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Burying the Hatchet

A few weeks ago, the derivatives market received news that cheered some observers and frustrated many more. After a long, and often ridiculous, legal battle, the Chicago Mercantile Exchange [CME] and the Chicago Board Options Exchange [CBOE] finally buried the hatchet.

These two exchanges operate in separate hemispheres of the derivatives world. As a result, they do not compete directly for market share (unlike the CBOE and its many competitors in the options space). Far from being rivals, the two exchanges actually offer a great deal of synergy to each other.

However, despite the many synergies between these two exchanges, they have been locked in a protracted struggle over a seemingly innocuous entitlement - the right of former CBOT members to trade on the CBOE (read "Much Ado About Nothing: CBOE, CME And The Battle Over The Exercise Right" for more information on the exercise right battle)

All Or Nothing

As with many epic legal battles, the end came not with a bang but with a whimper. Instead of a dramatic courtroom showdown, the two exchanges decided on a (relatively) simple compromise. In keeping with the spirit of a good compromise, both sides walked away pleased but not entirely satisfied.

The CME had been angling for full CBOE membership for all of its members. It was an almost laughable claim, but it also illuminated the extreme positions of the two litigants. The CBOE took the polar opposite of the CME's position, claiming that the CME's acquisition of the CBOT completely nullified the exercise right.

Even as they filed their papers in the Delaware Court of Chancery, both sides knew that their all-or-nothing positions were completely untenable. It was only a matter of time until a settlement was reached.

SEC Steps In

The CME gained a strong incentive to settle this dispute after the SEC ruled against it in January. The SEC agreed with the CBOE's position that no one could qualify as CBOE exercisers in the wake of the CBOT acquisition.

That decision left the CME in a very weak position going into the final hearings at the Delaware Court of Chancery. With another negative decision looming on the horizon, the exchange realized that it was time to settle.

The settlement dance began in earnest this past March, when the two exchanges put forward proposals that were roughly $400 million apart. After months of haggling, they eventually arrived at a deal valued at roughly $1 billion. Under the terms of the deal, CBOT exercise rights holders would receive 18% of the CBOE along with $300 million in cash.

The deal did not turn out to be the bonanza that many former CBOT members expected. However, it is far better than the paltry $100,000 the CBOE offered during the initial buyback round a few years ago.

Their Own Worst Enemies

The irony of this entire situation is that the exercise right, and the legal battle surrounding it, have been major stumbling blocks for both exchanges. The CBOE has salivated over the prospect of an IPO for years. The exchange and its members have long desired to follow in the footsteps of its rivals by floating shares to the public.

The "IPO lust" at the CBOE is understandable. After all, options volume is growing at a record pace and CBOE seats are trading near an all-time high. There has never been a better time for the exchange to cash-in its chips.

But these favorable conditions will not exist forever. Evolving trading technologies and new market models continue to erode the CBOE's market share (although proprietary products like SPX and VIX have slowed the blood loss). After years of delay, a relatively speedy IPO would undoubtedly be in the exchange's best interest.

However, the exercise right debate brought into question the ultimate ownership of the CBOE. The exchange could not start down the lengthy IPO road until this ownership issue was decided. So, while other options exchanges cashed-in on their success, the market leader was left watching the IPO/M&A action from the sidelines.

The protracted legal battle also hurt the CME. The exchange has seen its share price fall dramatically over the past year. This drop has been attributed to a variety of factors, including investor fatigue over the seemingly endless conflict with the CBOE.

The CME's plunging share price is not the only legacy of the legal battle. The conflict also had a negative impact on the exchange's expansion plans. The CME is known for its acquisitive nature, having gobbled up both the CBOT and NYMEX in the past few years. However, if there is one chink in this mighty leviathan's armor, it is the CME's lack of market share in the lucrative world of options.

Of course, the CME lists a wide variety of futures options contracts. But the truly explosive growth is in the equity options market these days. The CME's lack of traction in the equity options world makes the CBOE a tempting takeover target. The major stumbling block to such a deal (along with potential regulatory conflicts) was the ludicrous battle over the exercise right.

Instead of quickly settling this issue and moving on to more pressing matters, both exchanges proceeded to waste millions of dollars (and several precious years) locking horns over a concept that had ballooned well past the point of reason.

