Two Chicago Derivative Exchanges to Merge

October 18, 2006 at 11:24 am (Economics, Finance, Investment, US)

The Chicago Mercantile Exchange and the Chicago Board of Trade is to merge in an $8 billion deal. The merger of the two longtime competitors will create the largest derivative market in the world

The new exchange, to be named CME Group, will have an average daily trading volume of about 9 million contracts, representing $4.2 trillion, much larger than the New York Stock Exchange’s $87.2 billion daily trading value.

The merger signaled the rising position of Chicago as the world finance center. It also marked a milestone on the track of market integration.


From the New York Times:

Two Exchanges in Chicago Will Merge

By Alexei Barrionuevo

The Chicago Mercantile Exchange and the Chicago Board of Trade, longtime fierce competitors, said Tuesday that they would merge in an $8 billion deal creating the largest market for financial derivatives contracts in the world.

The transaction would be the latest in a wave of mergers among the leading financial exchanges, as they transform themselves from member-owned clubs to for-profit companies competing in markets that have become increasingly global and electronic.

The New York Stock Exchange, the Nasdaq Stock Market and smaller exchanges have announced mergers, and the New York exchange’s recent pursuit of Euronext, operator of four European stock markets, is driven in large part by Euronext’s derivatives exchange in London.

A combination of the two Chicago markets, which were founded in the 19th century to trade agricultural futures, would trumpet the spectacular rise of derivatives — financial contracts whose value is tied to or derived from currencies, interest rates, commodities or other things of value.

Derivatives have made risk more manageable for many businesses, including oil companies seeking to insure themselves against storms and banks trying to protect themselves against home mortgage defaults. Yet they have also fueled trading blow-ups, as in the near-collapse in 1998 of the hedge fund Long-Term Capital Management that shook the financial markets.

The business of trading such financial contracts has generated huge fortunes that have led many exchanges to begin looking for merger partners. They seek to create greater efficiency and more liquid markets where buyers and sellers more easily find what they want for the right price, much as on eBay.

By combining, the Chicago exchanges, to be named the CME Group, will have average daily trading volume of close to nine million contracts a day, representing $4.2 trillion in notional value, or the amount of the underlying assets, not the value of the contracts themselves. By a comparison of sorts, some 1.8 billion shares, or $87.2 billion, are traded on average on the New York Stock Exchange, the world’s biggest stock market, every day, although those shares, unlike derivatives, represent direct ownership stakes.

“That makes us the risk capital of the world,” said Terrence A. Duffy, the mercantile exchange’s chairman.

The combination of the two exchanges also signals the growing importance of Chicago as a center of global finance. The board of trade pioneered the concept of a futures contract — the delivery of a specific commodity by a certain date — in the 1860’s, originally for grains like corn and wheat. The mercantile exchange led the push into electronic trading in the early 1990’s.

Since then, these Chicago markets have been pressing further into the ever-growing world of trading derivatives contracts.

Derivatives can refer to a futures contract that is tied to the price of a commodity, like soybeans, and it can refer to arcane financial products not traded on any exchange, like credit default swaps, which can be negotiated between two hedge funds.

Often, the bet is not central to the underlying asset’s role; a bet on the coin toss in a football game rather than the outcome of the game itself would be a derivative bet, for example. Or a contract to hedge the weather risks affecting crop prices, rather than the future prices of those crops, would also be considered a derivative.

Driven by companies’ increasing desire to hedge risks, the derivatives markets have been growing rapidly. Since 2004, the notional value of interest rate, equity and credit derivatives has risen 44 percent, to $283.2 trillion, according to the International Swaps and Derivatives Association.

“The notional amounts are eye-popping,” said Janet Tavakoli, president of Tavakoli Structured Finance in Chicago.

The two exchanges, situated a few blocks from each other in Chicago’s downtown Loop, have storied histories. The board of trade once financed the formation of three regiments and an artillery battery for the union army during the Civil War, and the exchange’s first building was torched in the Chicago Fire of 1871. The mercantile exchange began as the Chicago Butter and Egg Board, later branching out to frozen pork-belly futures and live-cattle futures contracts.

While a half-century older, the board of trade was slower to move to electronic trading and to issue public stock, causing it to lose ground to the mercantile exchange. The move to electronic trading, led by the Chicago Merc, has made the board of trade’s clubby floor-trading world less relevant.

“The C.B.O.T. had to be dragged into the 21st century kicking and screaming,” Ms. Tavakoli said.

Tuesday’s announcement took some in the financial world here by surprise because the two exchanges, despite their intense rivalry, had discussed combining off and on for more than three decades. The ice began to thaw between them after they struck an agreement in 2003 for both to use the Chicago Merc’s clearinghouse, the board of trade’s chairman, Charles P. Carey, said in an interview.

After his exchange finally went public last year, the newly issued stock provided a currency to consider such a deal. “When we had member organizations,” Mr. Carey said, “the hurdles were insurmountable.”

Last December, over dinner at Gene & Georgetti’s, a popular steakhouse here, Mr. Duffy and Mr. Carey began to discuss a deal seriously. The talks accelerated over the last eight weeks, Mr. Duffy said.

The combination is expected to save $125 million annually in the second year after the deal closes, mostly through cuts in administrative and technology areas, the companies said. The exchanges will combine their trading operations into one trading floor at the board of trade.

But the mercantile exchange clearly prevailed over its rival. Mr. Duffy will become chairman of the combined organization, with Mr. Carey, vice chairman. Craig S. Donohue, chief executive of the mercantile exchange, will head the CME Group. The mercantile exchange will have 20 of the 29 board seats.

The deal faces regulatory scrutiny and a stiff breakup fee of $240 million if either exchange walks away. Regulators are expected to examine whether the combined entity can leverage its share of the futures and derivatives market into pricing power.

The merger “will create a mammoth enterprise with extraordinary pricing power,” said Meyer Frucher, the chairman and chief executive of the Philadelphia Stock Exchange. “Ironically, it may create more opportunities for others.”

Mr. Duffy and Mr. Donohue said that with an increased focus on electronic trading, the merged exchanges will make markets more transparent and more liquid for investors.

Mr. Donohue said the CME Group would compete more aggressively to build the exchanges’ derivatives market in Europe and Asia. Some traders said it would face tough sledding against Euronext’s London-based derivatives business and the Deutsche Börse’s Eurex derivatives market.

Jay Feuerstein, who heads Xenon Capital Management in Chicago, a hedge fund that focuses on trading futures contracts, said: “It will be tough for the mercantile exchange to take on the European exchanges and beat them. If they decide to offer some of the products that the Chicago exchanges offer, they have some built-in competitive advantages.”

Mr. Feuerstein added, “I am going to trade where there is the deepest liquidity, the cheapest transaction costs and the least credit risk.”

Still, while the deal could increase the CME Group’s reach overseas, the combination could stifle plans by Euronext and the New York Stock Exchange to increase its derivatives business in the United States. Euronext agreed to merge with the Big Board this summer, explaining in part that the move could create revenue opportunities related to derivative operations, some of which included plans to grow in the United States.

The combination of the two exchanges “makes them into a very, very big competitor indeed,” said Lynton Jones, a founder of Bourse Consult in London. “Euronext has been trying to get into U.S. markets without much success. They thought with the clout of the N.Y.S.E. behind them, they might do something. But I don’t see what that could be now.”




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