Streetwise Professor

ICE posted its presentation outlining its case for the CBT merger. Reading it raises the question (always central to economists): “Compared to what?”

In brief, ICE makes the case that a CBT-ICE combination would reduce costs and achieve some netting benefits in clearing. This is likely true–compared to a no-merger scenario. But that’s not the relevant comparison. The relevant comparison is to the competing offer on the table from the CME. IMHO, for every category (notably technology, clearing, and OTC potential), CME-CBT is almost certain to dominate the ICE-CBT. This is especially true with respect to clearing and OTC prospects.

ICE does offer some bangles that may be attractive to the CBT’s owners: a pledge to maintain the floor and an open ended commitment to fight for the retention of CBOE exercise rights. The former pledge has a sentimental appeal, but is unlikely to be decisive since even the ag markets are going electronic. The latter commitment is not particularly credible.

CME surprised me by not budging on price. There is an interesting poker game going on here. Is CME bluffing? Probably just being smart. They have the option to up their offer later if it looks like things are running against them. I think they have a stronger case on the merits that the CME-CBT combination will offer more value. If that case seems to be prevailing, why bid against yourself? Conversely, if it appears that it’s all about the Benjamins at the front end and the CBT holders look like they are about to okay the ICE deal because of the higher price, CME can jack up its offer and throw a monkey wrench into ICE’s plans–turnabout being fair play.

One key issue is the clearing piece, and particularly the ability of ICE to scale up NYBOT clearing to handle the substantial increase in business that a CBT merger would bring. ICE announced plans to increase NYBOT clearing capacity (subscription required) by a factor of 10. This is an admission that NYBOT’s clearinghouse currently is not up to the task. It’s not just about systems though. It’s also about people (management especially) and financial soundness. Ramping up scale like this is not a trivial task, and ICE can say what it will about its success in integration with IPE and NYBOT, but this is a whole different level of expansion, and ICE didn’t even own/operate IPE clearing (which was/is done by LCH.Clearnet). Missteps are almost inevitable. It would also be interesting to see how the credit agencies would rate an ICE clearinghouse if it succeeds in buying the CBT. Somehow I doubt that they would rate it as highly as the CME’s, due to both operational and financial risk considerations. The CME clearinghouse has a proven track record operating at the scale and in the products of the merged CME-CBT entity. ICE/NYBOT does not.

This raises another question. Heretofore all of the discussion of regulatory issues has focused on the DOJ. However, given the CBT’s prominent role in the Treasury market, it seems likely that the Department of the Treasury and the Federal Reserve (especially FRBNY) are taking special interest in how this plays out. I would imagine they have concerns about any transaction that would raise performance (and hence systemic) risks; movement of CBT contracts to a new clearing platform that arguably poses greater operational and financial risks would naturally raise such concerns. I don’t know what explicit authority DOT or the FRB would have to get involved, but I am sure that they can wield a lot of “soft power” even if they don’t have explicit jurisdiction.

As Yogi said, it’s not over ’til it’s over. In my mind, however, ICE has only one way to win the hand–if the DOJ opposes the CME bid. As I said in my original post on the merger, the stakes in the game are big enough for ICE to ante up to see if that card gets dealt. If it doesn’t, I would expect them to fold rather quickly and the CME to walk away with the pot.

One article about the ICE initiative suggests the possibility of a three way–CME+CBT+ICE. This is an intriguing possibility. As I noted in the previous post, the benefits of an ICE-CBT combination are underwhelming, but adding ICE to the CME-CBT combo would add additional savings to the already large benefits of the latter combination.

If this does happen, NYMEX would be in a very tenuous situation. I have been somewhat skeptical of NYMEX’s strategic situation. In particular, NYMEX does not own its technology. Pushed by ICE, it ran into the arms of the CME. The move to Globex turned out to be a win-win for the two Mercs. But if the CME combines with ICE, NYMEX is in a world of hurt. I doubt it would be feasible (especially given its technology track record) to build a credible electronic platform on the fly, and would have to partner up with another exchange (e.g., Eurex or EuroNext), and right quick too. Its negotiating position would be pretty weak, although it could potentially play Eurex off against EuroNext/NYSE.

