The CME-CBOT Merger
University of Houston economist Craig Pirrong has
Blogging is a way of commenting on events in real time, and it can be interesting to review one's posts about an event with a distinct beginning and end. The CMECBOT merger is one event that I have been blogging about since they announced the deal in October 2006, until now. The merger has garnered significant attention from around the industry regarding its economics and controversies – which include the nature of competition in the financial exchange markets.
Competition is central to the antitrust issues surrounding the merger. The Department of Justice drew similar conclusions. Another related theme is the effect of the integration of clearing and execution on efficiency and competition. Opponents of the deal argued strenuously that integration impaired competition.
I started my blog, www.streetwiseprofessor.com, in January 2006 to comment on and analyze developments on exchanges. This was well-timed, as the past 20 months have seen myriad changes in the derivatives markets – and the CMECBOT merger has been the most fascinating of those developments.
The CME-CBOT merger is not a surprise – this tie-up has been mused about for years, and there were talks of a combination in the run-up to the CBOT's IPO in 2005. But the timing of the deal was a surprise. There was no serious uptick in rumors or conjectures about an impending deal in the days leading to the announcement. Following are a series of blog excerpts as I watched the exchanges complete this merger.
10.20.2006
The Big Deal
What's next? The exchanges are confident that anti-trust review will not cause problems. Perhaps, but I would expect the deal to get some attention from DOJ. It's a big deal, and those tend to attract attention. Moreover, exchanges have attracted little anti-trust scrutiny in the past, but with sea change in the industry, the tendency towards concentration in trading, and the prospect for further consolidation, that may change. DOJ will recognize that this deal will establish a precedent for future mergers in derivatives, equities and options, and will likely want to be comfortable with it.
The key will be market definition. If it's an individual futures contract market (e.g., Treasury futures), the deal won't increase concentration as the exchanges don't compete head-to-head in any contract. If it's the derivatives markets – including the OTC derivatives market – there's no problem because the futures markets are small relative to the overall derivatives markets.
Economically, I think that the first two are more economically sensible than the third. The third market definition presumes that different futures are close substitutes for one another. This is problematic. Different futures – even closely related futures such as Eurodollars and Treasuries – are not good substitutes for hedgers. They may be substitutes for some speculators, but I am doubtful that the cross-elasticities are very high. Moreover, some pairs of contracts are actually complements for some speculators. For instance, traders who spread Eurodollars and Treasury note futures, or corn and live hog futures, consider these contract pairs complements. Thus, there is not a strong prima facie case that “futures” is the appropriate market definition.
Post-Merger Perspective
Although market definition issues remained central
to the debate in the months after the merger
announcement, soon another issue moved front
and center – the competitive implications of the
CME 's ownership of the clearing house. Opponents
of the deal argued that exchange ownership
of clearing impeded competition in execution.
I invoked the Chicago School of economics to
cast serious doubt on these objections.
12.5.2006
I Can See Clearly Now
[T]his argument [against the integration of clearing and trade execution] is very retro. BC – Before Chicago (School) in fact. It is a re-hash of the monopoly leveraging argument Chicago economists and legal scholars demolished in the 1960s and 1970s. If the monopoly bottleneck is at the clearing level, the clearing operator would like to encourage competition in execution. This would increase the demand for clearing services by reducing the costs of execution services that are complementary to clearing. This would allow the clearing monopoly to charge a higher price for its services.
As the Chicago School scholars noted long ago, this reasoning leads to a presumption that there is an efficiency rationale for the integration of clearing and execution. Integration eliminates double marginalization problems and reduces transactions costs.
That is, the centripetal force of liquidity induces trading to concentrate on a single exchange. This confers market power on the incumbent exchange; it is very costly to coordinate a simultaneous defection of order flow sufficient to overcome the liquidity incumbent's advantage.
Thus, the clearing integration issue is a red herring. The CME is not a combination of a natural monopoly clearer with an execution facility that would be a near perfect competitor if shorn of its clearinghouse; it is a natural monopoly clearing house merged with a natural monopoly execution facility. This is exactly WHY they are integrated. Integration addresses the problems posed by bilateral monopoly.
Post-Merger Perspective
An April post argued that exchanges are not
likely to compete aggressively on fees, and that
a combination of the CME and the CBOT would
not dull innovation in the futures industry.
4.12.2007
More on Exchange Competition and Merger
Exchange fee cutting did appear to be decisive in the Eurex vs. LIFFE case in 1998. This involved competition in identical products – no basis risk or spreading considerations. This is not relevant in evaluating the CME-CBOT merger. LIFFE made key strategic errors that are unlikely to be repeated in the future. It did not respond to the Eurex price cuts, whereas such inaction is unlikely in the future. Anticipating a quick response to price cuts, an exchange is unlikely to initiate a round of price cutting. And due to the rough parity in other trading costs, the Eurex price cut was sufficient to induce tipping, meaning that the effect of the price cut was exaggerated. This is not likely to happen in competition between different products. For instance, a CBOT price cut is not going to cause all volume to leave Eurodollars.
