Streetwise Professor

After almost 8 months, the Justice Department’s Antitrust Division finally weighed in on the CME-CBT merger. And the verdict? A green light.

Here’s the press release. The DOJ’s reasoning is quite solid–and very similar to my initial take on the competitive implications of the deal. On market definition, the Feds reasonably concluded:

More specifically, the Division determined that although the two exchanges account for most financial futures (and in particular, interest rate futures) traded on exchanges in the United States:

* their products are not close substitutes and seldom compete head to head, but rather provide market participants with the means to mitigate different risks; and

* they are, absent the merger, unlikely to introduce new products that compete directly with the other’s entrenched products, in part due to the difficulty of overcoming an incumbent exchange’s liquidity advantage in an established futures contract.

Good for them, not falling for the “US futures” market definition that the deal’s opponents were pushing. It is particularly interesting that the DOJ recognizes that execution is not highly competitive due to the incumbent’s liquidity advantage.

On clearing, the DOJ didn’t buy in to the fungibility argument:

Finally, the Division investigated whether the combination might foreclose entry by other exchanges into financial futures as a result of the integration of virtually all financial future contracts into a single clearinghouse. The evidence indicates that neither the clearing agreement nor the transaction will foreclose entry by other exchanges. Indeed, the New York Stock Exchange, in connection with its acquisition of Euronext.liffe, recently announced its intention to offer futures products, and the Intercontinental Exchange (ICE), in connection with its bid to purchase control of CBOT, has publicly stated its intent to offer interest rate futures regardless of whether its bid succeeds.

In a nutshell, the Division did not base its decision on the Chicago School argument, or the efficiency gains associated with integration. Instead, it noted that integrated entry (by ICE or NYSE/Euronext.LIFFE) was a viable form of competition. This is hard to square with the earlier statement that incumbent exchanges are largely immune from entry, but the logical outcome is the same. If execution is not highly competitive (due to an incumbent’s liquidity advantage) then integration with clearing will have little impact on entry by either integrated or non-integrated exchanges. Even though the reasoning here is a little shaky, the conclusion is the right one; the arguments against “silos” were not a reasonable justification for scotching the deal.

All in all, the Division is to be complimented. There was a lot of political heat to make the opposite call, and there were rumblings in the press that they would do so. They resisted this pressure, and made the right decision. The merged exchange will have market power, no doubt. But the CBT and CME had market power before any combination, and the relevant consideration is whether the merger would have reduced competition substantially. The DOJ does not have the authority to remake the futures industry and mandate the massive changes that would be necessary to enhance competition in clearing and execution. It had the limited authority to challenge this transaction if it deemed that it would reduce competition. It was my view from the outset that it would not, and I am pleased to see that the Division arrived at the same–and proper–conclusion.

So where do things go from here? In my initial take on the ICE offer, I stated that Sprecher was essentially long an option on the DOJ nixing the CME’s offer. That option just expired out of the money. ICE will probably not go away, but in my view the only way they can win the CBT is to overpay.

The interesting dynamic here is that unlike most takeovers, many of the shareholders of the target are also customers, so price is not the only consideration; customer/shareholders have to consider the cost savings and other benefits to their businesses that the combination will provide. Given that these benefits are clearly larger in a CME-CBT tieup than an ICE-CBT deal, ICE has to do much better on price than CME to prevail. CME can always trump the ICE bid because of this cost advantage–unless, as I said, ICE way overpays. (It is likely this realization that is behind the increases in ICE stock price when its prospects for prevailing worsen, and vice versa. This also interjects a weird dynamic into valuing the deals. When the ICE prospects wane, its stock price goes up, which makes its offer look more attractive. Mind bending.)

One wildcard is that these benefits do not redound to non-customer shareholders–hence the lawsuit by a Louisiana police retirement fund. This does raise interesting questions. It is easier to establish fiduciary duty when shareholders are homogeneous, than in the present instance where they are not. When shareholders are not consumers of the entity’s services, only price should matter. CME-CBT may be a better deal for the customer-shareholders (essentially the CBT members) even though the price is lower than what ICE is offering, but it may not be a better deal for the traditional public shareholders.