It’s hard to figure out what the market thinks of this possibility. Even before this all hit, I thought NYMEX was overvalued, but its stock went up 8 percent on the ICE announcement, and has held onto most of that gain. In contrast, ICE stock jumped up on the news, and then went down by almost the same amount by the end of the day. Indeed, it is now trading below the pre-announcement price. (CBT stock is above the pre-announcement level, but off its high.) I conclude that the market’s collective judgment is either that an ICE-CME tie up is unlikely, or that if successful this would make NYMEX a takeover candidate. Expanding on the first alternative, NYMEX’s strong stock price performance could suggest a market view that however things work out, the ICE endeavor divert its management’s attention and resources away from energy, thereby taking some of the heat off NYMEX. It is ironic, however, that the stock of a seeming bystander has done so well as a result of ICE’s move.

Little did I expect upon going to sleep last night in Boca Raton after participating in a CME-sponsored panel on the CME-CBT merger that I would awake to a reporter’s call this morning with the news of ICE’s unsolicited offer for the CBT.

Here are my initial thoughts on the situation.

First, the economics of a CME-CBT tie up are considerably more compelling than those of an ICE-CBT merger. Far more participants trade far more volume of some combination of Treasuries, Eurodollars, S&Ps and Dow than trade Treasuries (or grains/oilseeds) and coffee, sugar, cocoa, cotton, OJ or Brent Crude (ICE Futures key products).

From an operational perspective, this means that whereas a CME-CBT combination would allow many traders to use one screen, one system, one connection, and one point of contact, with ICE-CBT most traders will continue to have to deal with two systems, two screens, two connections, and two points of contact—just as they do today. Indeed, operationally things will be more complex as they will have to deal more extensively with two clearers, rather than just one.

From a clearing perspective, the potential margining and risk management benefits from joint clearing of CME and CBT products are self-evidently superior to those that could be realized from a CBT-ICE tie up. This is because the CME markets are bigger; the spreading between CME and CBT products more prevalent; and the pool of traders who participate in both markets larger. I don’t recall the industry clamoring for years for joint clearing of CBT and CSCE or NYCE products (CSCE and NYCE being NYBOT/ICE Futures predecessors); they were clamoring for a CME-CBT clearing link that was eventually established after years of back and forth. There was a good reason for that. The savings from the CME-CBT clearing link were—and are—clearly much larger than a CBT-anybody else clearing link. Moreover, CME has a real chance of making inroads into OTC clearing, which would create other scope economies and increase competition in that market. I don’t think ICE has any realistic chance at doing the same.

Moreover, from a systemic risk perspective, CME’s clearinghouse is financially stronger than NYBOT’s, has experience in operating at immense scale—scale that dwarfs what NYBOT handles—and sees a bigger part of the market than a ICE-CBT clearing operation would, meaning that a CME-CBT clearing operation would have a better picture of overall risk exposures.

Second, ICE is already undertaking an integration process with NYBOT. Near simultaneous integration of another, far larger, exchange, is problematic. See my earlier post re the LCH-Clearnet integration fiasco if you need reminding how integration issues can bedevil seemingly sensible deals. Since CME already clears CBT, a good part of the integration battle is already completed there. Moreover, Globex is a proven, scalable platform already used by most CBT participants, so migrating CBT contracts to Globex should be less difficult than migrating them to ICE.

Third, with respect to competition: As I noted in my October 2006 post on the merger, how one views the competitive impact of the CME-CBT deal depends on how one defines the market. If one defines the market as “futures” the CME-CBT merger leads to a substantial increase in concentration—far greater than a ICE-CBT combination. However, I think this is the least defensible market definition. Under a narrower definition—i.e., by product line, such as Treasuries or STIRs—the merger doesn’t increase concentration, as the respective exchanges already essentially have monopolies in these products. Moreover, if you are going to define the market as “futures” there is no reason whatsoever to stop there—you should expand the definition to include OTC derivatives (e.g., vanilla swaps). Indeed, in the case of the CBT, cash Treasuries should also be considered; one can create forward positions that are close substitutes for a futures contract through repo transactions. Nor should you just define the market as the US, as the futures business is increasingly global and with electronic trading location doesn’t really matter that much any more.

Many that I spoke to at Boca believe that a combined CME-CBT entity would have far more pricing power than the two exchanges do separately. Again, I am highly—emphasize highly—skeptical. Each exchange already has a dominant position in its own products, and is pricing its services accordingly. Moreover, as the Euronext and Eurex entry attempts demonstrated, the Chicago exchanges know how to defend their turf against new competitors. Entry leads to initial price cutting, but the eventual success of one exchange. Knowing this, potential entrants are likely to remain merely potential, and incumbents will continue to charge high fees unless and until some brave soul decides to trust to hope rather than experience. And the survivor will raise fees again when the loser (most likely the entrant) exits.

