Five Big Questions Following the CME/NEX Deal Announcement

  1. At $5.4bn, does the purchase of NEX represent good value for CME Group?

This is a tricky one to answer. When some of the other OTC FX platforms have been sold, it has been possible to calculate how much they cost per $1 billion of average daily volume (ADV) traded on each platform and then compare those costs. Obviously, because NEX Group consists of a broader range of assets than just and FX trading platform and CME Group already has an existing FX business that could provide more synergies, such a simple and direct comparison is not really applicable here.

Putting the question to market sources revealed a range of views, but even those that consider the price to be steep admit that the acquisition represents a shrewd strategic move by the CME.

“[Michael] Spencer knew he had assets that the exchanges wanted. With this deal the CME gets three different assets: BrokerTec, EBS and the post-trade business – and all of these assets come at scale. So although the pricing is rich, ultimately it’s a great fit because now the CME will be a one-stop shop for futures and cash products, which ultimately they get to clear through a single margin account, resulting in meaningful savings for investors,” says Vikas Shah, managing director at Rosenblatt Securities.

Similarly, James Sinclair, chairman of MarketFactory, observes: “It would be hard to think of two large companies that would be more complementary in our space. Not only for the FX spot/futures, but also because cash traders trade correlated futures, or at least use the market data. In addition, on the market infrastructure side, Traiana is very complementary to CME’s clearing and settlement.” 

In a call with analysts following the announcement of the deal, one question was put forward regarding whether or not the OTC markets that CME is buying into are really growth markets? After all, spot FX volume on EBS peaked in 2008 when the platform recorded an ADV of $214.1 billion for the year. Since then, this figure has dwindled downwards, reaching $82.6 billion in ADV for 2017. Similarly, ADV in US Treasuries on BrokerTec last year was $160.8 billion, the lowest it has been since 2013.

In response to this question on the call, Sean Tully, senior managing director, global head of financial and OTC products at CME Group, pointed out that the zero interest rate policy adopted by many nations following the financial crisis led to falling GDP, and therefore caused a reduction in the growth of the FX market. The suggestion being that, as the US Federal Reserve continues to raise interest rates, this cap on growth is likely to be removed.

He added: “Most importantly, if you look at the penetration, both on the EBS side and the CME Group side into the FX market, we’ve only just started to penetrate the market.”

Pointing out that the combined FX volumes of both platforms still represent a very small proportion of the overall $5.1 trillion per day FX market, Tully highlighted CME’s new monthly futures and CME FX Link products, as well as NEX’s electronic NDF and CNH trading business lines, as growth areas that could help the combined entity penetrate deeper into the FX market.

Michael Spencer, the CEO of NEX Group, pushed back harder on the question, stating: “It’s a bit of a simplification to represent the OTC market as not growing. Let me give you one example: NEX does a very large business in US government repo and European government repo, about $250 billion per day in each market and are the clear market leader in repos in US and Europe. These are not about to be futurised and are a core part of the funding structure in the wholesale financial markets globally. It’s a very central part of it.

“We’ve also been in a period, until recently, of ultra-low rates volatility, which has obviously tended to diminish volume turnover, particularly in things like cash treasuries, when the Federal Reserve is buying most of the issuance. So we’re seeing a change in the interest rate cycle, a withdrawal of the Fed purchase of US debt and consequently, we’ve seen a significant increase in repo activity in Europe and the US and an increase in volumes in cash treasuries. With the increase in economic growth and the budget deficit in the US, I would think it’s very realistic to expect that the volume turnover in cash treasuries is going to increase significantly, potentially.”

The argument that a combined CME/NEX offering is going to substantially improve its penetration of the overall FX market in the near-future is perhaps less convincing than the argument that the broader FX market, after contracting for the first time in 15 years, according to the Bank for International Settlement’s 2016 triennial survey of FX turnover, is poised to start growing once more. A rising tide lifts all ships, and this could provide a more immediate benefit to the combined entity.

It’s also worth looking at the aforementioned synergies when analysing the value of this deal. CME has said that it could realise annual run-rate synergies of $200 million by the end of 2021, assuming a 2018 completion.

Assuming that these projections are accurate, that’s a sizable saving. In the analyst call, it was stated that these synergies will be driven by technology and operations savings, along with reduced corporate overhead expense. Expanding on this in a subsequent press call, Terry Duffy, CEO of CME Group, said that there is an expectation of a 16% reduction in headcount following the merger.

