Streetwise Professor

October 20, 2006

The Big Deal

Filed under: Commodities,Derivatives,Exchanges — The Professor @ 9:58 am

Well, it finally happened. The CME and CBOT have announced their intention to merge. On the one hand, it’s not a surprise–this tie up has been mused about for years, and there were talks of a combination in the runup to the CBOT’s IPO not long ago. On the other hand, the timing of the deal was a surprise. There was no serious uptick in rumors or conjectures about an impending deal in the days leading to the announcement.

The economics of the deal are perfectly sensible–as they have been for years. When each exchange was a membership organization, however, politics and rent seeking stood in the way of the combination. As I noted in my 2000 JLE piece on exchanges, the members of exchanges are heterogeneous, and there is considerable disparity in the rents accruing to different members. Thus, any major policy change–including a major merger–is likely to have important distributive effects that raise the cost of implementing this change even if it enhances total member wealth. Indeed, the infamously Byzantine nature of member-owned exchange governance structures is a sensible way to control rent seeking–even though it slows decision making and impedes major strategic moves.

Electronic trading eroded the rents that exchange members–notably the locals and floor brokers who dominated exchange governance–earned from their special skills. As I predicted in my JLE article, the move to electronic trading completely undermined the rationale for the not-for-profit form and member ownership. In the early 2000s, the CME and the CBOT went for profit, and had IPOs. Distributive considerations were muted as a result. The exchange owners became much more homogenous–they were all essentially residual claimants to the stream of rents thrown off by the electronic trading system. All had a common interest in maximizing the share price. This reduced the political opposition to any deal, and made the CME and CBOT owners interested in maximizing the size of the pie, rather than fighting over the division of the pieces. Under these circumstances, the compelling economics of the combination finally prevailed.

What’s next? The exchanges are publicly confident that anti-trust review will not cause problems. Perhaps that’s the case, but I would expect the deal to get some attention from DoJ. It’s a big deal, and those tend to attract attention. Moreover, exchanges have attracted little anti-trust scrutiny in the past, but with sea change in the industry, the tendency towards concentration in trading, and the prospect for further consolidation, that may change. DoJ will recognize that this deal will establish a precedent for future mergers in derivatives, equities, and options, and will likely want to make sure that it is comfortable with it.

The key will be market definition. If it’s an individual futures contract market (e.g., Treasury futures), then there’s no problem–the deal won’t increase concentration as the exchanges don’t compete head-to-head in any contract. If it’s the derivatives markets (including the OTC derivatives market), no problem–because the futures markets are small relative to the overall derivatives markets. If it’s the futures markets (i.e., not individual futures markets, but something like “interest rate futures”)–then there could be a problem.

Economically, I think that the first two are more economically sensible than the third. The third market definition presumes that different futures are close substitutes for one another. This is problematic. Different futures–even relatively related futures such as Eurodollars and Treasuries–are not very good substitutes for hedgers. They may be substitutes for some speculators, but I am doubtful that the relevant cross-elasticities are very high. Moreover, some pairs of contracts are actually complements for some speculators. For instance, traders who spread Eurodollars and Treasury note futures, or corn and live hog futures, consider these contract pairs complements. Thus, there is not a strong prima facie case that “futures” is the appropriate market definition.

The deal also sparks additional speculation about what will happen with other exchanges. As I’ve said before, it makes sense to combine NYMEX and CME. Indeed, NYMEX has some of the same attributes–and weakenesses–as the CBOT. NYMEX has a strong slate of contracts, but like the Board, does not own its trading technology. Moreover, there is another benefit to adding NYMEX to the mix–the economies of scope in clearing. Clearing NYMEX, CME, and CBOT contracts together would be cheaper, and economize substantially on margin, relative to clearing NYMEX separately from CME/CBOT.

Beyond that? CBOE+CME+CBOT? There is already cross margining on index options and index futures, so that limits the potential margin savings. Also, CBOE clears through OCC, and there will remain advantages to clearing options on individual stocks that are traded on multiple exchanges through OCC. CME+CBOT+NASDAQ? That is intriguing, and I’ll give it some further thought.

In the meantime, as a Chicagoan, and a student of exchange history, the merger is somewhat bittersweet. The CBOT has been around since 1848, and has been a world leader in futures trading since the Civil War. There aren’t a lot of American business institutions that have been around for 150+ years, let alone world leaders for over 140. The Board was the scene of many important economic events, the birthplace of many important financial innovations, and the stomping grounds for many colorful, illustrious, and sometimes infamous, characters. The CME is also a storied institution with a distinguished past, but it only came into its own in the 1960s, and particularly the 1970s and 1980s. Indeed, the CME almost died when Congress outlawed trading of onion futures–the exchange’s leading contract–in the 1950s. Thus, this represents the passing of an age, and the passing of the torch from a venerable pioneer to a relative newcomer.

Fortunately, the combined entity will utilize the CBOT’s beautiful and historic building at LaSalle and Jackson (depicted in the background wallpaper of this site), so there will be visible and enduring evidence of the Board’s contribution to the city, and a reminder of the exchange’s glorious past. Moreover, the combination will ensure that Chicago will remain the dominant force in derivatives trading for years to come. So though the name “Chicago Board of Trade” will no longer live on, its legacy will. Modern futures trading was born in Chicago. In the last 20 years the futures industry has grown dramatically around the world, but for the foreseeable “future” its home address will continue to be 141 West Jackson Boulevard, Chicago, Illinois, 60604.

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