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.