

All in all a demonstration, as if another was needed, of Churchill’s dictum that national interest is the key to understanding Russia’s often riddling, mysterious, and enigmatic behavior. Russia deems Georgia to be in its sphere of influence, to deal with as it chooses. It further deems rogue states as useful pieces to play in its efforts to stymie the United States. In brief, the contrast between its actions in the UN with respect to NoKo, Iran, etc., and its behavior in Georgia reveals clearly that Russia deems its interests to lie in absolute order and control in its perceived sphere, and disorder and chaos outside that sphere. (Chaos in energy producing regions is of special value to Russia, as it leads to higher prices of the country’s most important resource.)

As I have noted before, Russia and Putin are feeling their oats in large part because oil prices are high, and this has boosted the Russian economy. In essence, Russia is a huge long speculation on energy prices, and big speculators are often quite assertive, bold, and arrogant when the market has moved their direction. Has Putin heard of Brian Hunter of Amaranth fame (or infamy)? Or Jeffrey Skilling? They too once rode commodity prices to fame and fortune–and then crashed ignominiously when prices moved against them.

It’s never wise to confuse luck with skill, or to assume that a winning streak is destined to continue. What goes up can go down–and almost certainly will. Oil prices have already fallen about 30 percent from their peak. They are still high by historical standards, but for the first time in a long time bearish factors are exerting themselves. Putin–and Russia–have ridden a very lucky streak–two intense hurricane seasons, political turmoil in major oil producing regions, robust growth in China and the US–but recent events have not been so favorable. Growth is the US is slowing (still respectable, but slowing). China is actively attempting to tamp down on investment-led growth, and to channel resources into services (which are less energy intensive). Huge inventories built largely on anticipation of another bad hurricane season are weighing heavily on the market since the feared storms failed to appear. Vlad and Russia are still majorly long–and very vulnerable to a further price decline that is a very real possibility.

Moreover, here and there are signs of political ferment bubbling beneath the surface calm of Putin’s Russia. Putin’s term ends soon, and the succession is by no means clear. The power he has accumulated at the center is a very rich prize, and many will take extreme measures to seize it. High profile assassinations–a staple of the Yeltsin years, but less evident in Putin’s term–are back in the news. It is by no means a certain outcome, but it is very possible that a power struggle in Russia may occur at the same time that energy price declines undercut the continuation of Russia’s modest economic rebound. And Russian power struggles are not a pretty sight. Again, not to say that it’s a certainty–but it is likely enough.

Remember, Vlad–pride goeth before the fall.

I do not write this with relish. To the contrary. As I have written before, both on this blog and elsewhere, Russia has suffered more tragedy than any nation deserves. I deeply sympathize with the travails its people have suffered. I ardently hope that it can make the transition to a free, liberal (in the classical sense), civic society, but am not sanguine. After all, classical tragedy is traceable to a tragic flaw, and Russia’s tragic flaws (autocracy and imperial ambition) have never been held at bay for long. They are reasserting themselves today, and the outcome is far too predictable.

So exchange speed dating continues apace. The latest, hottest rumored couples? First, a pairing of, shall we say, “mature” singes—the CBT and LME. Second, an international glamour couple—CME and Deutsche Borse.

Pairing CBT and LME makes some sense. Both are venerable commodity exchanges. LME has a very good franchise, and is making the transition to electronic trading. CBT has made an effective transition to electronic trading (there have been a few recent technology glitches, but the grains are steadily migrating to the electronic system). Moreover, CBT has the customer base and marketing resources to vastly expand LME’s reach. There are no antitrust issues. Regulatory matters may pose something of a complication, but they should be workable.

In some respects, ICE might be a closer fit with LME; ICE is already competing head-to-head with NYMEX, which (through its COMEX division) is LME’s sole serious competitor. Moreover, ICE has a major operation in London, which could ease regulatory and operational roadblocks. However, it is doubtful that ICE could do two major deals in short order; remember it is already in the process of acquiring the NYBOT. Moreover, (pace my just previous post) ICE is already taking a lot of political flak in the US. A good deal of this may well be the result of US politicians carrying NYMEX’s water. A proposed ICE-LME combination would certainly intensify that political scrutiny.

CME-DB is somewhat more problematic. Things are complicated, as there are proposals to merge DB’s stock trading operations with Euronext. This would make the CME-DB tie up a marriage between derivatives exchanges. This would make economic sense if the integration issues are not too severe. Globex is arguably the premier derivatives trading platform in the world, and Eurex’s system is getting a little long in the tooth. (Eurex is DB’s derivatives trading arm.) Both have strong, and highly complementary, franchises, and complementary strengths in customer base and marketing.

Integration issues are a big “if,” however. On top of the normal difficulties in merging systems (see my earlier post re LCH.Clearnet) the regulatory, and especially the cultural and political, barriers may be particularly acute in this case. Part of the hangup in DB-Euronext talks is German insistence that Frankfurt retain the leading role in the partnership. It’s likely that it would make similar demands of the CME. This could be awkward and messy. (Anybody following the Airbus fiasco? If you are, would you want to be involved with a European “national champion”? Is death an option?) There might also be some interesting anti-trust issues here. I don’t see any sense to combining DB’s stock trading operations with CME’s futures business.

Some of the reporting on the potential merger suggests that this may be more of a Teutonic pipe dream than a real deal. The Wall Street Journal story on the matter states “[a]n official at one of Deutsche Borse’s largest shareholders said Friday that the deal would be a ‘no brainer’ for the company’s shareholders if the CME pays up for Deutsche Borse shares. This person speculated that Deutsche Borse’s shareholders would seriously consider a bid for the company at . . . a hefty premium of 30% to the company’s closing share price . . . of Friday.” Well, duh! Who wouldn’t take a deal where the other side overpays? The article states that the CME can afford it, ‘cuz its rich. So some DB shareholders are hoping that ze rich Amerikaner borsen will throw money at them. I hope they throw money at me too, but I’m not holding my breath.

