The Future of Futures

The New York Stock Exchange and Euronext completed their debut as the first trans-Atlantic stock exchange last week, but the bigger news is what NYSE chief John Thain is promising next. The Big Board's quest to become a player in the derivatives business shows how global and competitive the market for these complex financial instruments has become.
Let's hope regulators are paying attention, especially as they weigh antitrust concerns surrounding two high-profile takeover bids for the country's oldest futures market, the Chicago Board of Trade. The CBOT is mulling offers from its Windy City rival, the Chicago Mercantile Exchange (CME), as well as from electronic upstart Intercontinental Exchange (ICE). In today's cutthroat world of global finance, exchange consolidation is more necessity than choice, and either tie-up would bring efficiencies and opportunity for investors.
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You can bet the CBOT's competitors realize the stakes, which is why they've been fanning antitrust anxieties, hoping to scotch the deal and forestall a tougher competitor. Like Mr. Thain, they can follow the money. Stock markets are crucial to raising capital, but their growth is limited by the number of companies that choose to go public, the economic health of a country, and such regulatory follies as Sarbanes-Oxley.
Derivatives, by contrast, are limited mainly by a lack of imagination. These days, hedge funds and other traders make bets on everything from interest-rate movements to how much snow will fall during ski season. These contracts hold profit potential whether world stock markets are booming or swooning. Global stocks were worth about $50 trillion last year, and bonds $65 trillion. The global value of derivatives contracts? Some $450 trillion, and exploding.
Yet derivatives exchanges are also facing the same pressures as their equity counterparts. For decades, regional exchanges relied on gentlemen's agreements to defend their turf. But technology has hurdled these walls, allowing competitors to offer services from anywhere on the planet. Markets like the CBOT have had to transform -- from membership clubs with floor traders specializing in farm products, into high-tech, electronic exchanges that wheel-and-deal in Treasury futures.
This competition has brought extraordinary benefits to investors by lowering trading costs, but it has also meant exchanges must grow to provide liquidity, develop new products, and seek efficiencies. Also driving the merger wave is the cash that exchanges have mined by becoming public companies themselves -- an innovation that itself has brought more accountability. The Chicago Merc's trailblazing decision to go public in 2002 gave it a competitive edge over the CBOT, putting it in position to offer its $8 billion buyout.
The worry is that all of this will confuse merger regulators, who prefer to focus on local market share. In this case, they've been furrowing their brows over the number 85% -- the percentage of the market for exchange-traded U.S. futures contracts that a combined CBOT-CME would hold. The concern is that an exchange that large would be able to unilaterally raise trading prices. This fear has given some momentum to ICE's own $9.7 billion bid, because an ICE-CBOT tie up would have only 33% market share.
This sort of static analysis is better suited to yesterday's oil and steel trusts than today's global financial markets. Exchange-traded derivatives are still in their infancy. An estimated 80% of the global derivatives pie isn't even handled by exchanges but is orchestrated by banks in over-the-counter transactions. U.S. share is also a poor measure of market power because today's exchange competition is global. One of Mr. Thain's goals in buying Euronext was to get access to its derivatives business, Liffe, and make it more attractive to U.S. investors.
Different exchanges also specialize in different products. The CBOT thrives in Treasury notes, soybeans, wheat and corn. The Chicago Merc focuses on interest-rate, stock-index and livestock futures. ICE touts contracts in natural gas, oil and sugar. The combination of either exchange with the CBOT would be more complementary than monopolistic, giving traders access to broader ranges of products in one place.
New entrants still face challenges, in particular building liquidity. This was the wall the Deutsche Boerse hit when it launched Eurex US and attempted to poach Treasury futures away from CBOT. New players need a significantly better mousetrap if they want to quickly attract enough market-makers to create real liquidity -- and that can be difficult in established markets.
Yet it can happen, and new technology has lowered the barriers to entry. In equity markets, online exchanges like Archipelago began stealing business from the NYSE and forced modernization. The same is happening in derivatives, notably with the 2000 creation of the International Securities Exchange as the first fully electronic U.S. options exchange. ISE's cheaper and faster service allowed it to steal business from the manual trading floors of its stodgier competitors, and within a few years was competing head-to-head with the Chicago Board Options Exchange.
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It's this potential that has older players looking to expand now, and the CBOT isn't alone in its merger ambitions. Mr. Thain is determined to grow his U.S. derivatives book and hasn't ruled out getting in on the Chicago action. The New York Mercantile Exchange, ISE, the Philadelphia Stock Exchange and the American Stock Exchange all have derivatives businesses that need to grow. European exchanges are also on the hunt for combinations, within their region or through deals in Asia, India or U.S.
All of which means that the best judge of the CBOT's competing merger offers are its own shareholders, not Beltway meddlers. Regulators may have the power to block a U.S. alliance, but they can't stop growth in exchanges across the world. They will merely impede the ability of U.S. companies to adapt and thrive in this new global marketplace.