What the NYSE Deal Means for the Major Players – And You

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The NYSE deal in which IntercontinentalExchange Inc. (NYSE: ICE) will acquire NYSE Euronext (NYSE: NYX), the operator of the New York Stock Exchange, is putting pressure on CME Group Inc. (Nasdaq: CME) to find a dance partner before closing time.

That's because the NYSE deal has highlighted the importance of futures and options exchanges like CME (Chicago Mercantile Exchange) in the future of trading.

A new regulatory environment, set up to address the issues thought to have caused the financial crisis of 2008, will require most over-the-counter derivatives – customized options and futures contracts between two companies – to be settled through clearing houses instead of as a private agreement between two investors.

Settling OTC derivatives through clearing houses will require market participants to put up collateral and adhere to specified margin requirements, which are not necessarily required in an OTC transaction.

Big derivatives exchanges, such as ICE and CME, see this as another money-making opportunity. And ICE just made a huge profit move with its NYSE deal.

"CME should be wary of this combination because it looks to be pretty formidable," Michael Holland, who oversees more than $4 billion in assets as chairman of New York-based Holland & Co., said in a phone interview with Bloomberg News. "The ICE people have done a very smart thing. CME should be concerned."

NYSE Deal Signals End of Era

ICE acknowledges the NYSE deal is all about NYSE LIFFE, Europe's second-largest futures exchange specializing in financial futures, which is operated by NYSE Euronext. ICE specializes in energy and agricultural commodity derivatives, so acquiring LIFFE gives ICE a broader, complementary product lineup as well as enhanced access to the European market.

By leveraging its existing clearing operations through the acquisition of NYSE LIFFE, ICE hopes to increase its clearing and settlement revenue as new regulation begins to take effect next year.

This seems to be the final nail in the coffin for the brick-and-mortar stock exchange and the ultimate triumph of electronic trading.

The NYSE and other stock exchanges around the world have lost market share to electronic exchanges, market makers and dark pools where the bulk of trading now takes place.

The idea of trading on the floor of a stock exchange now seems to be an anachronism -
a buggy whip in the Space Age.

Which brings us to the importance of CME.

CME's Counter Move

Most analysts are expecting CME to take a run at CBOE Holdings (Nasdaq: CBOE), the holding company for the Chicago Board Options Exchange and other subsidiaries.

CME is the biggest futures market in the United States while CBOE is the nation's largest options market. A CME acquisition of CBOE would be highly complementary and give the combined entity even more access to clearing and settlement business.

Others think CME may instead opt to acquire NASDAQ OMX Group (Nasdaq: NDAQ), which owns and operates the Nasdaq stock market.

Although NDAQ pioneered electronic trading, derivatives have come to dominate equities. Some analysts have speculated that NDAQ might have a go at CBOE, which would be a nice fit, but would CME really allow that to happen without a fight?

But all is not lost for NDAQ if it doesn't get a deal with CME. It could acquire – or be acquired by – an overseas futures exchange, say, Hong Kong Exchanges and Clearing (OTC: HKXCY), the largest futures exchange in the world, which lacks a presence in the U.S.

What All This Means for Investors

Whether this consolidation will be good or bad for investors remains to be seen.

But as Money Morning Chief Investment Strategist Keith Fitz-Gerald said. "trading activity is going to be more concentrated and if the big boys want to use that to their advantage they will."

The same thing goes for settlement and clearing activity. Investors don't usually think much about it but the trade isn't done until it settles. Clearing and settlement will become even more concentrated.

ICE and its rival, CME, and other major clearing houses will become "too big to fail," especially once the new rules regarding clearing and settlement of derivatives come into play next year.

Even after the acquisition of NYX, CME will still be bigger than ICE. But the game is about growth and, in 2013, grabbing as much clearing and settlement business as you can.

NYX shareholders have got to be happy about the NYSE deal because it unlocks a lot of hidden value in NYX shares. NYX shares were up more than 30% following the announcement of the NYSE deal and are trading at a small discount to the deal price of $33.12 per share.

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