The Futures Industry Association’s (FIA) annual conference in Boca Raton, Fla. often is the launching pad of so-called big industry news, but usually these announcements fail to inspire. This March the Intercontinental Exchange (ICE) dropped a bomb on the industry that still has people reeling, placing an unsolicited $9.9 billion bid on the Chicago Board of Trade (CBOT), which at the time was valued at $1 billion more than the Chicago Mercantile Exchange’s (CME) definitive merger agreement with the CBOT.
The CBOT and CME had been busy working on the consolidation and warding off criticism that the merger would reduce competition in the futures markets in the United States and create a behemoth exchange with pricing power that could squeeze member firms. That criticism is perceived to be coming from the large investment banks that often direct FIA policy.
After ICE’s big splash, it followed up by aggressively courting former CBOT members and current shareholders who were set to vote on the CME proposal on April 4. Once the CBOT agreed to delay the vote and take a closer look at the ICE proposal, it was time for the CME to respond. It did so with a presentation to CBOT shareholders that promised to point out the flaws in the ICE offer and show why the CME deal was still the superior offer despite the face value. The CME claimed that ICE had exaggerated the synergies of an ICE/CBOT merger and that the currency offered, ICE stock, was a much weaker currency than the combination CME stock and cash that was part of the definitive agreement between the CME and CBOT. ICE Chairman and CEO Jeff Sprecher has contended from the beginning that if cash were an issue, ICE could raise the necessary cash to make that part of the offer. The CME succeeded to some extent, as several CBOT shareholders speaking at the forum stated that they would prefer a deal with the CME. But those same members expected the CME to sweeten its bid, something CME Chairman Terry Duffy exclaimed it would not.
Former CBOT Chairman Pat Arbor, speaking directly after the CME presentation, said the view that the CME needed to up its bid was reflective of the majority opinion of former CBOT seat holders. “I told (CME leadership) when I walked in, ‘there is an overwhelming sentiment to go for the ICE deal unless the CME sweetens the offer.’ These fellows have always felt that the CBOT was worth more than the CME offer.”
Perhaps most frustrating for the CME, given the perceived Wall Street support for the ICE bid, is that so many member firms are willing to forego the benefits of its common clearing link (CCL) with the CBOT that they had fought for over so many years. While the FCM/exchange relationship has been strained, the clearing link was genuinely welcomed as positive for both the exchanges and firms.
“The FCMs have been saying for years that they want three things from a clearinghouse: capital efficiencies, operational efficiencies and low cost services,” says Kim Taylor, president of the CME clearinghouse. “Examples would be margin reductions, the risk capital efficiencies from the single guarantees fund and efficient collateral programs and processes. [Regarding] operational efficiencies, they want a single automated interface, they want straight through processing, they want a single set of systems and rules and processes around every aspect of the business. They want margin innovation and they want delivery efficiencies and innovations. A lot of what they say they want they got with the common clearing link.”
These efficiencies would go away, or at least have to be built up in a different clearinghouse, if the CBOT and ICE merge.
CME President and COO Phupinder Gill says that much of this clearing innovation has been done at the behest of the FIA. “The FIA board has sent us an agenda that has operational efficiencies as the centerpiece; the reason they have operational efficiencies as the centerpiece is because all of these [are] issues that they face on a post-trade basis. CME has done a tremendous amount of development on a post-trade basis, particularly in the last seven to 10 years.”
One of the first questions ICE’s Sprecher faced following the announcement was how could ICE offset the loss of the efficiencies created by the CCL, estimated to be $1.8 billion at the time. Sprecher says that much of the efficiency can be made with clearing offsets between CBOT and ICE products and moving to net margining from gross margining.
Gill and Taylor dispute that net margining would provide much savings and say the $50 million in margin offsets between ICE and CBOT is questionable and much less than the current $700 million to $1 billion in offsets between the CBOT and CME. “If we were margining this ourselves, the only risk offset we would give would be between the Russell and the Dow,” Taylor says. The only way you could get to $50 million is to take the entire open interest of the Russell and offset it with entire open interest from the Dow, which is unrealistic, according to Gill.