[Random thought: why is ICE trying to buy one dominant exchange, rather than competing with it head-to-head? What does that say about the feasibility of competitive entry?]

In my view, CME is not pricing its services now to deter a CBT threat in Eurodollars, nor is CBT pricing to deter a CME threat in Treasuries. Nor where they doing that before Terry Duffy and Charlie Carey met for dinner at Gene & Georgetti’s that fateful October night. They will cut prices when there is a real competitor to ward off, and not before. (The economics/industrial organization/game theory literatures have long recognized that potential competition is likely to have little effect on prices, except under special and arguably unrealistic assumptions about ability to adjust prices like those made in the contestability literature.)

It should also be noted that if—as has been suggested—the integration of execution and clearing in a single exchange is the impediment to competition (again something I dispute), the ICE deal is no different than the CME deal, as each involves an integrated clearing and trading operation.

Managing market structure through merger policy will not appreciably impact the competitiveness of the execution business in futures markets. Only something that radically socializes order flow—as the just implemented RegNMS does in securities—will have this effect. (Perhaps saying “mandating a centralized open access liquidity pool” is a less provocative phrase than “socializing order flow,” but they amount to the same thing.)

Absent the creation of an open access central limit order book for futures, or its near equivalent (a la RegNMS), the tippiness of order flow, and the difficulty of coordinating the simultaneous movement of order flow to a new exchange, give the incumbent execution venue decisive advantages. (An earlier post suggests that algorithmic trading may virtually link markets and socialize order flow, but this is still a possibility not a reality). Only stupidity (e.g., LIFFE c. 1998) or a refusal to adopt new trading technologies (e.g, LIFFE again, and almost NYMEX last year) gives an entrant a fighting chance.

Put differently, anti-trust policy generally, and merger policy in particular, are extremely blunt tools that, in my view, are not suited for improving competitiveness in derivatives markets, but may well impede the realization of important efficiencies. Thus, in my opinion, derailing a CME-CBT merger would not appreciably improve competition in the futures markets, but could deprive the marketplace of important operational, credit, and systemic efficiencies. For those who want to improve competition in futures in the worst way–well, scotching the CME-CBT deal would be it.

For historical reasons, derivatives markets have not experienced the same disputes over market structure that have raged for decades (three and counting) in the securities markets. Only a dramatic change in regulatory policy carried out under authority granted to the SEC by Congress, and implemented only after years of controversy, has begun to reshape the competitive landscape in securities—and even there, it is still to early to determine whether these changes will dramatically improve competition. If futures market participants are really concerned about competition, they had better be prepared for far more drastic measures than preventing this merger or allowing that one. DOJ is incapable of doing the heavy lifting with the tools at its disposal.

I hate to say I told you so, but, well, I can’t resist. At the start of the demutualization wave in the late-1990s and 2000-2001 I opined (in writing, and at conferences like one sponsored by the Chicago Fed in 2001 or early 2002, I forget which) that by becoming more like ordinary firms, futures exchanges would become subject to the same antitrust scrutiny as ordinary firms in other industries. I don’t think this message resonated then. Regardless of what DOJ does now, however, it will soon become conventional wisdom.

I should also note that I believe that the uncertainty surrounding what DOJ will do, and the recent stories to the effect that DOJ was moving to challenge the CME-CBT deal is what precipitated ICE’s move five months after the initial merger announcement. ICE is essentially long a call on what the DOJ does—if DOJ blesses the CME-CBT merger, the call will almost certainly end up out of the money because CME will win any bidding war. But if DOJ challenges the merger, or imposes unpalatable conditions (especially involving clearing) the call will be in the money. I’d put the option at the money now—and at the money calls are acutely sensitive to volatility. Uncertainty about DOJ is creating the volatility, making this a canny move by ICE. It is buying vega (or lambda, for you Greek purists) on the cheap.

A couple of final thoughts.

Both ICE and CME are impressive exchanges that are technically progressive. ICE was a technology leader from the get go, by design. CME has also been a technological leader (especially by comparison with other traditional exchanges), but only after demutualization did it fully unleash its technological prowess. Hence, from an innovation prospective, the market would do well regardless of whether CME or ICE ends up owning the CBT at the end of the day.

And lastly something more provocative—and completely conjectural/speculative. We know that the main opponents to the CME-CBT merger are the major bank/investment bank/FCMs. We also know that a couple of same are major investors in ICE. Could it be . . . ? Just sayin’. No concrete evidence, but some interesting conjectures pop into my Machiavellian mind.