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No More Second City

Chicagoans jokingly refer to their hometown as America's second city, but that sort of self deprecation is probably more the norm outside the exchange space. For 160 years Chicago has been the center of futures and derivatives trading, but with the consolidation of Chicago's two futures giants into the CME Group, accounting for 85% of U.S. futures volume in 2007, CME Group is now a global player capable of competing in the over-the-counter space on a global basis.

Just for perspective, the nearest competitor was the New York Mercantile Exchange, with 10.85% of the futures volume. The Intercontinental Exchange's piece of the futures pie is less than 2%; and now CME Group and Nymex have announced their plans to merge.
Clearing the decks

The CME was the first U.S. exchange to restructure itself as a publicly held for-profit corporation from a mutually owned not-for-profit in November of 2000, and on Dec. 6, 2002 it became the first U.S. exchange to have an initial public offering. Converting access to equity proved difficult and was no easier for those that followed, requiring years of debate and legal battles. But those exchanges that have completed the transformation now have a more nimble form of corporate governance; one that is focused on profits and customer service rather than balancing the many competing interests of its members.

The enormity of these changes and the pain and profits associated with them cannot be overstated. Before demutualization, exchange seat holders were more than simply the gate keepers to the trading pits; they literally owned them and made their fortunes by trading and by granting access to those trading floors for a price, either through leasing seats or charging commissions.

But completing that process also removed much of the subjectivity associated with valuing the exchange, creating a common currency that has allowed the wave of consolidation. It also sharpened the exchanges' mission to a single point: increase shareholder value. And the surest way to increase shareholder value, regardless of the industry, is to increase efficiencies, and that meant utilizing clearing as a revenue stream and allowing users to have direct electronic access to the markets on a near 24-hour basis.

Setting the stage

"The Common Clearing Link's advantages are vast but can be summarized by stressing the one word: single," said CBOT Chairman Charles P. Carey of the historic clearing link between the CBOT and CME in his July 10, 2003 Mid-year Chairman's Report. "The new Common Clearing Link helps assure benefits for CBOT customers, members and member firms via a simplified clearing system that combines a single point of collateral management; a single location for positions; a single risk management platform; a single clearing interface; and a single guarantee fund." And for customers, the CME Group says the savings have been profound.

"We looked at the capital savings of bringing the two markets together, and that figure is north of a billion dollars that we have been able to save our clients from a capital standpoint," says Rick Redding, managing director of products and services for CME Group.

For the exchange, there are two ways to benefit: first by cutting costs, and second by providing increased efficiencies to traders, which increases volume.

"You don't need two people doing accounts payable in two locations. So there are expense synergies related to headcount, IT programs or having two people doing the same functions on the trading floor," Redding says. Post merger, the CME Group says it reduced headcount by 380.

And on the business side, combining CBOT and CME interest rate products onto the same platform allows the exchange to get a better handle on risk in the system and create new trading opportunities by allowing traders to execute more trades faster and harmonizing rules. "It brings easier ways to look at the risk across a firm in the positions that they are carrying," Redding says. "By having those on there, they can execute trades faster and see more trades that could be profitable to them. That's more volume for the exchange. So we pick up the revenue synergies from that trading."

Show time

Adding the CBOT contracts to Globex took time, money and effort, but apparently less than allotted for. Initially, the CME said that electronic integration would take 12 to 18 months. Then a competitive bid from the Intercontinental Exchange (ICE) stalled the CME/CBOT merger for more than a month. But after the CBOT members voted to approve the CME deal on July 9, 2007, something remarkable happened: CME moved the integration date forward and the commodities and equity indexes went live on Globex on Jan. 13, and interest rates went live on Jan. 27, just seven months from the closing of the merger.

"For us, it was transparent. We had no technical issues," says Michael A. Manning, president and CEO of Rand Financial Services. "From the customer standpoint, they are coming in through one of the third-party systems, so as long as their front end is working, they don't even know what's going on in the background."

And other futures commission merchants had similar responses. "It was nothing but a blip on the radar," says Dave Glancy, VP at Iowa Grain. "We had experience with Globex, so it really was a non event."

Mark Sachs, president of Lind-Waldock, says the integration was seamless. "It went as it should have. They did a great job," he says.

Brian T. Durkin, CME Group's chief operations officer, led the team responsible for the integration and says a long planning cycle has been critical to their success. "When we moved from eCBOT onto Globex, the very first thing we did was gather our user base together very early on into the planning stages," he says. "We found that the secret to our success was proper engagement: over communicating, wherever possible, in terms of what our plan of execution would be." He says even though many client firms had access to Globex, they spent time with those firms calibrating communications infrastructure to maximize performance. "We have a whole team that is dedicated, from our technical support arena, to making sure that these thousands of user sessions are properly aligned to garner that performance efficiency."

And so far, the system has remained stable, even with the increase in trading volumes. "There haven't been any significant drop downs to note," says Boyd Cruel, analyst for Alaron Futures and Options. "There were days the eCBOT system would go down and we'd have to go straight to the pit."

Integration of the trading floor also was moved forward, and was scheduled to begin on April 7 for equity indexes, April 28 for interest rates and foreign exchange, and May 12 for commodities. "They have had a half-dozen meetings for our market. And they are doing it in a very orderly and thought out way," says Kevin P. Hubbell, a partner at Bear Brokerage. He says that traders in the Eurodollar options pit have visited the new trading floor and that the few complaints he heard were related to the physical space and limited to sightlines and angles, "nothing that couldn't be modified to satisfy their needs," he says.

