While the definitive agreement to merge the Chicago Mercantile Exchange (CME) and smaller Chicago Board of Trade (CBOT) creates the world’s largest futures and most diverse derivatives exchange, will users – and the big banks in particular – embrace the deal or seek alternatives to exert leverage over an increase in monopolistic power?
By creating a $25bn (€19.5bn) premier global derivatives bourse, some might ask why the arrangement was not dubbed the ‘Mega’ Merc Exchange. The new entity, CME Group Inc, will have a combined market capitalisation over 20 per cent greater than the next biggest pending deal in the exchange sector, Euronext and the New York Stock Exchange (NYSE).
While the tie-up follows years of flirtations with rival exchanges, this all US-solution has come to a head at time when the competitiveness of the North American capital markets has felt pressure from some regulatory changes that have driven users abroad.
“The CME has shown that it not only knows how to operate an auction market but [also] it knows how to bid for one,” states Adam Sussman, senior research analyst at TABB Group. “And, the CME hopes to elude the scuttlebutt that has followed previous exchange consolidation deals by offering a 16.8 per cent premium for the CBOT,” he adds. (CME will offer $8bn for the CBOT and be in the driving seat with 69 per cent control).
Whatever else, the momentum of exchange sector consolidation is here to stay and will continue. Whether there will be just one global exchange within 50 years time is mere conjecture, but it does raise the question of what actually constitutes an exchange. That’s a one for another day.
So much for CBOT’s independence dating back to 1848. This October’s announcement will, if ratified by the US Justice Department, turn out to have been a financial bonanza for CBOT stockholders. Given the short time since the CME became the first US exchange to pursue an IPO in 2002, are exchanges simply demutualising to be sold off to the highest bidder and milking their members en route? Perhaps. (CBOT listed in 2005).
Whether this deal is a good or a bad thing depends largely on where you sit and which angle is looked at. “Yes, it’s definitely a good thing for the exchanges,” says Mamoun Tazi, an analyst at Man Securities in London.
Advantage to whom?
“However, in terms of whether it’s also good for users then a question mark really hangs over that.” But says Mr Tazi if users “do not like what they see they could always go somewhere else.”
The deal, which is estimated to lead to $125m of collective savings, takes “advantage basically of the fact that users will have the whole yield curve - long and short interest rate products - under one roof with all the various derivatives products trading eventually on one trading [Globex] platform,” adds Mr Tazi.
In theory, savings could be passed on, but how this actually works is guess work at this stage. Savings could have been greater if there were two central counterparties to consolidate, as CBOT already uses CME clearing.
For the users of the exchanges’ combined services it is not a question of two screens being merged into one, but rather says Mr Tazi consolidation of two technology platforms systems and two IT departments. Performing everything on a single IT system will cut costs.
While users should benefit from having all the liquidity in one screen, some of the big firms already have this in place with systems that consolidate liquidity on one screen.
A senior London-based investment banker who declined to be named told FT Mandate in many exchange mergers the “devil is always in the detail” as far as cost savings are concerned. Often it was “mere platitudes” when the exchanges talked about such savings and users had “only so much lobbying power” on tariffs, in any case.
European exchanges are unlikely to be unaffected. Eurex, the derivatives exchange owned jointly by Deutsche Börse and SWX, which made a sortie into the US market and subsequently forced the Chicago exchanges to lower tariffs, could mount a counter-bid. They have not hidden their interest in the US and are involved with Man Group with a derivatives incubator project (USFE Group). In Europe, Deutsche Börse and SWX will launch the ‘Alex’ exchange this January for structured products.
While the TABB Group’s Mr Sussman, believes that the “most likely threat” to the CME/CBOT merger would emanate from Eurex, the largest European derivatives exchange, it would call for a big helping hand from its parent, Deutsche Börse. They themselves have been playing “spoiling” tactics over the NYSE/Euronext deal.
The ‘mega’ monopoly power of CME Group could make the European competition authorities re-evaluate their stance towards a coming together of pan-European exchange operator.
Some analysts think that is a distinct possibility since the stumbling blocks that Euronext put forward against such as tie-up with Frankfurt was the very competition issue voiced by the European Commission. Now this might pave the tortuous route to a European exchange superpower that could act as a counterweight to US giants – going head to head with them.
No doubt other derivatives exchanges in the US will be evaluating future possibilities. The Chicago Options Exchange, which saw a seat (membership) on their exchange hit a record high this October of $1.5m, might be inching its way closer to becoming a public company.