The economics of the CME-CBT combination are so much more compelling than the competing ICE bid, however, that it is likely that this obstacle can be overcome (unless ICE does something really stupid and way overpays). It may require a little creative financial engineering, or perhaps a settlement of the suit, or perhaps a further increase in the CME bid, but at the end of the day the gains from trade are sufficiently large to allow a structure that makes everybody better off. Traders being traders, there will probably be a lot of posturing and denigration of the CME bid by CBT shareholders in an attempt to get the Merc to bump up its offer. There will be stories about how the CBT holders will reject the deal. I would short those stories. CME may agree to increase its offer modestly in order to appear responsive, but even if it doesn’t, I fully expect that on 9 July both companies will agree to the deal, and that it will close shortly thereafter.

When that happens, an illustrious era will end, and another era will begin. I think that this will be good for the business, and good for Chicago. The coming years will be interesting, with complex interactions between exchanges and the OTC market (and a likely blurring of the lines between the two), and equally complex interactions between global markets. Let the games begin, and keep an eye on SWP for my take on the future of futures.

The Swiss exchange SWX and the Swiss clearing group SIS have announced their intention to merge. (The data and financial transaction services provider Telekurs will be part of the merger too.) The merging firms state that the pressure to innovate, regulatory changes, and customer demands for new services are driving the need to merge. These challenges require efficient coordinated response by the clearing and execution venues, and the firms have concluded that vertical integration will facilitate this coordination. This echoes an argument that I made in my working paper on clearing silos. I also made this argument in my presentation at the CME InformationXchange in Boca Raton in March. Charley Carey of the CBOT (whom I sat next to) asked if he could, er, “borrow” this argument when defending the integration of clearing and execution in a merged CME-CBT. (This was the day before the ICE bombshell.)

It is interesting that the Swiss have moved towards the silo model at the same time that integration of clearing and execution is under assault elsewhere in Europe and in the US. It provides a clear illustration that there are strong efficiency arguments in favor of integration. Hopefully this will induce some reflection among those who only see (or purport to see) insidious anticompetitive motivations for integration. But somehow I doubt it.

Along these lines, I just read Doug Whinston’s Lectures on Antitrust Economics. Whinston’s book provides a very readable overview of the potential anticompetitive effects of tying and other vertical restraints. Even Whinston admits that these arguments are merely statements of “possibilities” that would contradict the Chicago School view that such restraints seldom have anticompetitive motivations. As such, it is very difficult to think of practical examples of these models of “possibilities.” It is also abundantly clear that these models have no bearing on the tying of clearing and execution. The only model that is even remotely relevant is that of Carlton and Waldman, and my aforementioned working paper shows that an adaptation of this model to the exchange context does not support the view that integration and tying are anticompetitive. Instead, formalizing and extending ideas first propounded on SWP, the paper concludes that integration can enhance efficiency in numerous ways–and the Swiss announcement provides a timely and powerful endorsement of that conclusion.

LSE CEO Clara Furse writes to the FT defending exchange pricing. She notes that exchange fees represent a small fraction of total trading costs–which as I have noted is exactly what gives exchanges pricing power, though Ms. Furse doesn’t make that point.

The relation between elasticity and expenditure share reminds me of a story I use to illustrate this point to my students. I am a big history buff, and in the early 1990s I made a trek to the coast of the Cape Breton Island in Nova Scotia to visit the old French fortifications at Louisburg. (I highly recommend this to all military history buffs.) In any event, in the entryway to the Visitors’ Center was a sign saying that the museum was facing financial difficulties, and requesting donations to allow it to continue operating. I went inside, and paid my admission–C$8.50. I gladly paid this sum, and thoroughly enjoyed my visit.

When I returned home to Michigan, I sat down and wrote Parks Canada a letter. I explained that Cape Breton is very isolated, and as a result it is quite expensive to take a trip there. Flying was very expensive, and the typical auto traveler would spend several days to get there, thereby incurring several days lodging expense, plus the cost of gas, mileage, etc., not to mention the opportunity cost of time. Hence, the $C8.50 visitors’ fee was a small fraction of the cost of a trip to visit Louisburg, and doubling or trebling it would increase the cost of a visit by only a couple of percent, making the demand for admissions very inelastic. I told Parks Canada that as a result, they could raise the price substantially without reducing the number of visitors proportionally, thereby raising revenue–and solving the site’s financial difficulties.