Taylor adds that margin offsets aside, the guarantee pool for CBOT products in ICE’s new clearinghouse would have to be funded to the tune of $350 million and that the member firms would have to add $200 million to the CME clearinghouse once the CBOT products are taken out, making it a $550 million hit to member firms.
Gill has long contended that the net vs. gross margining benefit was a myth and says the CCL confirmed that. The CME was required to offer net margining to CBOT member firms as part of the CCL and Taylor found gross margining to be cheaper in some instances. “About 25% of Board of Trade clearing firms choose gross margining,” Taylor says.
She adds that the main savings from the CCL is operational. “They save money by not having to have as much staff, by not having to duplicate their own systems development, by not having to pay vendors for duplicate system development. Hell, they save money by not having two credit houses spending money to do the same things.”
Gill refers to the ICE’s estimate of $90 million in clearing synergies as nonsense. He notes the old Board of Trade Clearing Corporation (BOTCC) spent $45 million a year to clear trades prior to the CCL when the CBOT’s volume was half what it is today. “If the BOTCC were still in operation, based on our experience, their run rate for expenses would be anywhere from $65 to $70 million,” Gill says, adding ICE states it can do it for $17 million.
Sprecher contends he can deliver on his promises and points out ICE has a track record of running efficiently. “You can look at the size of this company and any metric around ICE, the revenue per employee, the market value per employee, the income per employee, and you can see that we are a very efficient company and we have the highest operation margins in our industry. We are lean and efficient and entrepreneurial.”
Taylor adds that ICE most likely would be running two clearing systems, one for the recently acquired New York Board of Trade (Nybot) and one for CBOT, which would add to the cost. “What we are trying to convey is that they can’t deliver what they say they can deliver.”
Sprecher says he can. “We’ve looked at it and we’ve looked at staffing it, we are very comfortable with the number we put forward. I don’t have a 1,200 person IT department to run my trading platform. We think we can run this [clearinghouse] for $17 million a year.”
“Can they ramp up? Yeah they can ramp up; there are a lot of smart people around. Will it take them some money to do it? Sure. Is it operationally feasible? Yeah,” says a mid-sized FCM head.
While there was some grumbling about the pricing power of a combined CME/CBOT, mostly attributable to the large investment banks and some questions regarding the Department of Justice review of the proposal, most of the industry assumed it would go through, and the firms that were talking supported it. Chris Hehmeyer, president and CEO of Penson GHCO (formerly Goldenberg Hehmeyer), said the afternoon of the ICE announcement, “We supported [the CBOT/CME merger], but this is a very credible offer. We were prepared to vote our shares for the merger but we have to take a look.”
Mike Manning, president and CEO of Rand Financial Services says the CME bid is the way to go. “In my opinion the CME proposal is still superior. It creates better value for shareholders. It creates a better business environment for customers and clearing member and as a shareholder/investor and somebody who does business on all these exchanges, the combination of CME/CBOT is the one that makes the most sense.”
In discussing the CME/CBOT merger, the head of the mid sized FCM notes: “I thought it was positive. If there had not been anyone else, it would have easily passed. Some of the bigger firms don’t like it and some of them are worried about pricing power.” He adds, that getting a deal done quickly is more important than the who is the eventual partner, as the CBOT is in a holding pattern until a deal is finalized. He apparently will not get his wish, as the CBOT and CME announced April 11 that they rescheduled their respective shareholder votes on the agreement to July 9. The delay may provide time for another bidder to emerge. NYSE Euronext CEO John Thain has expressed interest in developing a U.S. futures presence.