That said, it has different products from CME/CBOT, but it could “spur some smaller exchanges to band together,” Mr Sussman contends. There are a host to choose from: the American Stock Exchange, the Boston Options Exchange with links to the Montreal Exchange, and Philadelphia Stock Exchange, which dates back to 1790.
And, should Euronext not consummate its deal with NYSE, what new interesting combinations could that throw up? A renewed fight for the LSE between NYSE and Nasdaq, or possibly NYSE turning on Nasdaq? Data recently showed that Nasdaq was taking market share off its larger rival in NYSE-listed names.
Forming a monopoly
While it is “uncertain” whether regulators would allow a US exchange to be acquired by a foreign company, analyst Robert Rutschow at Prudential Equity Group in New York suggested in recently initiated coverage that Nasdaq “could become a takeover target” and foreign companies could be interested.
“The basic fact of the matter is that such a monopoly is being formed in the US. So, will Europe follow or will it not?” says Mr Tazi.
“My guess is that because the US authorities will most likely approve the transaction…it will put pressure on Euronext to consider a deal opportunity in the European theatre.” Brokers in Europe have also attacked a Euronext/NYSE combination.
With too much exchange power, a backlash might ensue. Bob Giffords, independent IT and banking consultant based in the UK, says that just as in Europe the investment banks are in the middle of ‘Project Boat’ and setting up an “IT piece” so some of big banks could be mulling the creation of a counterweight to the CME Group.
That could result in some “alternatives” whereby the banks could take their liquidity elsewhere in order to “gain certain leverage over them…should they not play ball.” Already we’ve seen Instinet Chi-X establishing as a standalone FSA regulated MTF offering a pan-European platform.
“Most of the exchange mergers have resulted in fairly minimal savings,” says Mr Giffords.
“These have been more for the owners of exchanges than for the benefit of the users of exchanges.” Without doubt money is saved on the technology, although it “doesn’t amount to a huge amount” at the end of the day, he says.
Given that most of the costs in Europe are on the post trade side, banks want “multiple” back offices and clearing arrangements. “The $64bn question is not whether the big banks will side with one or other exchange…but will they pursue and play their own game?” adds Mr Giffords.
The really interesting game will be whether or not the investment banks start pressing for horizontal operation of markets across the board, arguing that any vertical integration between execution and post trade activities is anti-competitive. CME/CBOT strengthens the vertical silo model, and removing competition can lead to more monopoly power. Europe certainly needs competition - period.
BENEFITING SHAREHOLDERS OR AN UNEASY ALLIANCE?
The CME Group has been billed as a transforming merger that will create operational and cost efficiencies for customers and exchange members, while also claiming that it will deliver significant benefits to shareholders.
With a combined market valuation a day prior to the announcement of 17 October 2006 of $25bn, some analysts have suggested that “too much power” might rest with these Chicago exchanges.
Following Eurex’s foray into the US, the exchanges initially cut their trading tariffs before raising them after Eurex pulled back. Could increased monopoly power see tariffs raised again? Indirectly the deal could herald a Franco-German alliance between Euronext and Deustche Börse as a counterweight to the US giants.
Customers will have access to what is described as one of the world’s most liquid marketplaces and an array of benchmark exchange-traded derivatives based on the US interest rate yield curve (for example, CME Eurodollar futures, CBOT 10-year US Treasury Note futures).
In addition there will be equity indices, foreign exchange derivatives, agricultural (grains and livestock futures contracts) and industrial commodities, plus energy and alternative investment products (i.e. weather and real estate).
Accretive to earnings in 12 to 18 months after the closing of the deal (around mid-2007), pre-tax cost savings through the combination have been penciled in at more than $125m collectively – commencing in the second full year following the closing. This will largely be driven by technology, administrative and trading floor-related cost reductions.
Exactly how such savings are passed to users and exchange stockholders and in what precise split remains open to question, and dependent on the position of the exchange’s management.
Unifying IT operations and eventually rolling CBOT products onto the CME Globex trading platform should create synergies. (CBOT uses Atos Euronext Market Solutions’ ‘Connect’ system at present). Trading floor operations will be consolidated into a single CBOT pit facility, moving open-outcry activities at the CME’s premises to CBOT’s floor.
While there will be access to distinct products and services as well as yet to be revealed “innovative” new product offerings, integrated market data services could potentially save on exchange feeds.
Management says there will be a “seamless continuation” of current clearing arrangements (using CME clearing), which secures existing margin benefits for customers. Core trading rights, membership or clearing privileges at either exchange should be unimpaired by the merger.
