Exchange Mergers: Who Is Coming To The Dance?

Yesterday the exchange space was ruffled by the two announced mergers, TMX and LSE, and NYX and Deutsche Borse.  It’s always interesting to play “As the Exchange Turns” to see what’s next.

Andy Kessler recently wrote a great book “Eat People:  And Other Unapologetic Rules for Game Changing Entrepreneurs.  Many of his rules should apply to M+A activity too.  There are a lot of ways to view who will buy who.  As I said yesterday, when the merry go round stops in a few years, there will be 3-4 exchanges world wide, just like credit cards.  A global economy demands global scale.  When exchanges buy another, they expect to wring out cost savings in the operational end.  Concurrently, there should be some strategic value to the front end.  The merger ought to eat some people too.

For example, the NYX, D.Borse merger makes really good sense.  They can combine all three of their product lines to create a juggernaut.  Cash equities (NYSE, D. Borse) Cash Options (AMEX, ISE), Futures (Euronext-LIFFE, Eurex).  Plus they get global scale.  They are strong in stocks and futures, weak in options.  The merger also validates the vertical silo business model in exchanges.  Until someone figures out how to do it horizontally, or regulators allow, its not happening.

If we assume that both deals announced yesterday go through, what does the competitive landscape look like and who makes the next chess move? Who looks like they might get whacked?  Here are our players in no particular order: CME, ICE, CBOE, NDAQ, along with the newly combined TMX-LSE.  In the long run, the NYX-DB isn’t done yet either.

I am eliminating the Asian exchanges from my analysis.  Regulators there would have a hard time allowing them to merge, or be consolidated.  Someday, a place like the Shanghai Stock Exchange will merge with someone else, but right now it’s practically impossible given the state of the Chinese government.  Last year, ASX merged with SGX, and even that small merger has caused consternation among indigenous regulators.  Bursa Malaysia is a small exchange that has a partnership with CME.  Japan and South Korea each have great exchanges, but again, it is highly unlikely that their governments would allow a change in ownership.  Partnerships are even difficult.

In South America, the CME already owns a large part of the dominant player, BM&F.  The rest of the region uses it as a proxy exchange, not unlike the old Iron Curtain countries and the Deutsche Borse.

The Indian exchanges aren’t big enough yet, and like China it’s doubtful the Indian government would allow a merger to happen.  The Indians mistakenly think exchanges are utilities.  Even in the US, some legislators and regulators will be queasy about Germany’s Deutsche Borse buying the citadel of capitalism, the NYSE, but they ought to let the transaction go through.  It’s good for global companies.  It will spur innovation.

One thing you should keep in mind, it’s really tough to steal market share from another exchange.  Once liquidity finds a home, it generally stays.  The only way it moves is either government regulation, a killer ap-or the “all in” (commission, liquidity, clearing, cross margining) cost basis is cheaper.  It’s sometimes more capital efficient in the long run to simply buy the contract (exchange).  The only time it has happened is if an open outcry arena was competing against an electronic contract.

The other way for an exchange to quasi dominate another is by leasing or renting technology to it in the form of a matching engine or clearinghouse.  For example, the Kansas City Board of Trade clears it’s trades at CME and uses GLOBEX.   The KCBOT runs a great market, but no one is going to knock down the door to buy them.  They are too small, no scale.  Theoretically, an exchange could roll up lots of these little exchanges. But the time and cost to do it would make an any executive crazy.  Think about Nordstrom trying to roll up all the clothing boutiques in the US.  Bad strategy.   Much better to rent them until the end game.

Indigenous regulators usually have blinders on.  They forget, or are unaware that global finance doesn’t rest neatly inside geographical borders.  Every world wide exchange competes for money from every other.  That still is too narrow a lens to view the market with.  Cash, option, futures and OTC markets all compete for money.  The most important thing regulators can do is regulate with an eye towards transparency, information and price.  Sunshine is good.  Makes the roaches run away.  Blackrock is finding that out in their business.  Customers are getting gouged in almost every market because of poor regulation.  Governments can do more to curb innovation than anything else.  Regulators also need to communicate efficiently with regulators from other countries.  One positive of the worldwide financial meltdown is that there should be open lines of communication established!

So here are the players:

CME Group($CME)-they trade 98% of listed futures in the US.  They trade 12 million contracts per day, and its growing. They have a presence in Europe, Asia, South America via partnerships and hubs.  They recently received approval for a clearinghouse in London-so it’s no secret they are making an aggressive physical move into Europe.  They are a futures exchange only.  No stocks, no options, very little OTC. They take the trade from end to end.  Order execution, settlement, and clearing.  The combination of Eurex and Euronext-LIFFE consolidates two tough competitors.  No doubt they will attack the US Treasury complex.  CME’s smartest move might be to concentrate on defending and growing its existing turf.  By purchasing an exchange like the $CBOE, or merging with $NDAQ, they have to wear a lot of hats and answer to a lot of different regulators.  That increases costs, and I am not sure it increases scale.  The only way it does is if they have a novel way to exploit synergies between the CME equity futures complex and the stock or option exchanges.  NDAQ conveniently has an options market.  While it’s not as robust as the CBOE, it might not matter since all options are fungible unless you develop proprietary contracts like CBOE’s VIX.  CME recently purchased Dow Jones, so they have a good brand name and good base to invent things from.  CME’s market cap is $20 billion. Debt to equity is .69.  They have the capital to buy anyone.  The action from yesterday looks neutral to CME.  They will mind the store, and watch.

