Streetwise Professor

August 19, 2008

That’s Where

Filed under: Commodities,Derivatives,Economics,Energy,Exchanges — The Professor @ 11:10 pm

In one of my earliest SWP posts, Whither NYMEX?, I pondered the future of NYMEX. Somewhat later (and in an interview on CNBC) I predicted that NYMEX would wind up in the hands of the CME. That prediction has come to pass with yesterday’s vote by the NYMEX membership to accept the CME’s merger offer. The weeks leading up to the vote saw the chest-puffing bluffing that one can expect from canny experienced traders trying to extract the most from a trade as possible, but the CME management did not budge after raising its offer to the holders of trading rights, and in the end the trading rights members meekly accepted the CME bid.

This outcome was almost inevitable given the lack of any competing bid for NYMEX. This distinguished the NYMEX bid from the CME’s bid for the CBT, where ICE made the Chicago Boys sweat. The lack of a competing bid was in no way surprising, given (a) the contract between CME and NYMEX to trade the latter’s contracts on GLOBEX, and (b) the clearly superior synergies between CME and NYMEX as compared to NYMEX and anybody else. ICE was not a player in this game because of antitrust obstacles that would have been acute particularly in the hothouse environment surrounding energy prices and the criticism that the USDOJ has faced. NYSE-Euronext wasn’t a good fit at all, and wouldn’t have offered nearly the same economies in clearing. NYMEX was also not viable as a standalone in the long run, especially given its weak technological position, doubts about its management, and Byzantine internal politics (factors discussed in Whither NYMEX.) So, when push came to shove, the members had no better option than to accept the CME’s bid.

So, now the question becomes: Whither CME? The decline in the company’s stock price has been pretty stunning, but its fundamentals are still strong. It has, however, effectively completed one phase of its strategy–and of the industry’s evolution: the consolidation of the US futures trading industry on a first rate execution and clearing platform. It can expect continued growth in revenues from growing trading volumes, especially when the credit crisis runs its course. But that organic development is not going to be sufficient to generate the profit growth capitalized even in the company’s currently lower stock price. CME will need to develop a whole new product line. The most likely candidate is OTC clearing. The acquisition of NYMEX is a step in that direction given the New York exchange’s nice OTC energy clearing business. But the big prize is clearing of OTC financial derivatives, notably credit derivatives. That is an immense market, and cracking it faces numerous challenges.

Clearing works best with homogeneous products traded in transparent markets with accurate and reliable pricing. (I have a working paper that argues that traditional impediments to risk shifting–moral hazard and adverse selection–are most acute when products are customized and heterogeneous, require specialized valuation expertise, and when there is not reliable pricing information.) These conditions are not yet met in OTC credit derivatives.

Moreover, CME will face competition in this business. The big banks are not willing to give up this lucrative business without a fight, and even if the CDS market moves to centralized clearing, the big banks have already established a clearing entity in combination with The Clearing House Formerly Known as BOTCC to vie for this business.

CME’s management will spend some time on the integration of its new acquisition, but this should be a relatively straightforward process given that NYMEX contracts already trade on GLOBEX and that there is considerable overlap between clearing memberships on the two exchanges. Once that task is complete, Donahue’s and Duffy’s real work begins–to revolutionize the management of derivatives performance risk by integrating OTC and exchange clearing.

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