NYSE pulls rug from under Chicago Mercantile’s feet

When the chiefs of the NYSE and the Chicago Mercantile Exchange sat down for a public debate six months ago, the New Yorkers talked of wanting to avoid a “sumo match”.

Craig Donohue, the CME’s chief executive, will have tightened his protective mawashi this week amid signs that the NYSE is overtaking the CME as the dominant force driving consolidation of the global financial exchange industry.

The flurry of bids last week for Euronext, the pan-European stock and derivatives platform, has obscured two key developments which will determine the industry’s future.

First, futures and options are the dominant growth drivers for financial exchanges. Low-margin cash equities have been left trailing in the wake of derivatives trading as changes in investors’ asset-allocation strategies fuel the expansion of the hedge funds which have pushed up trading levels and profits at the major exchanges.

Second, analysts said that NYSE chief executive John Thain has conjured a remarkable transformation of a group which less than two years ago was mired in scandal and the inertia of entrenched member interests.

With an IPO and the move towards hybrid and floor and screen-based trading under his belt, Mr Thain’s bid for Euronext would create the first transatlantic cash-equities exchange but, more importantly, accelerate the expansion of its own small derivatives business, and form a formidable global competitor to the CME.

The NYSE’s renaissance puts a large dent in the CME’s stated role of leading industry consolidation. “

Some analysts believe the CME has underestimated what Mr Thain has achieved, pointing to its reaction to the NYSE’s merger last year with Archipelago, the US-based electronic exchange. “What the NYSE did was an attempt at playing catch-up. We are the model they are following,” said Leo Melamed, a former CME chairman and influential board member, at its annual shareholders’ meeting in 2005.

Derivatives are the key source of revenues, profits and future growth at Euronext and its potential suitors, which include the NYSE, Deutsche Börse and, in recent months at least, the CME.

Mr Donohue has long prized Liffe, the derivatives’ arm of Euronext which contributed 36 per cent of group revenues in the first quarter of 2006 through its dominance of the European market for short-term interest-rate contracts and expansion of single-stock futures’ contracts.

The CME exerts similar control of the US short-term market and held talks with Euronext about acquiring Liffe, while quietly hoping that a successful Deutsche Börse bid for the Paris-based operator would see it pick up the unit to soothe regulatory concerns about a monolithic European derivatives exchange.

The NYSE’s move on Euronext would scupper that plan and leave the CME with the option of trying to build its European business organically, or using a market value approaching $15.5bn - $6bn more than the NYSE - to effect a deal with Deutsche Börse, whose own Eurex derivatives arm is the global market leader by contract volume. Speculation about a US-German deal has started to emerge.

Mr Donohue has made it clear that he sees little value at present in creating an exchange trading both derivatives and cash equities.

But he has predicted that a futures exchange would acquire a stock exchange at some point. Business in Europe and the US would be concentrated in seven or eight major markets within a decade, with a tail of niche exchanges trading specialised assets.

Mr Donohue has said in the past that the development of the futures’ industry tended to turn conventional wisdom on its head, but a successful NYSE bid for Euronext would perform a similar flip with his own predictions. It is also a year since the Chicago Board of Trade – the third-ranked derivatives’ exchange - turned down an approach from the CME in favour of pursuing an initial public offering. Chicago traders are starting to speculate that the CME may have to look again to its cross-town rival.

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