Streetwise Professor

April 6, 2011

The Battle of Silo Continues*

And now on two fronts, as it were.

The battle over the “vertical silo” (i.e., vertically integrated in econspeak as opposed to bizspeak) approach to execution and clearing remains under assault in Europe:

European Union states want to extend a draft law curbing risk in privately negotiated derivatives to the whole sector, which could ultimately dent profitability of the world’s first mega bourse merger.

. . . .

But banks say the merged group should be opened up to clearing competition. Extending the law’s scope to regulating listed as well as OTC derivatives would achieve this goal.

It would make it easier for users to clear listed contracts transacted on Deutsche Boerse or Euronext’s LIFFE derivatives platform elsewhere and not be locked into the group’s clearers.

“The inclination among OTC derivatives fans like us is ‘why differentiate between one derivative and another?’,” said David Clark, chairman of the Wholesale Markets Brokers’ Association.

“The big deal in all this is the competition element with Deutsche Boerse. This move to extend the scope of the draft law has got politics written all over it,” Clark said.  [Politics?  Whoda thunk?]

. . . .

Exchanges sense integrated business models are under threat.

“Some are trying to weaken vertical structures by creating clearing links with other structures. That creates systemic risk and shifts focus away from the real issue of dealing with OTC derivatives,” an exchanges industry official said on condition of anonymity due to the sensitivity of the issue.

The battle between the “verticalists” and “horizontalists” in clearing is a decade old and has never resolved, with the same two countries pitted against each other today as back then.

“Verticalists” and “horizontalists”?  Sounds like something out of Swift.  Count me as a verticalist–or more accurately, a marketalist.  That is, that this is something best left to market processes rather than legislation and regulation.

Now a battle on vertical integration is evidently brewing in the US too.  At least in the eyes of some market analysts, ICE’s CEO Jeffrey Sprecher is worried that a horizontalist, non-marketalist US Department of Justice may condition acceptance of a NASDAQ-ICE-NYSE-EuronextLIFFE merger on opening up of the derivatives clearinghouse (from Bloomberg: no link yet):

IntercontinentalExchange Inc. may drop out of its joint bid for  NYSE Euronext if the U.S. Department of Justice raises concerns about the deal’s combined futures business, Sanford C. Bernstein & Co.’s Brad Hintz said.  ICE, the second-largest U.S. futures market, and Nasdaq OMX Group Inc. made an unsolicited offer for NYSE Euronext last week, valued at $11.3 billion, countering Deutsche Boerse AG’s February offer for $9.53 billion. In the proposal, Atlanta-based ICE would take NYSE’s Liffe futures-trading markets, expanding in Europe. New York-based Nasdaq OMX would take NYSE Euronext’s listings, equity and options units.

ICE and CME Group Inc., the world’s largest futures market, own their own clearinghouses, which may create barriers to entry and be anti-competitive, the U.S. Department of Justice said in 2008. Equity and options exchanges –such as those owned by NYSE Euronext and Nasdaq OMX–use centralized  clearinghouses like OCC that aren’t owned by any one market.

“The most important issue facing these competing offers is the possibility that the ICE/NYSE Liffe merger will resurrect DOJ concerns with vertical integration of futures execution and clearing,” Hintz, an analyst at Sanford C. Bernstein in New York, wrote in a e-mailed note today. “If this issue arises ICE will likely drop out of the bidding and the Deutsche Boerse deal moves  forward.”

Yes, be afraid.  Be very afraid.  I have the sense that the DOJ’s Antitrust Division is itching to attack vertical integration in derivatives, the economics be damned.

* This perhaps corny (perhaps?) title was inspired by my recollection that today is the 149th anniversary of the first day of the Battle of Shiloh.  Two of my great-grandmother’s brothers fought in the battle: Eli and John, who served in the 46th Ohio Volunteer Infantry.

Eli was something of what is called a “Jonah” in the Navy–a hardluck guy.  He was captured at Shiloh, and held in a prison camp in Montgomery, AL for a couple of months.  Exchanged, he returned to Ohio.  He claimed he was unable to return to his regiment because of dysentery contracted during his imprisonment.  His military record includes a note from his family doctor, believe it or not.

His efforts to stay home were unavailing, and he was ordered to report to his unit.  He returned to the 46th shortly before the Battle of Chattanooga.  He proceeded to lose his belt and cartridge box, for which he was dunned $10 pay.  He was then assigned duty as a wagon driver–probably not an endorsement of his soldierly qualities.

Maybe he straightened out, or the need for infantrymen was pressing, for he was in the ranks again for the Atlanta Campaign.  Unfortunately for him.  He was shot in the left arm close to the shoulder joint at the Battle of Dallas, GA, 28 May, 1864.  The surgical record indicates that the regimental doctor performed a resection of his left arm, removing the bone from the shoulder to the elbow.  This surgery was required because the ball struck too close to the joint to amputate.

My great-grandmother told my grandfather that “Uncle Eli had a dead arm.”  His arm dangled uselessly at his side, and my great-grandmother remembers him using his right hand to lift up his left to rest it on the dinner table.

John, on the other hand, served without incident or injury from October, 1861 to the muster out of the regiment in July, 1865.  Pretty amazing, given that the regiment fought at Shiloh, the Siege of Vicksburg, Chattanooga (the storming of Tunnel Hill, the bloodiest part of the battle), the Atlanta Campaign (including the Battle of Atlanta on 22 July, 1864), the March to the Sea, and the Battle of Bentonville.  One lucky brother, one unlucky.

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  1. It would be inequitable for the DOJ to block ICE from creating a vertical whilst leaving the mammoth vertical of CME in tact, with whom ICE would be competing. Surely ICE would have reasonable grounds for a legal challenge on the basis that if the DOJ are to impede their corporate activity then they must consistently apply this policy and require the unbundling of trading and clearing (or demerger of the activities) at CME.

    Comment by John Wilson — April 6, 2011 @ 2:28 pm

  2. @John–I agree it would be inequitable, and that could well prove decisive in dissuading the ATDDOJ from challenging the merger on those grounds. That said, never say never. They have an opportunity to review a merger in ways they don’t have to challenge existing structures.

    The ProfessorComment by The Professor — April 6, 2011 @ 4:23 pm

  3. […] Streetwise Professor talks about a different kind of silo.  A vertical business silo in the US.  Banks want to end the silo, commodity […]

    Pingback by Breakfast Links Points and Figures — April 7, 2011 @ 6:37 am

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