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January 2, 2007

CME and CBOT Get Hitched: Merger may bring greater options competition

By Mark Longo

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  • CME and CBOT Get Hitched: Merger may bring greater options competition

The recent deal combining the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) stands out as a merger that could very well pose a threat to the U.S. options exchanges down the road. In the short term, however, it will have a more immediate influence on the global derivatives markets.

The idea of the CME and CBOT joining forces is not new. Analysts have been floating the idea of a merger between these two futures exchanges for years.

It's easy to see why this idea was so frequently discussed. Most mergers require the companies involved to spend a great deal of time eliminating redundant divisions and merging competing product lines. But the product lines of the CME and CBOT are almost entirely complementary. The merging of back-office systems should also go smoothly because the CME is already clearing the CBOT's trades.

Shall We Dance?

The merger dance between these two rivals had come tantalizingly close to fruition several times in recent years. The rumor mill went into overdrive in 2003, when the CME announced it was taking over clearing responsibility for the CBOT's trades. Many observers saw this as the precursor to a union of the two exchanges. Merger scuttlebutt resurfaced last year when the CME tried to pre-empt the CBOT's IPO. The CBOT wisely refused the CME's buyout offer, choosing instead to take its chances on the open market. The result was nearly a threefold increase in the price the CME was forced to pay to acquire its cross-town rival. Despite previous merger speculation over the years, the actual announcement of the deal caught many off guard. The CME took extraordinary steps to prevent negotiations from leaking. Only a select few at the CME and CBOT were even aware of the talks, let alone that a deal was imminent.

This merger of two futures powerhouses has understandably been a major topic of discussion throughout the derivatives world. With contracts on everything from soybean meal to Eurodollars, their dominance of the U.S. futures markets is a foregone conclusion. The impact of this merger on the options markets is far less certain. Longtime readers of this column know that the CBOT and CME have made many attempts to invade the options world in recent years. While most new options industry entrants have focused on the booming equity options market, the CME and CBOT have taken a very different tack. These exchanges have leveraged their dominance of the S&P 500 and Dow futures products, thereby allowing them to gain a foothold in the specialized but highly lucrative world of index options.

Institutional Boom

With so much of the growth in the options markets coming from the institutional sector, the index options market has become a very desirable niche. It is also a market segment desperately in need of new sources of competition. While the equity options market has devolved into a competitive free-for-all, the index options market has moved almost entirely in the opposite direction. A series of restrictive licensing agreements has negated competition in the index world.