Urge to merge

The landscape for US commodity exchanges is undergoing considerable change, with many heavyweight names announcing mergers or new co-operations. David Watkins looks at what this will mean for energy trading

As commodity trading volumes soar, cash-rich commodity exchanges in the US are searching for new ways to maintain their edge. Recent merger and acquisition activity has put the fiercely competitive market under the spotlight.

Past months have seen the Atlanta-based Intercontinental Exchange (ICE) announce a $1 billion purchase of the New York Board of Trade (Nybot); a proposed merger between the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT); and a new trading agreement between the New York Mercantile Exchange (Nymex) and the CME.

As the various agreements take shape, energy market participants are watching with interest to see the effect on the market.

"What we'll see over the next six months is these current acquisitions being completed and integration taking place," says Camron Ghaffari, research analyst with Morgan Stanley who covers the US exchanges space. Synergies gained from consolidating trading platforms and combining complementary products on the same platform will spur additional volume growth, he says.

While some brokers and traders have voiced concern that a reduction in competition between exchanges might increase fees and, in the case of CME and CBOT, create monopolies, others view it as a way of streamlining the trading process, ultimately making it cheaper to trade.

"Consolidation is going to de-fragment the market and assimilate like-kinds of transactions rather than spreading them over different exchanges and clearing houses – which seems more efficient to me," says Keith Kelley, managing director of inter-dealer broker TFS Energy.

"I'd speculate also that the gains in technology and productivity also brought by consolidation activity will mean that actual costs are going to decrease," he adds.

In this respect, ICE's proposed takeover of Nybot serves as a prime example. If approved by the Securities Exchange Commission and the Commodities Futures Trading Commission (CFTC), the deal will enrich ICE's commodity portfolio with products such as cocoa and coffee while granting Nybot access to an electronic platform.

Perhaps of greater significance is the fact that it also gives the Atlanta exchange access to Nybot's US-based clearing facility, the New York Clearing Corporation, a move that ICE predicts will generate savings of up to $41 million in clearing fees per year. ICE trades are currently cleared on the London platform LCH.Clearnet.

"This point alone makes the deal worthwhile," says Michael Cosgrove, president of Amerex Brokers. "ICE is now going to keep a lot of money that it was paying away to a third party. The deal should also give ICE greater ability to introduce cleared contracts more quickly. They will not have to wait for the LCH to respond – they'll have their own clearing house under their own control."

ICE's chairman and chief executive Jeffrey Sprecher notes that the merger's mutually beneficial synergies make perfect sense in an age where interest in commodities is growing at a phenomenal pace, driven by both new technology and soaring physical demand.

"Nybot was interested in the deal because they don't have electronic trading technology," he says. "Meanwhile this merger gives us access to a US clearing organisation that we think over time we can exploit because of the growth of and demand for credit amelioration in the over-the counter space," he says.

This growth in the opaque OTC sector presents a rapidly evolving regulatory challenge to all sides. The past 12 months in particular have seen ICE protest that it is being made a target of US politicians and various industry groups who are calling for greater reporting standards on OTC energy derivatives that don't currently come under the jurisdiction of the CFTC.

The consensus is that the new Democratic majority in the US Congress will push for greater regulatory scrutiny. Earlier this year, Democratic New York senator Charles Schumer asked the CFTC to stop ICE from listing crude oil contracts that lay outside CFTC's market oversight. Energy contracts such as the exchange's West Texas Intermediate contract are cleared in London, therefore falling under the jurisdiction of the UK regulator, the Financial Services Authority (FSA).

With ICE's acquisition of a US-based exchange therefore placing it under the radar of the CFTC, questions regarding the future of its relationship with its UK clearing partner remain unanswered, with all three parties now in talks. Sprecher notes that as the market innovates, the

regulatory regime must innovate with it. "These cross-border alliances that we all may form will only make sense if we can homogenise the regulatory regime," he says.

Nanette Everson, general counsel with the CFTC, acknowledges the sheer pace of evolution in the energy market in the past 12 months, echoing Sprecher's view that understanding between all parties is essential for growth. "Our view is that globalisation, cross-border processes, consolidation and all these things that are happening in the markets are things that are embedded in the CFTC's legislation and in our mandate from Congress to help foster international competition," she says.

"These markets are increasingly global in scope and financial services regulatory policy must be flexible to account for these rapid changes. The CFTC should continue to foster productive and co-operative working relationships with our counterparts in foreign jurisdictions including the FSA, and that's exactly what we are doing."

One such 'cross-border event' is ICE's WTI crude futures contract. Upon its launch in February, Nymex complained to the CFTC that while the new contract would be outside the jurisdiction of the US commodity futures regulator, it could still be offered on trading screens in the US.