A couple of weeks later I received a letter from Parks Canada. They thanked me very much for my letter. They also said I was the only person that had ever written them suggesting that they raise fees;-)

The FT comes out foursquare for “fungibility” in futures clearing. [Is it just me, or do you get a sense of deja vu when reading that article? Is it just me, or do you get a sense of deja vu when reading that article? FT must be really impressed with its reasoning, as it repeats it word for word three times.]

In a nutshell, the FT believes that open access into clearing is a sufficient condition for competition in trade execution. Its case is a weak one. It asserts that there is “cutthroat competition” in US equities, and attributes that to the industry’s clearing cooperative, the DTCC. Well after the creation of the DTCC, competition in listed equities was very weak. The NYSE was dominant. Most of the off-exchange execution was of the cream-skimming variety. That’s better than no competition at all, but it’s hardly cutthroat. The NYSE members earned substantial rents as a result. In Europe, clearing fungibility didn’t allow the LSE to gain any headway in its foray into Dutch equities. In US futures, Eurex and EuronextLIFFE offered both execution and clearing when they attempted to go after CBOT and CME, respectively, and both failed miserably.

Competition is arguably heating up in US equities, but that is attributable to RegNMS, which effectively socializes order flow and undermines the liquidity network effect that gives a dominant exchange considerable shelter from entry. Although open access clearing probably facilitates competition in this environment, it is not a sufficient condition; additional measures are necessary to reduce market power in execution.

The strongest evidence for the FT case is US options, where the OCC operates a fungible clearing mechanism, and trading in individual options is split among several exchanges; tipping has yet to occur. This example needs further study to prove whether it is the exception that proves the rule that competition in execution is highly imperfect, or whether it shows that execution in fact can be highly competitive.

A key issue here is payment for order flow. Option exchanges pay for order flow. This may reflect underlying factors that make the US options market unrepresentative of what might happen if clearing fungibility is extended to futures.

Payment for order flow can arise from excessive tick sizes. Too large a tick can impede competition for liquidity. It can serve as a price floor that supports more trading venues than would exist in its absence. That is, it can dull the tipping effect. The move to pennies will provide an interesting test of this hypothesis.

Payment for order flow can also arise when some order flow is uninformed. Payment for order flow can serve as a cream skimming mechanism; market makers rationally pay for order flow that is verifiably uninformed Basic microstructure theory shows that multiple cream skimming trading venues can exist. Thus, although theory suggests that order flow that is not verifiably uninformed will tip to one trading venue, verifiably uninformed order flow will not tip, and may be served by multiple venues.

There needs to be more detailed study of the US options example before it is used as the basis of regulatory and anti-trust intervention into the organization of futures trading.

There is one major reason to doubt that competition in futures execution is likely to be cutthroat even given open access to clearing. If clearing is truly a natural monopoly (as the FT argument implicitly assumes), then a dominant clearinghouse (such as the CME) would like to encourage competition in execution, not discourage it–this would allow it to make more money from its monopoly clearing operation. Clearing and execution are complements. The derived demand for the putative clearing monopolist is higher, the lower the cost of execution. Competition and entry in execution reduce execution costs, so the clearing monopoly would encourage it. However, if execution is not highly competitive, integration between the clearing and execution venue can improve efficiency. Thus, if the FT is correct, the CME would have no incentive to tie clearing and execution–but the CME is a diehard defender of tying. Either the CME is stupid, or the FT is wrong. Any guesses where I place my bet?

This is the old Chicago School argument that vertical restrictions are likely to have an efficiency rationale, rather than an anticompetitive one. I still have not seen a convincing refutation of the relevance of this argument to futures trading.