Essentially, whether or not $5.4 billion represents value for money depends on how the CME integrates and deploys the NEX assets. These two businesses have the potential to be highly complementary to one another, and bringing together the largest FX futures trading venue with one of the largest OTC FX trading venues could definitely be a winning combination, especially given the post-trade elements on both sides of the deal.

Just to throw a spanner in the works, however, there’s one final thing worth pointing out.

Although the CME says that it has “received irrevocable commitments to our transaction from the entire NEX board of directors”, there is no break-up fee included in the deal as currently proposed.

“That’s very unusual for a deal of this size,” says one market source, adding: “I don’t necessarily think that this is a done deal, there might be other firms who will try and come in and pay up for [NEX].”

The source speculates that the lack of a break-up fee could benefit Michael Spencer and NEX Group, pointing out that CME is financing half the deal with cash and half of the deal with shares, and therefore another group could come in with either an all-cash offer or a higher bid.

This is certainly possible, but – going back to the topic of value for money – it would be much harder for any other firm to either justify the $5.4 billion price tag or increase it. While NEX remains an attractive asset, and could be a great purchase for a big exchange group looking to buy its way into the FX and treasury markets, the cost savings and business synergies would not be anywhere near as big for pretty much any other firm that could afford to outbid the CME.

  1. Could there be more deals for OTC FX Platforms?

As another OTC FX platform looks set to be acquired by an exchange group, one of the most obvious questions to ask is: will more go the same way?

There are two potential reasons to think we might be reaching the end of this trend. One is that there aren’t that many OTC FX platforms that are of a notable size, in terms of volumes, left to sell. Another is there aren’t many buyers with deep enough pockets and a business interest in the FX market left to buy one of these platforms.

Aside from Currenex, the top five OTC FX platforms by trading volumes have all changed hands in recent years (this is including the 55% of the Financial and Risk business of Thomson Reuters that Blackstone has agreed to buy, given that this unit includes the trading platforms owned by the firm). And yes, FXSpotStream is now one of the larger venues in terms of volumes but, given that it is a bank-owned consortium operating as a market utility, it should arguably be considered separately to these other platforms when it comes to M&A activity.

It could be the case then that potential buyers are sceptical that there are assets worth buying in this space. While it’s always dangerous to give too much credence to the industry rumour-mill, anecdotal evidence suggests that a number of the smaller platforms are currently available for the right price, and have been for some time now. This could suggest that demand might be flagging.

Meanwhile, exchange groups are the obvious candidates to buy OTC FX platforms, but who is really in the market for one?

Intercontinental Exchange (ICE) does have an FX business, albeit a relatively small one, and has proven in the past that it isn’t averse to spending big money to acquire assets that it wants. Nasdaq has flirted with FX, without ever becoming a major player in the space. London Stock Exchange (LSE) Group has no existing FX business to speak of, although it does own LCH, which has taken the lead in FX OTC clearing.

“This issue here is that these firms need something at scale to move the needle for them in FX. When you’re a large, multibillion dollar company, something that throws out a few million in cashflow just isn’t going to cut it, no matter how sexy the platform is,” says Shah.

And yet despite this, there are some that see the potential for more deals.

“I think that there is still appetite for more platforms to be acquired,” says Javier Paz, a senior analyst at Aite Group. “One can also speculate that the Blackstone acquisition for the Thomson Reuters assets – for whatever reason that was done – will not be the final home for those Thomson Reuters products.”

Paz also raises the possibility that the exchange groups that have already bought OTC FX platforms – Deutsche Bourse, Euronext and Cboe – could be tempted to buy additional ones to increase their market share.

Sinclair is another who sees the possibility for more deals to buy OTC FX platforms.

“There could be more deals, and I think that they could be unexpected ones. The reality is that FX is an attractive asset class because trading it is a fundamental requirement for trade or cross-border investment, meaning that there will always be a steady market,” he says.

Though much will depend on the future performance of the platforms that haven’t been bought, it is ultimately hard to see NEX being the last OTC FX platform to change hands. If nothing else, each new deal arguably puts the remaining platforms willing to sell under more pressure to find a buyer because, in this game of musical chairs, no one wants to be left at the end without a seat.

  1. Do OTC FX platforms need scale to survive?

Following the announcement of CME’s proposed purchase of NEX, Profit & Loss highlighted the supermarket business model being espoused by senior figures at both firms, namely that it would benefit each to scale up and offer everything that FX market participants might need in one place.

These two firms are hardly alone in talking up the importance of scale – each of the OTC platforms that have been acquired in recent years has been expanding their offerings to try and help scale their businesses.

Does this mean that the platforms that don’t get acquired will struggle to compete in the future?

