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.