I should also note that although “non-profit cooperatives” sound like wonderful things, they can often be an effective way of exercising market power. After all, the NYSE was a non-profit cooperative for years–and ran a restricted entry cartel. My working paper on clearing shows that a user-owned clearing cooperative can be efficiency enhancing, or it can be an incredibly effective way of cartelizing the brokerage business. Moreover, even if the clearing cooperative avoids the dark side, and prices services at cost, if my surmise is correct that competition in execution is highly imperfect, all this will do is transfer rents to the dominant execution venue. The LSE–which gets clearing services from a user-owned entity, but which has the highest margins of any equity exchange in the world–is a great example of that.

So, all in all, I am less than persuaded by the FT’s argument–no matter how many times they repeat it. The case for remaking the futures business with the blunt tool of antitrust is far from made.

In FI magazine, Galen Burghardt makes a good point:

This may be a good time to reflect on the influence that the electronic revolution has had on the costs of trading, and consider asking the exchanges to make drastic reductions in their minimum tick sizes. Now that the locals have been taken out of the equation of exchange decision-making, all major stakeholders— traders, hedgers, exchange shareholders, and brokers—would stand to gain enormously from such reductions. It would be a win/win/win situation.

It is indeed something of a puzzle that demutalized exchanges have not reduced tick size. As I have noted before, the demand for exchange services is a derived demand. The higher the price/cost of complementary services, such as liquidity supply, the lower the demand curve for exchange services–and hence the lower the fee that the exchange can charge. By reducing tick size, an exchange will reduce the price that liquidity suppliers charge; if the tick size is currently binding, the marginal cost of liquidity provision equals the tick size, and competition between potential liquidity suppliers dissipates any profit they could earn by resulting in queuing of orders and a commensurately lower probability of execution of a limit order. By reducing the tick size, the exchange reduces the marginal cost of liquidity, and raises the derived demand for its services. It can profit from this by raising its fee.

Thus, it is not quite the win-win-win Burghardt suggests; any decline in liquidity costs that results from a reduction in tick size will be offset in part by an increase in exchange fees. There is also a cost issue–lower tick size is likely to lead to more message traffic as more orders are entered and canceled. So exchanges will have to bulk up capacity to deal with a lowered tick.

Given the pressure on exchanges to generate earnings, it is surprising that they have not been more aggressive in exploiting this strategy. Perhaps the penny tick experiment in equity options will convince futures exchanges to take the plunge and reduce tick size. Message traffic has not overwhelmed the options exchanges, and the penny experiment seems to be generating a big uptick (no pun intended) in volume.

Holman Jenkins wrote a blistering article (subscription required) on the all-too-typical inanities of market definition in anti-trust. He didn’t mention CME-CBT, but as I wrote on the day the merger was announced, market definition will be the key issue. I know with near metaphysical certainty which market definition is the wrong one–the one that is most often cited by opponents of the deal, namely “US futures.” One can only hope that Jenkins’s cynical view of the antitrust authorities (namely, that they rig the definition of markets in order to permit them to file cases so as to justify their existence) isn’t confirmed by the Justice Department in the exchange merger case. There is virtually no economic rationale for the US futures definition, but it is the only one under which it is possible to challenge the merger. If Justice uses that definition, it will go a long way to validating Jenkins’s cynicism.

The debate over exchange competition and mergers–and the CME/CBT merger in particular–continues to percolate. I’ve commented on several aspects of this debate, but other remarks are in order.

Further my previous musings on elasticities of substitution between CBT and CME products. I’ve opined that they might be negative (due to spreading). I’ve also opined that even things like Treasury futures and Eurodollar futures are unlikely to be close substitutes due to the non-negligible basis risks. But upon further reflection, I believe there is another even more important factor.

Specifically, the demand for an exchange’s services is a derived demand. That is, futures traders demand a bundle of services–liquidity, brokerage, clearing, execution, etc. Of this bundle, liquidity costs (e.g., price impact costs) are probably by far the biggest. Exchange fees represent a relatively small fraction of the total cost of a trade.

This is exactly what gives exchanges pricing power. If the exchange’s fees represent say 5 percent of the total cost of executing a transaction, if an exchange doubles its fee, the cost of trading goes up by 5 percent. Thus, the demand for an exchange’s services is very own price inelastic. Hence the ability of exchanges to earn such nice margins–this inelasticity gives them considerable pricing power.

