Streetwise Professor

April 5, 2007

I Swear I Read This Someplace Before

Filed under: Commodities,Derivatives,Exchanges — The Professor @ 8:22 am

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.

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