Streetwise Professor

May 10, 2006

Merc + Merc

Filed under: Commodities,Exchanges — The Professor @ 11:41 pm

After earlier negotiations went nowhere, the Chicago Mercantile Exchange and the New York Mercantile Exchange entered into an agreement whereby NYMEX contracts will be listed on CME’s Globex system and traded side-by-side with the NYMEX open outcry markets. This followed a brief interval in which NYMEX tried to convince an apparently skeptical (and probably justifiably so) marketplace that its legacy electronic systems (Access and ClearPort) were up to the task of staving off ICE’s challenge.

As I noted in my February post “Whither NYMEX,” the NY exchange was vulnerable due to its technological weaknesses, and viewed in that light the deal makes perfect sense. I surmise that NYMEX played hardball in the initial negotiations, and the CME walked. CME then played its cards perfectly, announcing that it intended to offer energy futures of its own on Globex. Already having its hands full with ICE, NYMEX was in no position to tangle with the biggest kid on the block, so it did the prudent thing and combined with the CME.

NYMEX did what it had to do, but the deal is a coup for CME. It gets a nice revenue stream (with very little additional cost) from an established franchise, whereas competing with NYMEX would have been expensive (with marketing expenses, likely fee waivers, etc.) and of uncertain outcome.

Is this the end of the story, or just the beginning? Methinks the latter. There is a potential double-sided opportunism problem here. CME has the technology. NYMEX has the contracts. They have entered into a contractual relationship whereby they share these assets. If Globex trading of energy contracts takes off, as is reasonably likely, each party is in a position to hold up the other. It is very possible that we will see haggling over fees, threats to walk from the agreement, and so on.

How can these problems be forestalled? Merger. A combination would economize on the transactions costs inherent in the double-sided holdup problem. It could also result in some cost savings, especially on the clearing side.

Whether or not this will occur will depend on how electronic trading fares. If my conjecture that electronic trading of NYMEX energy contracts will take off is correct, the deal is almost imperative. Moreover, such a development will undermine the strength of the floor community who might otherwise oppose the deal. The deal will also be easier to consummate after NYMEX has an IPO.

If things play out this way, then the question will become: Whither ICE? That’s a post for another day.

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