This also has important implications for cross price elasticities. For instance, if the CBT halved its trading fee on Treasuries in an attempt to attract business from the CME, the cost of trading Treasuries would fall by about 2.5 percent (again assuming that fees represent about 5 percent of the cost of a trade.) Thus, in this example, the cross price elasticity for CBT/CME services is about 2.5 percent of the cross price elasticity (taking ALL costs into account) between Treasuries and Eurodollars. Thus, if I am correct that the “gross” cross price elasticity (taking all costs into account) is small to begin with due to basis risks and spread trading, the cross price elasticity relevant for evaluating the competitive effects of a CME-CBT merger is far smaller. Even if the gross price elasticity is somewhat larger than I conjecture (and positive), the effect of the fact that exchange fees represent a relatively small fraction of total trading costs tends to make the relevant cross price elasticity small nonetheless. Small cross price elasticities drastically attenuates the “static” competitive effects of the merger of exchanges trading non-overlapping product sets.

There is one case where exchange fee cutting did appear to be decisive–Eurex vs. LIFFE in 1998. A couple of points. First, this involved competition in identical products–no basis risk or spreading considerations. This is not relevant in evaluating the CME-CBT merger. Second, LIFFE made key strategic errors that are unlikely to be repeated in the future. In particular, it did not respond to the Eurex price cuts, whereas such inaction is unlikely in the future. Anticipating a quick response to price cuts, an exchange is unlikely to initiate a round of price cutting. Third, due to the rough parity in other trading costs, the Eurex price cut was sufficient to induce tipping, meaning that the effect of the price cut was exaggerated. This is not likely to happen in competition between different products. For instance, a CBT price cut is not going to cause all volume to leave Eurodollars.

Thus, in my view, cross price elasticities between CBT and CME products are likely to be quite small, meaning that the “static” competitive implications of the merger are likely to be quite benign.

Now consider the impact of the merger on innovation. John Lothian opines that the merger would reduce competition to innovate. This is a complicated issue, but I respectfully disagree that innovation will suffer, or that if efforts to innovate do in fact decline, that this is necessarily inefficient.

I should note that there is little agreement among economists about the effect of market structure on innovation. Profitability is what provides the incentive to innovate. Reduction of competition through merger does not attenuate this incentive, and may strengthen it.

I don’t believe that a CME that absorbs the CBT will rest on its laurels, and feel no need to innovate. Indeed, the high CME stock price clearly capitalizes the stock market’s expectation of high cash flow growth. This growth is unlikely to result from volume growth in existing products alone, as healthy as this growth has been. Pleasing the god of the street will require growth from other sources–new products. The CME is like a pharmaceutical company that needs to keep its pipeline full. The stock market will punish the CME if it fails to do so. This will tend to concentrate management’s minds and keep them on the hunt for new products.

Moreover, even if one believes that more competitive market structures are more conducive to innovation, in the modern electronic trading era, in which foreign exchanges (absent regulatory barriers) can offer products in US markets (and vice versa), and in which global financial firms trade on exchanges around the world, the relevant market is the world market. Looking at the US market share of a combined CME-CBT entity is inappropriate in this regard. From a world-wide perspective, the increase in market share (or the Herfindahl index) resulting from the merger would not typically present anti-trust concerns.

It must also be remembered that the winner-take-all nature of exchange competition can mean that competition to create new products can be inefficient. The winner of the competition earns a rent. As in patent races or land rushes, competition to earn the rent can dissipate it, creating a social cost of approximately the same magnitude as the rent. Thus, competing firms can spend too much on innovation. (More innovation, or more expenses spent on innovation, are not always better. There can be too much innovation, or too much spent on trying to develop new products.) Perhaps counterintuitively (to most folks) softening competition can actually improve welfare.