As I’ve commented before, CME has exhibited admirable strategic discipline. Its management hasn’t let money burn a hole in their pockets. I trust that they will continue to do so, and only do a deal that makes economic sense.

A few thoughts regarding the Amaranth matter.

First, the good. A large hedge fund blows up, losing $6 billion in a matter of days, and the market just chugs along with no problems. Quite a contrast to the tumult that accompanied the demise of LTCM 8 years (to the month) earlier.

Now, that said, we shouldn’t get too complacent about this. For one thing, although the dollar value of Amaranth’s loss dwarfs that of LTCM (which lost about $2 billion in equity), the market is just much bigger today. It remains to be seen whether a fund with the same relative size as LTCM could implode without wider fallout. For another, LTCM’s problems occurred during a time of—indeed were caused by—a general financial crisis sparked by a de facto Russian default. This caused a rush for liquidity, and since LTCM was long illiquid instruments and short liquid ones, it was devastated. Its losses, combined with the fact that it was counterparty to most major financial institutions, threatened to make a bad situation worse. In contrast, Amaranth’s travails occurred during relatively quiescent times in the broader financial markets—although natural gas markets were indeed highly volatile and unsettled. It still remains to be seen whether a major hedge fund collapse in the midst of a financial crisis could touch off an acute systemic problem.

Second, the bad. The Amaranth episode proves again, as if further proof was needed, the danger of the “superstar trader” complex. Gas trader Brian Hunter reportedly made Amaranth $800 million in 2005. Whereas historically the fund had kept a close watch on its traders, requiring them to operate out of its Greenwich, CT offices, Amaranth let Hunter set up his own little empire in Calgary. Moreover, it is plausible that Hunter’s past success made the fund’s management loath to question his judgment in putting on the massive spread trade that apparently brought down the house. For you slow learners out there: big winners need more supervision and oversight, not less.

Third, the ugly. Not that we should be surprised, but the usual suspects in DC immediately leapt into action to use the Amaranth situation to justify yet again (yet again . . . ) their tiresome claim that the OTC energy markets are a threat, and that additional regulation is required. One failproof way to identify quackery is if the doctor always prescribes the same “cure” (nostrum is more like it) regardless of the patient’s symptoms. If anything even remotely untoward happens in the OTC energy markets, Drs. Feinstein, Levin, and Coleman (see, it’s not a purely partisan game) always prescribe greater oversight of electronic OTC trading platforms (read ICE) and the mandatory reporting of large OTC energy derivative positions. Possible manipulation—position reporting. Large investor loss—position reporting. Energy prices go up—position reporting. Energy prices go down—position reporting.

What, pray tell, would the CFTC have done with additional information in the Amaranth case? Since Amaranth’s positions posed no plausible manipulative threat in the immediate term (as they were 2007 gas positions) the CFTC could not have used the information to facilitate a manipulation investigation. Nor was fraud a remotely likely problem. Furthermore, CFTC is not in business to keep adults from losing money by speculating the wrong way. Perhaps the agency might have directed inquiries to Amaranth’s FCMs to determine whether the positions posed a threat to the financial viability of these firms and their other customers. Since there have been no reports that any FCM was seriously injured by Amaranth’s difficulties, however, it is unlikely that such inquiries would have led to any CFTC action that would have had the slightest effect on developments.

Even with regard to matters clearly within the CFTC’s ambit—notably, the prevention of manipulation and fraud—it is highly unlikely that position reporting is all that helpful. Position reporting might—and I emphasize might—facilitate early intervention to prevent a manipulation. As I’ve written in the past, notably in my book on manipulation (now #1,565,885 on Amazon after reaching the low-500,000s in late-August!), however, prevention is inefficient as compared to ex post deterrence. As Judge Easterbrook put it, an undetected manipulation is an unsuccessful manipulation. Highly anomalous price movements are the hallmark of manipulation. Transparent exchange prices, and prices on transparent electronic OTC platforms like ICE, provide the most reliable information regarding manipulation. Anomalous price movements—and the complaints of traders harmed by them—can trigger further inquiry to determine whether a manipulation has plausibly occurred, or is in process. Position information can be requested and obtained at that time. Why incur the cost of routinely collecting and analyzing masses of information about positions, most of which is almost completely irrelevant to detecting, deterring, or preventing manipulation? Put differently, a large position may be a necessary condition for manipulation, but it is clearly not a sufficient one. It is more efficient to utilize scarce enforcement resources to examine circumstances in which the primary indicia of manipulation—anomalous prices—are present, than to scrutinize big positions even when price distortions are not evident.

Ironically, raising the cost of doing business on transparent electronic platforms would likely force business into less transparent ways of transacting. This would reduce the availability of reliable price data that is of essence in any manipulation case.

To those who might say: “well, by the time that prices become distorted it’s too late—we need to catch these things ahead of time” I reply: just how, exactly? All manipulations are associated with big positions, but many big positions are not associated with manipulation in any way. One needs to worry about both type I and type II errors, false positives and false negatives. Raising the costs of accumulating large positions may reduce the frequency of manipulation—but it can also constrain the accumulation of large positions for legitimate business purposes. This is costly. A rifle shot approach directed at particular markets where the signs of manipulation are manifest is more efficient than a shotgun approach like that advocated by Sens. Feinstein, et al.

So I venture a daring prediction: the next time the energy market catches a cold, the flu, colitis, or any other ailment known to man or beast, the Capitol Hill Medicine Show will prescribe its Sure-Fire Senatorial Position Reporting Cure.