I don't believe that a CME that absorbs the CBOT will rest on its laurels, and feel no need to innovate. Indeed, the high CME stock price clearly capitalizes the stock market's expectation of high cash flow growth. This growth is unlikely to result from volume growth in existing products alone, as healthy as this growth has been. Pleasing the god of the street will require growth from other sources – new products. CME is like a pharmaceutical company that needs to keep its pipeline full. The stock market will punish CME if it fails to do so. This will tend to concentrate management's minds and keep them on the hunt for innovations.
Moreover, even if one believes that more competitive market structures are more conducive to innovation, in the modern electronic trading era, in which foreign exchanges (absent regulatory barriers) can offer products in U.S. markets – and vice versa – and in which global financial firms trade on exchanges around the world, the relevant market is the world market. Looking at the United States, market share of a combined CME-CBOT entity is inappropriate in this regard. From a global perspective, the increase in market share (or the Herfindahl index) resulting from the merger would not typically present anti-trust concerns…
Given the nature of liquidity – and the consequent winner-take-all nature of exchange vs. exchange battles for market share in a given product type – excessive rent-seeking competition between exchanges is a real concern. Given these circumstances, I do not believe that concerns about the impact of the merger on innovation can provide a firm basis for blocking it. All in all, I am skeptical that the CME-CBOT merger will appreciably reduce innovation.
Post-Merger Perspective
In addition to objections about the lack of
innovation, the Financial Times editorialized
that exchange ownership in clearing was a
major impediment to competition, and that
the DOJ should intervene in the CME-CBOT
merger to open this purported “bottleneck.”
5.24.2007
Color Me Skeptical
There is one major reason to doubt that competition in futures execution is likely to be cutthroat, even given open access to clearing. If clearing is truly a natural monopoly – as the FT argument implicitly assumes – then a dominant clearinghouse, such as the CME, would like to encourage competition in execution, not discourage – this would allow it to make more money from its monopoly clearing operation. Clearing and execution are complements. If the derived demand for the putative clearing monopolist is higher, the cost of execution is lower. Competition and entry in execution reduce execution costs, so the clearing monopoly would encourage it. However, if execution is not highly competitive, integration between the clearing and execution venue can improve efficiency. Thus, if the FT is correct, CME would have no incentive to tie clearing and execution – but CME is a diehard defender of tying.
Post-Merger Perspective
After months of anxious anticipation,
in mid-June the DOJ finally weighed in,
and announced that it was closing its
investigation of the merger because it
deemed that the combination would not
substantially reduce competition.
6.12.2007
Good Economics Wins Out
The DOJ didn't buy into the fungibility argument either.
The Division investigated whether the combination might foreclose entry by other exchanges into financial futures as a result of the integration of virtually all financial future contracts into a single clearinghouse. The evidence indicates that neither the clearing agreement nor the transaction will foreclose entry by other exchanges. Indeed, the New York Stock Exchange, in connection with its acquisition of Euronext. LIFFE, recently announced its intention to offer futures products, and the Intercontinental Exchange (ICE) has publicly stated its intent to offer interest rate futures.
In a nutshell, the Division did not base its decision on the Chicago School argument, or the efficiency gains associated with integration. Instead, it noted that integrated entry, by ICE or NYSE/Euronext. LIFFE, was a viable form of competition. This is hard to square with the earlier statement that incumbent exchanges are largely immune from entry, but the logical outcome is the same. If execution is not highly competitive, due to an incumbent's liquidity advantage, then integration with clearing will have little impact on entry by either integrated or nonintegrated exchanges. Even though the reasoning here is a little shaky, the conclusion is the right one; the arguments against “silos” were not a reasonable justification for scotching the deal.
All in all, the Division is to be complimented. There was a lot of political heat to make the opposite call, and there were rumblings in the press that they would do so. They resisted this pressure, and made the right decision. The merged exchange will have market power, no doubt. But the CBOT and CME had market power before any combination, and the relevant consideration is whether the merger would have reduced competition substantially. The DOJ does not have the authority to remake the futures industry and mandate the massive changes that would be necessary to enhance competition in clearing and execution. It had the limited authority to challenge this transaction if it deemed that it would reduce competition.
Post-Merger Perspective
As this merger closes, an illustrious era will
end, and another will begin. I think that this will
be good for the business and good for Chicago.
The coming years will be interesting, with
complex interactions between exchanges and
the OTC market (and a likely blurring of the lines
between the two), and equally complex interactions
between global markets. I fully expect that
this partnership will blaze yet more trails, and
thereby enhance the efficiency of the financial
markets in the 21st century and beyond.
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