Listing CBOT contracts on CME's Globex electronic trading system will save the exchange $150 million, and the 'revenue synergies,' increased profitability based on more trading volume, are another $75 million, according to the CME. One of the most important synergies will be the consolidation of the CBOT's five separate Treasury pits. And as for the CME trading floor at 20 S. Wacker Drive? The CME Trust sold the trading floors to real estate firm Tishman Speyer, which will convert them to office space. CME Group also extended its lease at the building through the year 2022.

On the road

The CME's Globex is perhaps the best distributed electronic trading platform, supported by intense marketing and multiple communication hubs around the world, but acquiring the CBOT also gave the CME Group a boost in its globalization efforts.

Redding says that legacy CBOT commodity products, such as wheat, corn and soybeans are much more global in nature than CME legacy commodity products, such as cattle and hogs. "And that's very important. That's very strategic for us to help globalize our product base and globalize our market," he adds. Another example would be an international client who was buying or hedging with CBOT U.S. Treasuries products. That trader could benefit from having CME interest rate products, such as the Eurodollars, on the same platform, which could result in new trading strategies.

The CME Group is aggressively extending itself through international projects, like the recent equity swap with The Brazilian Mercantile & Futures Exchange, which includes order routing, offshore collateral management and "super-clearing" membership. CME Group also has proposed a five-year agreement to list KOSPI 200 futures contracts on Globex and has offered a super-clearing membership and access to CME foreign exchange and interest rate products to the China Foreign Exchange Trade System.

Coming soon

The CME began hosting New York Mercantile Exchange (Nymex) energy and Comex metals contracts on Globex in the second quarter of 2006, and since then Nymex has had six consecutive record volume quarters.

If CME Group successfully acquires Nymex, it would do more than add the extremely valuable energy and metals suites to their product mix. They would pocket all of the transaction fees currently split with Nymex and capture all of the clearing fees that had been going to the Nymex Clearing House. CME Group expects $60 million annually in expense synergies from the merger, beginning 12 to 18 months from closing the deal. And the deal is compelling on several other fronts as well, helping CME Group's plan to expand its share of the over-the-counter (OTC) market and feeding globalization efforts.

The OTC market is huge, and Nymex is a big player in those markets. According to the Bank for International Settlements (BIS), at the end of June 2007, the notional value of OTC derivatives totaled $516 trillion, 135% higher than the level recorded in 2004, representing an annual compounded growth rate of 33%.

The average daily volume trading on Nymex's OTC ClearPort Clearing platform was 511,527 contracts. By gaining access to Nymex's OTC market and the Nymex ClearPort Clearing platform, CME Group would dramatically increase its share of the OTC world and could potentially use the ClearPort OTC trading and clearing platform to drive more expense synergies with CME Group's OTC initiatives.

Durkin declined to talk about the technical merger with Nymex, except to say, "We have an excellent template for handling migrations, whether it be from an electronic trading platform or consolidating trading floors. And we have a very strong team that has a high level of expertise in doing that; and I and my colleagues have been through a number of platform changes, so we know what that is all about."

Nymex's energy and metals contracts, much like the CBOT legacy products, also serve an international client base, with a heavy concentration of users in the Middle East and Asia. And in the same way that the CME Group has been able to increase volumes by combining contracts onto a single trading platform and clearing house, the CME Group could increase both expense and revenue synergies and increase trading volumes. Nymex also has strategic relationships with the Dubai Mercantile Exchange.

If the deal is approved by the U.S. Department of Justice, the Commodity Futures Trading Commission (CFTC), CME shareholders and Nymex's shareholders and members, the combined exchange would host more than 97% of the futures volume in the United States. It's no wonder that the New York investment banks are getting nervous, nervous enough to band together to announce the launch of their own exchange.

The critics

Some traders are cheering at the prospective efficiencies that would come to the futures markets, including presumably lower clearing costs and cross margining opportunities. But a group of New York based investment banks and technology firms have teamed up and plan to create a competitor: the Electronic Liquidity Exchange (ELX). The backers of the ELX are formidable and include JPMorgan, Merrill Lynch & Co., Citadel Investment Group, eSpeed Inc., Bank of America, Credit Suisse, Barclays Plc, Citigroup Inc., Deutsche Bank AG, GETCO LLC, PEAK6 and Royal Bank of Scotland Group. Although a headquarters and CEO have yet to be chosen for the exchange, it is widely expected that the first contracts to be listed will be U.S. Treasury futures.

Another threat may prove to be Nymex members, who have filed lawsuits claiming the CME Group bid is too low. Another group successfully petitioned a meeting to review Nymex Bylaw 311 G, which says that any floor traded contract that is terminated and available only via computer, or where 90% of the volume is via computer, that Nymex members will receive 10% of the revenues or 100% of special fees.

The deal also would be subject to regulatory approval, including the CFTC and the U.S. Department of Justice, which approved the CME/CBOT merger, but also recently made known its objections to vertically integrated clearing of financial futures. In that same comment letter to the Treasury, however, it also said energy markets should be exempt from such changes.

"Preventing this merger can only weaken the U.S. futures industry at a time when it is truly a global industry," Manning says. "You wouldn't dream of doing anything that would be anti- global competitive to the auto industry or the electronics industry. Everybody in the country knows the competition that we are against in those industries and we are against that same competition in the futures industry."

But with its size, CME Group is not simply competing as a futures exchange on a global scale but as a financial services behemoth competing against every large investment bank, which are also, by the way, its largest customers. CME Group, however, increasingly looks at the end users of its products as its customers, a fact not lost on the large investment banks who view CME Group as a threat. How this conflict plays out over the coming years will determine what the industry looks like down the road. And while the view will be global, expect Chicago to be a prominent part of that picture.

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