Investment banks fight CME-Nymex merger

BY Melanie Wold
24 Mar 2008


Market turmoil and the near failure of investment bank Bear Stearns have given a new meaning to the term counterparty risk, leaving futures exchanges with vertical clearing looking more desirable to investors and regulators alike.

The CME Group merger with the New York Mercantile Exchange announced last week puts together two strong exchanges with vertical clearing models and a broad product range. The merger will result in the absorption of Nymex’s over-the-counter clearing platform, Clearport, into CME’s clearing business.

This, along with other synergies, is expected to help give the combined group annual savings of $60m (€38m), according to the CME.

However, the bigger and more diversified combination of CME and Nymex may trigger more anti-monopoly scrutiny, particularly if pressure from bulge-bracket banks intensifies. The vertical clearing model came under fire when the US Department of Justice sent a letter to the Treasury Department in February.

The DoJ warned that futures exchanges’ control over clearing had made it difficult for other entities to compete in the financial futures markets and did not allow futures contracts to be fungible or traded through other exchanges.

CME members expressed concern over the letter and its timing, with the overwhelming belief being that investment banks, looking to wrench control of clearing away from exchanges for their own purposes, may have been behind it.

The 12 financial institutions forming a new futures exchange, Electronic Liquidity Exchange (ELX), plan to take on the CME head-to-head. Bank of America, Barclays Capital, Citadel, Citigroup, Credit Suisse, Deutsche Bank Securities, JP Morgan, Merrill Lynch, Royal Bank of Scotland, electronic brokerage eSpeed and derivatives traders Getco and Peak6, plan to launch US Treasury futures this year.

Julio Gomez, global head of research at consultancy Financial Insights, said: “Having a combined CME/Nymex controlling the clearing of such a large piece of derivatives trading makes it harder for trading firms to have end-to-end control of trading across asset classes.

"That means they can’t reduce trading costs or improve trade order processes without getting CME’s buy-in. That’s a problem in a rapidly evolving marketplace. That’s why ELX has support.”

If the investment banks could convince regulators to remove the lock CME has on clearing, it would give them the opportunity to trade similar products in more than one venue.

Craig Pirrong, a professor of finance and the energy markets director for the Global Energy Management Institute at the University of Houston’s Bauer College of Business, thinks it is likely investment banks were behind the DoJ’s strongly worded letter but not because of clearing.

“I think it was more that the big banks worry about CME encroaching on their OTC turf – swaps.”

A former trader on the Chicago Board of Trade said the DoJ letter was a shot across the bows of the CME: “Think of it as business combat. First the CME announces it is going into swaps trading, complete with counterparties and mark-to-market a couple of times per day. Swaps is a gigantic marketplace, 10 times bigger than futures, and the banks want to keep it.”

According to figures from CME, interest rate swaps command a $271 trillion market. Last summer, CME said it would extend the use of its Swapstream electronic interest rate swaps trading platform that it acquired in 2006 to offer a centrally cleared interest rate swap product.

The exchange said CME swaps on Swapstream was to be the first interest rate OTC swap to offer the benefits of central counterparty clearing using CME’s OTC clearing solution, CME Clearing360. It launched last month with 33 buyside early adopters, including banks, mortgage banks, asset managers, hedge funds and proprietary trading firms.

The former CBOT trader said the second part of the battle was where investment banks try to remove the exchanges’ hold on clearing to make the contracts more fungible: “Then the banks can trade one exchange versus another and skim off the spread.”

Investment banks want to be able to open a position in one exchange and then close it out in another exchange, said Sang Lee, managing partner at Boston-based consultancy Aite Group. “This would certainly lead to more competition and, ultimately, a more competitive pricing structure.”

Pirrong disagreed. “Liquidity attracts liquidity – it would be virtually impossible to make inroads into CME’s business. This is where the DoJ dropped the ball,” he said.

Combining CME and Nymex futures and clearing under one roof gives the new joint exchange further diversification of revenues, with products in every major asset class, from interest rates to oil to corn. It helps CME to compete globally with other cash, OTC and regulated markets, including energy, because of Nymex’s global scale.

Additionally, CME’s experience and vertical clearing structure will help when dealing with the regulators. The Commodities Futures Trading Commission recently pledged to enhance trade surveillance and is doubling its technology budget to achieve this.

Energy markets have been under-monitored by regulators and the CFTC is determined to crack down on price manipulation. The CME has more extensive experience with self-regulation and with outside regulators, due to its wide range of financial products, and can help smooth the way for Nymex to better provide transparency and to spot trading abuses.

CME’s size and scale, once Nymex is included, may put more pressure on rival energy marketplace Intercontinental Exchange to find a partner. Lee said if the deal goes through it will be tough for ICE to remain independent: “ICE will need to look for a larger exchange to link up with.”

The deal is expected to be completed by the end of year. Some Nymex members and shareholders were unhappy with the CME’s $9.3bn bid and have already launched a class action suit against both exchanges.

Although market weakness on the day of the announcement was partly to blame for Nymex and CME shares falling, there may have been an element of protest from Nymex shareholders. The former trader at the CBOT (and a CME shareholder) said: “We’ve been punished for trying to take over Nymex.”

The combined strength of the two exchanges cannot be discounted, however. Pirrong said: “Nymex is better off with CME than going it alone as a one-trick pony like ICE.”

 

Yes, bankrupt US institutions entering the futures business. I swear I am living in the matrix

 

Brilliant analysis of the "problems" facing all listed exchanges now that the Money Masters have decided they want to own/control them for their own devious means. Proliferation of trading platforms outside recognised exchanges will reduce transparency and increase trading risk immensely and will contribute to the financial catastrophe down the track that awaits us all. The mantra that it must occur in the guise of competition is nothing more than greedy banks trying to cherry pick certain areas of exchange business to feather their own nest.

They are not content to gift the financial world sub prime, CDO's and other questionable products - now they want to "control" all facets of buying and selling for their own greedy aims. I believe that these Investment Banks and their ancillary trading desks/hedge funds for their own greedy aims orchestrated the financial meltdown of listed Exchanges early 2008. Indeed, their negative stance and continuing questionable agenda towards listed Exchanges continues to this day. Sovereign Exchanges do not need the “proposals they have in store”. They must be resisted at every turn, otherwise regulatory standards will erode noticeably and financial Armageddon will become a certainty.

 

The banks and wall street have become parasites