The heat over ICE

| March 21, 2007 | 0 Comments

The heat over ICE

The battle for the CBOT between CME and ICE is illustrative of the future of futures. Futures exchanges are no longer simply markets, but for-profit businesses, and unlike most for-profit businesses or even most exchanges special considerations must be made. Futures contracts are not like stocks, which can be bought at one exchange and sold at another. Most futures contracts are not fungible between exchanges, and so the survival of a futures contract depends not merely on their utility but their ability to attract market share. Liquidity attracts liquidity, this is the social phenomenon known as network externalities. Interest in commodity exchanges has surged as hedge funds have poured money into these markets and as China announces one of the largest investment programs in history to invest in “strategic assets” such as mining and energy resources.

The CBOT and CME have a long history in commodity trading, but their greatest growth has been in financial futures. The CME’s primary strength comes from the benchmark Eurodollar contract, the second highest-volume derivatives contract in the world according to the Futures Industry Association and used to manage risk from short-term interest rate changes. The CME’s second highest volume contract is the E-mini S&P 500, favored by retail traders for speculation and institutional portfolio hedgers. This is traded in higher volume than CBOT’s benchmark 10-Year Treasury Notes futures. As corn and soybeans expand from food to energy sources and from the pits to the electronic markets, CBOT’s agricultural products are becoming increasingly important. The two exchanges have a large overlap in core customers, and the CBOT already clears its trades through the CME, meaning they are already dependant on them and have seen the stability the CME provides. Given the overlap, a merger would allow the two to provide a central pool of liquidity and the benefit of reduced margins for trading related products.

On the other hand, the merger would also likely give CME and CBOT pricing power for these important contracts and preserve the fees they charge in the face of increased competition from investors on the global hunt for the best price. This led the Futures Industry Association, which perhaps reflects primarily the interests of the major bank and investment institutions, to oppose the merger. Also, the CME has been approved to offer a credit-event futures, which taps into the enormous over-the-counter credit derivatives market that these banks make handsome profits on. CME and the CBOT both have designs for providing access to real estate derivatives, another large asset class that needs risk management.

CME is cash-rich, with 28% growth in volume and a 26% increase in revenue. This makes it ripe for a hostile takeover, and the CME may feel the pressure to make an acquisition. Now enters ICE, with an unsolicited bid to purchase the CBOT and the CME faces the prospect of a bidding war. ICE is offering to place CBOT on a pedestal: keep the name, move in to the historic CBOT building, keep the management, keep the lucrative metals contracts that would be displaced by NYMEX metals if the CBOT and CME merge, and give CBOT shareholders a majority stake in the new firm.

But should the CME really be threatened? ICE is innovative, but the CBOT will need a clearing facility, and ICE won’t clear through LCH.Clearnet as they have until recently with their purchase of NYBOT and its own clearing facilties. Stability is absolutely critical to a firm like CBOT, and the prospect of trading using NYBOT’s clearing, untested at the volumes CME handles, is probably unappetizing. ICE & CBOT’s product lineup would be diverse, but the benefits to cocoa traders who will get access to Eurodollars may be slimmer than short-term interest rate traders (Eurodollars) who will get access to long-term interest rate products (Treasury futures).

The important reminder is that nostalgia is no match for dollars, and that even with the long fruitful connection between the Chicago exchanges, this bid is being considered seriously. Markets don’t magically appear, but are hewn with hard work and marketing to create a useful product. As markets become professionalized and globalization and innovation pressures mount, expect radical changes in the structure of the futures industry.

Trading Futures, Options on Futures, and off-exchange foreign currency transactions involves substantial risk of loss and may not be suitable for all investors. You should carefully consider whether trading is suitable for you in light of your circumstances, knowledge, and financial resources. You may lose all or more of your initial investment. Opinions, market data, and recommendations are subject to change at any time. The information contained on this email does not constitute a solicitation to buy or sell by Infinity Futures, Inc., and/or its affiliates, and is not to be available to individuals in a jurisdiction where such availability would be contrary to local regulation or law.

Khurram Naik is a derivatives broker at Infinity Futures in Chicago. He is a graduate of Carnegie-Mellon and has worked in research in cognitive science and education at Princeton, Harvard and Carnegie-Mellon University. He is also a former field director for a political campaign. He maintains a blog on literature and cognitive science. He can be reached at

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