Streetwise Professor

February 21, 2006

Whither NYMEX?

Filed under: Commodities,Exchanges — The Professor @ 2:07 am

The New York Mercantile Exchange–NYMEX–is in the midst of very challenging times. In some ways, these are the best of times for NYMEX. Energy trading is booming. This has generated substantial volume increases at the exchange, while the rebound in over-the-counter trading has led to record setting business on ClearPort, the exchange’s OTC clearing system. The boom in business led to a steep rise in the NYMEX seat price to $3.775 billion–though this price has fallen substantially, as I will discuss in more detail below.

But not all is sunshine and roses. The exchange has also experienced some difficulties. A die-hard advocte of open outcry trading, NYMEX was originally planning to assist in the creation of a floor-based exchange in Dubai. It later bowed to reality and Dubai will be an electronic marketplace. More importantly, NYMEX spent a pretty sum to set up a trading floor (first in Dublin, then in London) to compete head to head with the International Petroleum Exchange (now ICE Futures) in the trading of Brent crude. The effort failed miserably, and NYMEX is now going electronic in its battle for Brent.

NYMEX has also seen steady erosion in gold trading volume. The Chicago Board of Trade’s electronically traded gold futures contract now has about 20 percent of a market that was once virtually 100 percent COMEX/NYMEX.

And the biggest threats are just beginning. ICE has launched trading in a West Texas Intermediate (WTI) futures contract in direct competition with NYMEX’s flagship WTI (light crude) contract; indeed, the ICE contract is cash settled against penultimate NYMEX WTI/CL futures. In its early days, the electronic ICE WTI has attracted a market share of better than 10 percent. (Registration required.) And now the Chicago Mercantile Exchange is considering entering the energy derivatives market. ICE is clearly a strong competitor, but the CME, with its Globex trading system, sterling reputation, and excellent marketing channels could be in another league altogether.

These developments have put a dent in NYMEX’s seat price. A seat last sold for $3.05 million, a very respectable number, but almost 20 percent of its recent (and all-time) high.

NYMEX is responding. The exchange has announced a rapid move to side-by-side trading (i.e., electronic trading while the floor is open). It has also indicated that it will invest $15 million in new technogy, and there have been reports that NYMEX is looking to partner with Euronext or Eurex to get access to more advanced trading technology. (Eurex is also shopping for a US partner–could NYMEX fit the bill? Reports I have read suggest that Eurex is looking more to a securities exchange with an options license.)

NYMEX definitely has some vulnerabilities. As at some other open outcry exchanges (but not all), its electronic system was something of a stepchild. This is not the only time that floor traders thought that stinting on the development of an electronic system would extend the life of the floor. Such thinking makes sense if you live in a bubble and need not fear competition from other exchanges, but is potentially lethal in the real world where competitors can offer a potentially superior technology. Ironically, the NYMEX floor community might have been better served by investing in an advanced and robust electronic system years ago as such a system could have helped deter entry; competitors would have been less likely to enter knowing that NYMEX was in a position to move its order flow advantage to a viable electronic platform at the flick of a switch.

It’s too late for that, however: NYMEX is in the position of playing technological catch up. Its order flow advantage is clearly important, but as the Eurex-LIFFE episode proved it is not insurmountable if the incumbent (NYMEX in this instance) does not respond quickly to the competitive threat. NYMEX is not behind the 8 ball to the same degree LIFFE was in 1998, but it needs to act quickly to protect its franchise. Technology has not been the exchange’s strong suit (take a look at its web page if you want a quick demonstration of that), and even adopting somebody else’s trading technology (e.g., LiffeConnect) doesn’t happen overnight.

Moreover, to an outsider NYMEX’s internal politics seem byzantine even by comparison to other member owned exchanges–which is saying something. There is considerable opposition to the proposed sale of a 10 percent stake in NYMEX to General Atlantic. As always, it is difficult to gauge how deep the opposition runs, but the opposition is vocal and includes many well known NYMEX members. Fifty-five people (!) are running for the 10 open board seats in the next board election. That further suggests considerable discontent and division of opinion at the exchange. That’s not conducive to a nimble response to one–and perhaps two–looming competitive threats.

How will things play out? Prediction is risky, especially about the future (as Mark Twain said), and that is particularly true in the present instance. One should never underestimate the importance of network effects and the order flow advantage of an incumbent exchange–but one shouldn’t overestimate it either. It is not a talisman that makes the incumbent invulnerable. NYMEX has an achilles heel–its technology. The open question is whether the order flow advantage will buy NYMEX enough time to address this vulnerability. If I was a betting man, I’d say that it will, but that the odds are only a little better than 1:1.

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