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Regulatory culture clash on derivatives in NYSE/Deutsche Börse

by Suzanne Miller  |  Published January 13, 2012 at 4:28 PM
NYSE227x128.jpgAt this point, nobody really thinks they'll pull it off. But as a final regulatory decision approaches, NYSE-Euronext and Deutsche Börse AG executives are working frantically to convince regulators that if they are allowed to combine, they won't devour Europe's futures and clearing business. Good luck with that.

On Wednesday, the NYSE reacted to unconfirmed reports that antitrust regulators in Europe were recommending that the merger be quashed, vowing to fight to the bitter end.

In reality, it looks like the two exchanges lost the argument weeks ago, when regulators ruled that the over-the-counter derivatives market doesn't count as a competitive counterweight to the listed equity derivatives business. It's a decision that has confounded many in the derivatives world -- a group that already feels its business is widely misunderstood, including among regulators. It also highlights a potential schism between the thinking of U.S. and European regulators on what constitutes a global marketplace.

The global versus regional debate has made headlines for other foiled exchange mergers the past several months, though most were undone more by nationalist concerns rather than by academic debates on what constitutes a market for global securities.

For the two exchanges now on the brink of losing 15 months of intense work, the derivatives debate is anything but academic. While they admit NYSE-DB would end up with more than 90% of the European exchange-traded derivatives market and some 30% of the region's stock trading, they argue that the OTC derivatives market is a significant competitor, along with the U.S. futures powerhouse, the CME Group. Europe's regulators disagree, which has brought players from all corners of the marketplace rallying to the exchanges' defense.

"I don't think the EU regulators took the right decision in not counting overseas exchanges and OTC markets in their review," said Justin Schack, managing director of market structure analysis at Rosenblatt Securities Inc. in New York. "Liffe and Eurex are out there competing every day with the OTC markets. And if you ask the CME, they'll say they're competing with Eurex and Liffe and OTC swaps."

In fact, it's common knowledge -- at least in the derivatives world -- that end-users looking to hedge interest rate costs regularly jump back and forth between the listed derivatives and OTC swaps markets. Larry Tabb, founder and CEO of the research firm Tabb Group, gives an example: "If I book two different swaps that don't align, I can hedge the risk by taking the difference and converting it in the futures market. So for example, I have two different interest rate swaps but the maturities don't equal. They leave me with a 71-day calendar spread difference for $10 million. What I can do is then convert that 71-day exposure for $10 million into an equivalent of three-month Eurodollar futures. This enables me to hedge not exactly, but very closely."

In essence, players use both markets to hedge and customize interest rate risks. "What seems to be happening is that the EU competition authority is looking at competition in the futures market as very isolated from the rest of the risk transfer market," Tabb said.

If the two exchanges fail in this last-ditch effort to convince regulators to take a broader view, the CME will emerge as a clear victor, along with Nasdaq OMX Group, the London Stock Exchange and other entities, which have vigorously lobbied against the trans-Atlantic marriage. The EU's apparent decision to block the deal "puts Europe out of sync with other developed markets," Schack said.

"The decision stands in contrast to what happened in the U.S. when regulators allowed the CME to consolidate the futures business. The U.S. 'bought the argument' that CME competes with overseas and OTC markets," he added.

Other observers noted that if European regulators had cared to look harder, they would have understood the CME's own argument that the listed and OTC markets are often used interchangeably. In 2009, CME published a primer called "Interest Rate Products: Creating Inexpensive Swaps." Diego Perfumo, an analyst with Greenwich, Conn.-based Equity Desk Research, pointed out that "[t]he paper highlights that listed interest-rate derivatives can be used as a substitute for OTC swaps -- providing arguments that the [EU's] antitrust review is based on a false premise.

For the CME, the merger would have created its first formidable competitor. Alone, Germany's Eurex and New York's Liffe are each less than half the size of the CME. Together, they'd still be smaller -- but not by much.

At the same time, the CME has a vertical model, which means that all futures contracts traded on its exchange can only be cleared through the CME -- so CME products are not "fungible" on other exchanges. That contrasts with the cash equities business, where contracts can be traded on one exchange and cleared on another. The so-called vertical model allows the CME to sew up a bigger share of the market, which in the U.S. represents a virtual monopoly in the futures business.

Some of Europe's big exchanges also operate as a vertical silo, most prominently the Deutsche Börse. But European regulators like EU Competition Commissioner Joaquín Almunia have been outspoken in wanting to see a more open and competitive model, where end-users can trade and clear on multiple platforms of their choice -- a change that the London Stock Exchange has lobbied hard to bring about. That is likely another reason regulators have taken a dimmer view of the New York-German merger, as it would only serve to fortify a massively bigger vertical model.

Still, some critics suggest that the decision could end up holding Europe back relative to the U.S., at least in which market is leading more progressively. How that plays out over time, from a competitive perspective, remains unclear. U.S. end-users could ultimately lobby to force the CME to open up its model. But that's a way off, if it happens at all.
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Tags: derivatives | Deutsche Börse AG | Europe | futures and clearing business | NYSE-Euronext | regulation

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