Rise of the CME Leviathan

Money Talks
CME Group completed its acquisition of the New York Mercantile Exchange [NYMEX] this week. The acquisition marked the final act in a dramatic takeover drama that has both captivated and concerned the futures world.

The final terms of the acquisition were announced on Thursday. NYMEX shareholders that opted to receive CME Group stock were paid $7.29 in cash and .2164 CME shares for every NYMEX share. (That amounted to $80.98 at the time of this writing.) Shareholders that opted for a cash payment received $81.16 for every NYMEX share.

Despite those lucrative payouts, the CME/NYMEX deal almost fell apart due to a dispute over taxes. NYMEX members were outraged that an additional $750,000 payment for exchange members was taxable as ordinary income. It took a great deal of behind-the-scenes wrangling, along with a promise to produce $60 million in cost savings, to finally seal the deal.

And Then There Was One...
The NYMEX acquisition completes the CME's transformation into the leviathan of the derivatives market. Already a powerful player in the futures realm, the CME's acquisition of the Chicago Board of Trade [CBOT] last year propelled it into a rarefied position in the financial world.

The combined CME/CBOT entity (aka CME Group) controls 98% of the U.S. futures market. In the history of the U.S. financial system, few exchanges have approached that level of dominance in a major financial sector. You would have to travel back in time to the early days of the New York Stock Exchange to find something even resembling an analogue.

However, even at its height, the NYSE (NYX) did not have the same market share that CME Group enjoys today. It also participated in a market that was far smaller, and had far less influence, than the modern U.S. futures market.

The Derivatives Frenzy
The inner workings of the derivatives market are normally only of interest to clearing professionals and others who deal in financial minutia. However, the recent surge in commodity prices, and the resulting political outrage over commodity speculation, have turned the derivatives market into front-page news (read It's Time To Ban CEOs & Senators From The Derivatives Markets for more information).

The CME/NYMEX deal brings the highly volatile, and highly controversial, crude oil contract under the CME's dominion. Trading activity in this contract sparked the current debate over the role of speculators in the commodities market.

Not surprisingly, many of these same opponents of speculation have begun to question the impact of the CME/NYMEX merger on the overall marketplace. They argue that it isn't prudent to allow one exchange to establish such a dominant position in a critical financial sector. Merger proponents, on the other hand, argue the somewhat quizzical point that the CME/NYMEX deal is critical to fostering global competition down the road.

The Leviathan Rises
As usual, the truth lies somewhere between these two extremes. On its surface, the notion that a company could control 98% of any market is fundamentally abhorrent to most Americans. We are a nation that worships at the altar of free competition and always roots for the underdog. Monopolies run against the very nature of our natural identity.

As a result, it would seem to most observers that the CME leviathan will have a markedly negative effect on competition in the futures industry. However, this belief is focused around a fundamental misunderstanding of competition in the futures market.

The truth is that there has never been competition in the domestic futures market. At least not to the extent that we've seen in the U.S. options market. The reason for this is quite simple: most options contracts are fungible, while most futures contracts are not.

U.S. options exchanges spend millions of dollars every year trying to distinguish themselves from a sea of cookie-cutter rivals. They battle for market share on a daily basis (read "Option Market Winners & Losers" for more information), relying on little more than transaction costs and execution speeds to set themselves apart.

Futures exchanges, on the other hand, have long enjoyed de facto monopolies in their major contracts. While the CME, CBOT & NYMEX all operated in the same marketplace, they weren't at each other's throats for market share like their options counterparts.

Instead, each futures exchange maintained control of a separate fiefdom. The CME maintained a strong presence in currency contracts while the CBOT dominated agricultural & fixed-income contracts and NYMEX controlled the lucrative energy market.

Through its string of acquisitions, CME Group has merely aggregated these separate fiefdoms under one banner. While the combined exchange will have broad pricing power across a wide array of products, the net effect on daily competition in the futures market should remain roughly the same.

The Clearing Issue
Of course, there is one aspect of the merger that raised the eyebrows of U.S. regulators and critics alike. In February, the Department of Justice (DoJ) issued a terse letter to the Treasury department recommending the clearing function be separated from futures exchanges. In the DoJ's view, consolidation of the clearing and trading functions in a single exchange rendered that exchange far too influential in the marketplace.

A number of European regulators took a similar view on the issue, prompting them to consider revising their clearing regulations. This lingering controversy led many skeptics to believe that the CME/NYMEX deal would never pass regulatory muster. After all, the CME/CBOT deal faced a comparatively lengthy approval process in 2007. Most observers assumed that the CME/NYMEX deal would face even greater regulatory scrutiny in 2008.

However, despite those concerns, the DoJ eventually approved the merger. With that approval, the hope for eventual clearing reform in the U.S. futures market all-but evaporated.

The Threat From Overseas
While the U.S. is still the Mecca of the derivatives world, the futures market has truly become a global marketplace. As a result, the lingering threat of competition comes not from domestic exchanges but from overseas rivals.

Many proponents of the CME/NYMEX deal argue that consolidation is merely the natural evolution of the U.S. futures market. The days of small regional exchanges operating in independent fiefdoms are over. If U.S. exchanges want to compete in the global marketplace against government-supported foreign exchanges, consolidation is the only option.

Of course, critics counter that the CME leviathan merely fosters protectionism at home rather than spurring competition abroad. The slow pace of technological advancement in the futures industry, along with the dogged resistance to electronic trading in the futures pits, are two oft-cited examples of this protectionism.

See No Evil
At the end of the day, it is difficult to argue in favor of a virtual monopoly in any industry. Monopolies always stifle innovation and curtail progress in their sector. Observers need only compare the relatively innovative Microsoft of 20 years ago with the bloated & reactionary monstrosity of today to see the damage unchecked monopolies can wreak on individual firms and entire marketplaces.

Yet if U.S exchanges planned to survive and compete in the 21st century, then some form of re-organization was necessary in the futures market. India, China, Europe & South America are increasingly looking toward the derivatives world as a source of economic expansion. Regardless of your opinion on monopolies, the CME leviathan will be in a better position to negotiate with, and compete against, these marketplaces than any independent regional fiefdom.

Disclosure: None

Comments

[kkin365:]

One hears about free trade or competition only when that suits one's position -- down in a dominant country/industry/compa... heart, it craves for monopoly. Cynical? yes; valid, also yes.

2008 Aug 30 04:55 PM