The CFTC responded by allowing ICE to continue, while promising to investigate further. The electronically traded look-alike WTI product has gone on to capture a considerable 35% market share within its first year of trading, setting an ICE open-interest record on November 1 of 442,223 contracts. Nymex WTI total open interest averages at just over one million contracts.

On one hand, the success of the ICE contract indicates how electronic trading is transforming the energy landscape. Yet Nymex's flagship floor-traded WTI contract, the most widely traded energy futures contract in the world, has continued to enjoy high volumes as the exchange continues to promote duality between open outcry and electronic trading.

This year, Nymex introduced side-by-side electronic and open-outcry trading in its physically-settled energy futures contracts on its ClearPort system, before listing its energy futures and options contracts on CME's electronic Globex platform. Many see this move as being crucial in enabling the exchange to fight its corner.

"It looked at one point like ICE had Nymex on the ropes," says TFS's Kelley. "The key tactical move in which Nymex has embraced Chicago's Globex system has allowed it to come back strong electronically and regain lost market share."

Indeed, on November 8, total Globex energy futures traded a record 437,601 contracts, surpassing the previous record of 415,437 contracts traded on October 3. Volumes of Nymex products on Globex are now approaching half its floor business, which has nevertheless continued to grow.

The figures point to what Felix Carabello, CME's director of alternative investments, describes as "an evolution in electronic algorithmic trading. These traders have been asking for access to metals and energy markets, and since we started in June there have been some adjustments with pricing and more traders have come on board. But the market isn't yet showing us what its full potential is."

Nymex provides an interesting window onto the debate regarding floor trading versus electronic trading, as currently both businesses are successful. However, many feel the days of open outcry trading there are numbered.

While trading in the front months of the WTI contract has migrated to the screen, floor trading is now concentrated on the back months. "Within 60 days [of Nymex listing its front month contracts electronically] a significant number of floor brokers that had been trading these front-month contracts had disappeared," says a source close to Nymex who asked not to be named. "For years, Nymex maintained that there was no room for electronic trading, and yet within 60 days, the front-month part of the floor became a ghost town."

One super-commodity exchange?

With its November initial public offering ending 130 years as a private, member-owned exchange, speculation as to what Nymex will do next is rife, with some in the industry strongly expecting some form of merger soon.

The proposed merger of the two Chicago exchanges, which they predict will create a $4.2 million notional value of 9 million contracts daily, casts a considerable shadow across the landscape.

"It would make perfect sense for Nymex and CME to merge sometime in the future," says Kelley. "The synergies would be obvious in bringing various elements together into one 'super commodity' exchange."

Yet such a move may be complicated by an issue that may even threaten the proposed Chicago merger itself: a non-compete clause between Nymex and CME, whose Globex system was due to carry products listed on Nymex's Comex subsidiary by the end of this year. This means gold, silver, copper, palladium, aluminium and platinum products potentially competing with gold and silver contracts carried by CBOT.

"There is a non-compete clause in the agreement and CME cannot list any competing products on its platform that would compete with Nymex's products," says Morgan Stanley's Ghaffari, who adds that this, along with the anti-trust scrutiny raised by the proposed merger between CME and CBOT, is one of the major obstacles that may impede the smooth closing of any transaction between the Chicago giants.

"From my understanding, CME sent a delegation of executives on the day the merger was announced to talk to Nymex; they obviously value the relationship and would not want to jeopardise it."

While it has been suggested that CME may close down CBOT's metals division as a result, Ghaffari questions the idea. "It would be problematic to close down one of the products where there is actual head-to-head competition in this market – I don't think it is a viable alternative," he says. "There are only two instances where there is head-to-head competition in the futures market right now and that's in ICE versus Nymex and CBOT versus Nymex. I don't think it would look too good from a merger-obstacle standpoint for the CME to unilaterally shut down the CBOT's metals business to protect Nymex."

On the cards

Another union some market watchers believe is likely at some stage is a merger between an exchange and an inter-dealer broker, thereby putting the shorter-term exchange business with the longer-term broker business under one roof.

"If you look at the distribution of open interest and volume along time in a typical contract, what you find is that the vast majority of open interest and volume in a futures exchange or an exchange-type model like ICE is bunched up in the first 90 days of the contract," says Amerex's Cosgrove. "But if you look at where an inter-dealer broker makes money, it's typically much further out along the curve than the first 90 days. Currently ICE and Nymex are not touching our business. We're having our best results ever. We have yet to see the purely electronic model showing any sign of making serious inroads into the areas where we earn our living. Currently ICE and Nymex are complementing our businesses."

As the red-hot energy sector continues to beguile and surprise investors, the urge to merge will increase, according to the experts. Exchanges, inter-dealer brokers and clearing houses look set to continue in their courtship in the months to follow.

As Ghaffari concludes: "More consolidation is on the horizon."