Against this is a good point that Lothian raises. Specifically, nobody knows exactly what the right design for any futures product should be. Everybody agrees that credit derivatives are the Next Big Thing for exchanges. But nobody agrees on what the “right” credit derivative product design should be. Having more exchanges experimenting with different designs increases the likelihood that one of them will be close to optimal. Losing a “laboratory” through merger may reduce the odds of finding the Goldilocks design. Note, however, that exchanges can revise their contracts if they don’t appear well-suited to market needs. Also, at the risk of being repetitive, due to the rent at the end of the rainbow for the winning exchange, exchanges may spend excessively to find the product that is Just Right.

All in all, I am skeptical that the CME-CBT merger will appreciably reduce innovation. Moreover, given the nature of liquidity (and the consequent winner-take-all nature of exchange vs. exchange battles for market share in a given product type), dissipative (“excessive”) rent seeking competition between exchanges is a real concern. Given these circumstances, I do not believe that concerns about the impact of the merger on innovation can provide a firm basis for blocking it.

Today from Reuters:

IntercontinentalExchange Inc.’s (ICE.N: Quote, Profile, Research) bid for the Chicago Board of Trade may have been fomented by a broker backlash against the potential power of a combined CBOT Holdings Inc. (BOT.N: Quote, Profile, Research) and original suitor Chicago Mercantile Exchange Holdings Inc. (CME.N: Quote, Profile, Research).

Atlanta-based ICE, virtually unknown in the futures business just a few years ago, stunned the industry in March with an unsolicited bid that would give CBOT shareholders a majority stake in the combined company.

Banks that are among the largest futures players have signed on to advise ICE, whose innovative proposal for CBOT has at the least created a roadblock to the consummation of a marriage between the two largest U.S. futures markets, each of which has called Chicago home for decades.

“ICE may be getting support from some some of the brokers who were critical of the CME-CBOT deal,” said Keefe, Bruyette & Woods analyst Richard Herr. “The development of ICE’s bid for CBOT speaks to a further intensification of the brokers versus exchanges.”

Last week ICE said that UBS AG (UBSN.VX: Quote, Profile, Research) and Societe Generale (SOGN.PA: Quote, Profile, Research), parent of brokerage Fimat Group, had joined Morgan Stanley (MS.N: Quote, Profile, Research) as co-advisers in its offer for CBOT, which is the parent of the No. 2 U.S. futures exchange.

Oh now I remember. I advanced this hypothesis the day the ICE deal was announced.

Although the Reuters story focuses on “brokers”–implying FCMs–it is also important to emphasize the point (raised somewhat parenthetically in the story, he said parenthetically) that these FCMs are arms of big banks that dominate the OTC derivatives market. Methinks that the OTC desks of the big banks is where the real source of the opposition lies.

The story quotes a FIMAT exec providing a rationale for the FCM/bank opposition to the merger:

“Separately, both the CBOT and CME already have virtual monopolies for most derivatives contracts they offer to the public,” wrote Fimat general counsel Gary DeWaal in a November editorial in the Financial Times.

“Naturally the new entity would have significant pricing power and … unparalleled power effectively to inhibit real competition.”

I agree completely with the first statement. The second one is highly arguable, and depends on implicit assumptions that are highly dubious. Merging two monopolies would increase pricing power only to the extent that the monopoly products are substitutes (in which case the businesses aren’t really monopolies–hence something of a contradiction in Mr. DeWaal’s reasoning). I have seen no explicit estimates of cross-elasticities of demand for CME and CBT products, but doubt they are large, and suspect they might not even be positive. That is, as I have pointed out before, it may well be the case that the products traded on the two exchanges are complements, rather than substitutes. (This would imply negative cross-elasticities). This is because the exchanges’ products are traded in spreads (e.g., Treasuries vs. Eurodollars, corn vs. live hogs). In this case, the exchanges will engage in double marginalization/markup because neither takes into account the impact of its pricing on the sales of the complementary product. Merger would actually improve the efficiency of pricing in this case. Add in the effect of cost savings, and the welfare improvement resulting from the merger could be large indeed.

In any event, its good to see that the press is finally catching onto the possibility that support for the ICE effort is not all Mom and Apple Pie, but likely reflects the very intense commercial interests of large financial players looking to protect their own turf.

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.