Bell Of the Ball

Of course, this begs the question: Where do we go from here?

Assuming that the settlement deal is approved, the CBOE will finally be free to explore the IPOs, mergers and acquisitions that have consumed the options world in recent years. As the current king of the options hill, and the only major options exchange without an owner/controlling partner, the CBOE is now the bell of the ball.

CBOE CEO William Brodsky recently claimed that his exchange already has "many suitors." Rumors of a potential acquisition by the NYSE have also resurfaced in recent weeks as the CBOE/CME settlement talks neared conclusion (read "NYSE & CBOE Laying Down Their Swords?" for more information on this long-simmering rumor).

An Options Powerhouse?

An acquisition by NYSE Euronext makes a certain degree of sense. It would reunite the NYSE with the "green room" options business it sold to the CBOE over a decade ago. It would also put the CBOE under the same umbrella as NYSE Arca Options and AMEX. The resulting options powerhouse would control over half of the listed U.S. options market.

Given those numbers, it's hard to argue against the deal from a market share perspective. However, there is a significant amount of overlap between those three exchanges. The CBOE, AMEX and NYSE Arca trade nearly identical product lines. In addition, NYSE Euronext already has a maker-taker options exchange and a traditional options exchange in its stable. As a result, the addition of the CBOE would be redundant from a "model diversification" perspective.

Although the CBOE's market share would be compelling for NYSE Euronext, the true value of the exchange lies in its proprietary index products (SPX, OEX, VIX, etc). These products have seen dramatic increases in volume and have allowed the CBOE to maintain its overall volume lead over the ISE (read "The Race For The Next Great Options Monopoly" for more information on proprietary options products).

Rival exchanges have eyed the SPX hungrily for years. The ISE has even gone so far as to challenge the validity of the proprietary SPX contract in court. While the opportunity to acquire this contract would be a significant bonus for NYSE Euronext, the exchange has also been on an acquisitions spree in recent years. Is it truly in the position for another major acquisition at this point?

A Regulatory Nightmare?

While the NYSE Euronext/CBOE combination makes sense, an acquisition by the CME is practically a no-brainer. The deal offers a tremendous amount of synergy for both exchanges. There is almost no overlap between the product lines of the CBOE and CME. The deal would also grant the CME access to the exploding equity options market and facilitate the CBOE's foray into the non-fungible world of futures.

While the CBOE/CME combination makes sense on almost every level, there is one significant hurdle to this deal - regulation. The SEC, CFTC, Justice Department and both houses of Congress would certainly have a great deal to say about this potent combination.

The CME has already come under regulatory scrutiny for its acquisitions of the CBOT and NYMEX. So far, despite the near-monopoly status of the CME, it has managed to obtain regulatory approval for both deals. But, in this heightened regulatory environment, the potential roadblocks to a CBOE/CME deal would be considerable (perhaps even insurmountable).

That fact may dampen overall enthusiasm for such a deal at the CME, which may not want to tempt its fate again so soon after receiving approval for the NYMEX deal.

In terms of acquisitions, the CME is in a similar situation to NYSE Euronext. It recently completed one major acquisition and is currently in the throes of a second. A third major acquisition in as many years would be a strain on even this exchange's considerable resources. At the same time, the decline in CME stock has deprived the exchange of much of its buying power. A CBOE acquisition just may not be feasible right now.

And Then There Were None

At the end of the day, Brodsky's claim to have "many suitors" may not be far from the mark. There are quite a few domestic and international exchanges/funds/firms that would love to add the leading U.S. options exchange to their portfolio.

Whether its NYSE Euronext, CME or some unknown acquirer, the CBOE is destined to be in the cross hairs relatively soon. Given the strong interest in this sector, it wouldn't surprise me if the "birthplace of the options business" never even made it to the IPO phase.

As soon as the respective memberships approve the exercise right settlement (the CBOE's vote is currently scheduled for July 17), it will be open season on the exchange. Shortly after that, the last of the unattached options exchanges will follow in the footsteps of the P-coast, PHLX, ISE and AMEX.

What impact will that have on the derivatives world? Only time will tell. Thankfully, it doesn't look like we will have to wait very long to learn the answer...

Source: Burying the Hatchet: CBOE, CME and the Road Ahead