Despite issuing a press release stating concerns over the proposed CME-CBOT merger and just yesterday having an editorial in the Wall Street Journal deriding the loss of competition a CME/CBOT would cause, the FIA has neither come out against nor in support of the ICE proposal, as has been reported in other publications. In fact, FIA President John Damgard acknowledges the benefits of the clearing link. “We are used to taking the common clearing link for granted and to pull that apart would cause some real heartburn,” Damgard says. As for FIA board members, he says they are split with many firms playing a roll in either merger proposal and despite some concerns over the competitive environment. He sees the benefits of a CME/CBOT deal. “The merger between the Chicago exchanges holds a hell of a lot of benefits to the industry, building on the benefits that took place as a result of combining the clearing. There are a lot of efficiencies that are going to come along with consolidation. There are obviously people who want to weigh that against what it would mean to have a serious competitor vs. no competition at all.”
Of course, that is where Damgard and the CME split company. The CME argues that very little direct competition would be lost if their deal goes through, that they compete on a global basis, and in the OTC market.
To the extent that the CME and CBOT compete now is not so much the issue to these detractors as much as maintaining an overall competitive environment where some domestic exchange will have the ability to compete. The size of a combined CME/CBOT scares some entities to the extent that they are willing to forego some margin and operational efficiencies to ensure there is not one dominant U.S. futures exchange.
“There has been competition for new product innovation by two exchanges. It is hard to imagine what [the industry] would have looked like with just one. The innovation in our industry comes from competition,” Sprecher says.
But competition comes in all forms and the CME and numerous industry insiders have indicated the competition the large investment banks are concerned with is the competition a combined CME/CBOT will present in the over-the-counter financial markets.
“The New York banking community does not want their fiefdom encroached, this has always been the case,” says Robert “Buck” Haworth, CEO of Born Capital LLC. “They are very smart and resourceful, whether working through the FIA or through a company like ICE.”
Manning, who agrees that competition in the OTC space from a Chicago exchange combination is a motivating factor for large FCMs opposing the deal, argues that benefits of a CME/CBOT deal would be immediate. “If the [CBOT/CME] merger went through, the industry and investors would see tangible results and quarterly bottom line performances. Contrast that with an ICE/CBOT merger where you would have to start integrating the Board of Trade’s giant trading platform and clearing with a system that is untested at these enormous volume levels.”
The head of the midsized FCM we spoke to wants to see an end to the process. “I am neutral to which party wins the bidding, [however] time is of the essence. The integration of some of the systems — even the trading floor — are on hold. Everything is on hold waiting for this to happen. I am more concerned with this happening sooner than later and less concerned about who the party is,” says the mid-sized FCM.
He adds that both sides raise solid concerns. “It is a valid argument for the large players to be concerned about pricing power at the CME; it is also a valid argument for the CME to say that the banks are concerned with [competition from them in the OTC space]. The biggest customers of the CME are also the biggest competitors of the CME. That has been true for a while.”
In the end, those who oppose the CME/CBOT deal do so because they do not want to see one behemoth exchange with market share that a CME/CBOT exchange would have. They are less concerned about the operational and clearing efficiencies that may be lost in an ICE/CBOT deal. The consensus seems to be that having two competitive futures an exchange with two clearinghouses has a value that goes well beyond any possible loss of efficiency.
The FCM community has always been leery of the CME’s clearing structure. They have argued that it is their money and they should have more control over it as they did in the BOTCC structure. Though they pushed for the efficiencies that would be created by merging the two clearinghouses, it was the structure they longed for. When the CME and CBOT announced the CCL, they gritted their teeth and smiled knowing they were outmaneuvered. They certainly enjoyed the efficiencies and savings it delivered but they still longed for more control.
The CBOT board has rescheduled the shareholder vote on a merger with the CME for July 9, and while former members clearly wanted to see the CME up its bid, Manning says that shareholders may be changing their tune as they compare the two offers on an apples-to-apples basis. He adds though, “If ICE makes cash more of a significant component, than I think the Merc really needs to beef up its offer.”
The mid-sized FCM added, “The deal is not going to be determined [by outside forces]—unless their is an external influence like the Department of Justice—the deal is going to be determined by the former members of the CBOT. And to them, a lot of it is going to be monetary.”