$ICE-ICE just got isolated a little bit.  They are strong in softs and energy.  LSE would have been an interesting combination for ICE, since they already are in London with their purchase of the IPE.  ICE has done a great job growing the Brent Crude contract.  ICE has been the most successful exchange in the OTC space.  They have a very aggressive, entrepreneurial CEO in Jeff Sprecher.  They own a clearinghouse, so like CME, they are an end to end vertical silo. Even with all those positives, they aren’t very big; 2-3 million futures contracts per day worldwide.  They need to get bigger, otherwise they will get swallowed.  They have to be looking at $NDAQ or $CBOE.  That begs the question, if ICE moves on CBOE can CME let it happen?  There is a lot of emotional baggage in Chicago. ICE has a market cap of just over $9 Billion.  Their problem would be their debt.  ICE is pretty highly leveraged. The good news is their revenue is growing, but still, debt cuts both ways.

$CBOE-there is only one reason they went public.  To get bought.  Question is, who is the beau that will escort them to the ball?  CME might, but it will have to be bolder than just buy the CBOE.  Buying them doesn’t do anything but put their foot on a base.  CBOE is profitable, and out of all the options exchanges, they are the best of breed.  ICE has to be looking at them.  But, I might put my money on NDAQ.    The CBOE market cap is $2.6 billion.  Deutsche Borse bought the ISE for $2.8 billion(April 2007).  Valuations of exchanges are down.  A crazy number should be out of the question.  CBOE has paid down it’s cash balance YOY, so no suitor is going to get a deal.   69% of its cash went to stock repurchases last year.  Much of the rest of it went for other shareholder related transactions.  They have zero debt.  CBOE will try and put as much make up on as they can, might even wear something revealing to attract a higher bid.

$NDAQ-market cap of only $5.59 billion, NDAQ has been struggling.  Being a stand alone stock exchange isn’t a profitable business because of the SEC.  The SEC allows dark pools, internalization etc, and that has eaten up the NDAQ.  The good news is they don’t have a lot of debt.  They tried unsuccessfully to purchase the LSE.  NDAQ is also too small.  Stay small and get eaten.  For them it might be worth it to take on debt and buy CBOE.   There are a lot of synergies, and NDAQ also owns OMX giving them a foot print in northern Europe.  OMX is considered to be a really innovative exchange, and that culture might fit well with CBOE.  ICE might also have a run at NDAQ.  This would put ICE on an equal footing with NYSE/DB, because it would have a foot on every base in exchange finance, plus a more established global footprint than CME.   But, they would still be small.  Again, their strategic question would be do they want to take on a lot of debt to buy someone?  Their dalliance with LSE cost them market share and focus, and it hurt their stock price.

TMX-LSE-It’s probably far too soon to consider them ripe for consolidation.  But, I don’t think it will be that far off.  Tom Kloet really pulled off a masterful stroke in getting the LSE.  The LSE is important culturally and historically. There also is value because being at the centre of Greenwich mean time gives it a competitive advantage. LSE volume is off, they have been eaten by dark pools, but they are still the LSE.  It’s a trusted brand.  TMX is in good financial shape.  CME might look at them hard.  Geographically, a combination with CME would lock up the Western hemisphere from Brazil to Canada.  Plus, the new CME clearing in London could interface with the LSE and be a tough competitor in Europe. TMX/LSE also pairs well with CME’s commodity business. Clearport could be an interesting addition to their business.  Kloet knows CME very well, having served as Treasurer of the CME Board before he became CEO of what ultimately became SGX.  ICE also has to be looking at TMX/LSE lovingly.  ICE has a strong presence in London, so the LSE fits. Plus, it is always looking to expand it’s commodity business and TMX can do that for them.  ICE already works with the TMX subsidiary NGX on crude oil.  NDAQ would also look at them, but the combination wouldn’t be as powerful.

The other creative move that a big player could do is similar to the “double dog dare” of the movie A Christmas Story.  Instead of swallowing one exchange, why not swallow two if the entire ball of wax makes sense?  It might not make sense go piecemeal.  For example, if you were CME, why stop at the CBOE?  It only gets you into one space.  If you are going to have to deal with the SEC, why not buy an established stock exchange like NDAQ too?  You could get the whole thing for close to 9 billion.  As long as you could wring out lots of operational costs on the back side, and dynamically create a robust equity futures, options, stock market on the front side it might be appealing.  However, the SEC probably won’t let that happen.  Governments curb innovation.

There are a lot of moving parts to the whole play.  Once you add in Asia, it gets really complicated.  Asia will come to the party someday, but it has to develop.  The first act of the play will be consolidating North America and Europe.  It will happen in the next two-three years.  Once dominoes start to fall, it doesn’t pay to wait.  Besides, the global economy is demanding it.  Companies want to raise capital.  Combined worldwide markets are a lot more efficient than national ones.

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