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.
The Chicago Board Options Exchange maintains a stranglehold on the popular S&P and Dow indexes, leaving the other options exchanges to fight over its table scraps. (The situation has become so important to options exchanges that the ISE recently launched a federal lawsuit to challenge the validity of restrictive options licensing agreements.) Newcomers to the index options world are often surprised that the only real competition in this marketplace comes from the CME and CBOT.
Bringing greater competition is not the only benefit of this merger of futures exchanges. The new juggernaut may also revitalize the way futures options are traded in the U.S. Perhaps the most common complaint that options traders have about futures exchanges is that their technology is antiquated. The futures markets appear to lag three to five years behind their options counterparts in terms of systems functionality. A perfect example of this technology gap is auto-quote, the system that automatically updates options quotes along with every tick of the underlying. Auto-quote has been a fundamental part of the options markets since the late 1990s. However, this technology wasn't integrated into the systems of most futures exchanges until late 2005.
Technological Blues
With most futures exchanges expanding their competitive efforts into options, the technological disparity between these two marketplaces has come into stark contrast.
The futures exchanges have made numerous attempts to correct this problem over the years, meeting with varying degrees of success. The CBOT launched its E-CBOT trading platform in an attempt to gain greater traction in the electronic market. However, a number of problems with this platform have been a significant impediment to the growth of its Dow options products.
To date, the only unqualified electronic success in the futures markets is the CME's Globex system. The Globex platform has been the launch pad for a number of successful products including the seminal E-mini S&P 500 futures contract. This product's small size and ease of use revolutionized index options trading and paved the way for the adoption of electronic trading throughout the derivatives world.
With the CME and CBOT joining forces, the foundering E-CBOT system can finally be abandoned and its products ported over to the far superior Globex platform. This is exciting news for futures options traders around the world. With two of the world's largest exchanges pouring their resources into a single electronic platform, the days of the technology gap may finally be coming to an end.
Although this merger is still a long way from completion, the CBOT/CME deal holds a great deal of promise for the options industry. Futures options traders may now finally enjoy the same level of electronic access to their marketplace that equity options traders have known for years. In addition, they may finally receive the same level of functionality that has existed in the equity options world for the better part of a decade. One shortcoming in this merger, however, is that its product offerings for equity and index option traders remain relatively sparse. Aside from S&P options, and to a lesser degree Dow options, there isn't much for the average options trader to sink his teeth into yet.
Crossing the River
However, I don't expect that will be the case for very long. With options volume continuing to expand at a record pace, this market has become an important source of growth for a futures industry whose main product lines are showing their age. Speculation of a futures exchange crossing the Rubicon into options has surfaced many times over the years. Unfortunately, the numerous regulatory and logistical hurdles involved in a cross-industry merger or acquisition have traditionally proven insurmountable. That is, until now. With the formation of the CME/CBOT juggernaut, we may finally have an exchange with enough muscle to get the job done.
The views in this column are those of the author and do not necessarily reflect the opinions of Traders Magazine. The author welcomes comments and questions. He can be reached at Mark.Longo@sourcemedia.com