Sinclair claims that this is not the case, pointing to a recent whitepaper that MarketFactory published in which he actually argues that FX market liquidity will continue to fragment and more OTC trading venues will come to market.

He makes the point that, back when EBS and Reuters were the only two major FX platforms, one could have easily surmised that if they were bought by other entities – as EBS was – that there would have been nothing left to buy in the future, and yet history has shown that such an assumption would have been well wide of the mark.

“The reality is that the barriers to entry are falling in this market, and people will continue to innovate and produce new models,” says Sinclair. “If you are a platform operator, if you have fixed costs, then you can add new matching algos on top of that to reduce your overall cost, so it makes sense for these firms to add new models onto these existing platforms. But equally, outside the walls of the supermarket you have firms with new ideas and new innovations that we cannot predict.”

Perhaps more than scale, OTC FX platforms need diversity to survive. In an interview with Profit & Loss back in 2016, Carlo Koelzer, CEO of 360T Group and global head of FX at Deutsche Bourse Group, explained why he thought it was important as a platform to build up a critical mass.

“At this point, the pure platform that we operate has become a commodity, FXall has it, Bloomberg has it,” he said.

The key then, he argued, is to differentiate around this part of the business.

There is, as they say, more than one way to skin a cat, and as Sinclair points out, innovations could come to market that will help platforms diversify, solving problems for users that they might not even yet be aware they need help with.

Another way to diversify is by scaling up, a.k.a., the “supermarket” approach. The big derivatives exchanges have proven how effective this can be with the “vertical silo” models that they have traditionally operated. They long ago worked out that the more times that they can touch a trade during the course of its lifecycle, the more profit they can make off that trade, while also increasing efficiencies for their users. Subsequently, they have built businesses structured to keep trading activity within the business as much as possible from pre-trade, to execution, to post-trade. This model has proven very effective to date, and it will be interesting to see once the acquired OTC FX platforms are integrated into these vertical silos what impact it has on competition.

There is also another perspective to consider when analysing the need for scale amongst OTC FX platforms.

Urs Bernegger, founder and advisor at Helvetti AG and a former global head of FX spot and PM trading at UBS, claims that the goal of these exchanges is not actually to scale up these platforms and build an “FX supermarket”, but rather to push more trading onto the listed markets.

“I do not buy the argument that exchanges get involved with such high price tags to scale up the current OTC model. We will see a “change of model” rather than a scale up of the old model (OTC),” he says. “Gobbling up the ‘old models’ allows the exchanges to dictate the speed of the introduction of the ‘new FX hybrid’, which will consist of traditional OTC, exchange traded and cleared features. Regulators love a central limit order book (CLOB) and look at this as fair market practice. Therefore, we should expect a further push towards such a system from the regulators as well.”

This is certainly not the message coming from the CME though. In the analyst call, Duffy was pretty emphatic in stating that the exchange group is “committed to maintaining the existing market structure and committed to maintaining the existing liquidity centres”.

Moreover, this debate leads nicely onto the next question…….

  1. Will the CME purchase of NEX actually lead to more futures trading?

Once again, there appears to be two broad schools of thought here.

On the one hand, it could be argued that the CME has a mature FX business on its Globex platform, and as such the firms that want to trade FX futures products have been doing so for some time now. In addition, the exchange operator tried to launch FX futures in Europe, an initiative that was shut down at the end of last year after it failed to gather significant traction.

The counter argument to this narrative put forward by the CME on the analyst call is that, once it acquires NEX it can leverage EBS’s penetration amongst regional banks in Europe and Asia to sell them FX futures products. The banks currently, as one exchange representative put it, “don’t take advantage of the capital and margin efficiencies associated with futures products”.

Not everyone is buying this argument. One source with experience in pitching FX products to regional banks in Europe insists that they simply don’t want to trade futures. As evidence of this, they point back to the failed CME Europe venture.

“In the very early stages of the push to get more futures trading in Europe there were a lot of regulatory complications, there were certain barriers for European entities trading on US exchanges because of Dodd-Frank. So the CME launched in Europe to remove the regulatory obstacle and the firms there still didn’t sign up to trade on the exchange,” they say.

It could also be argued that the demise of FXMarketSpace offers another cautionary tale. A 50/50 joint venture between CME and Thomson Reuters that launched in 2006, FXMarketSpace was a centrally cleared OTC FX platform, and as such claimed to offer margin benefits to its users. Despite this, the platform failed to garner the expected level of interest and trading activity from market participants and was subsequently closed in 2008.

On the other hand, some market participants point to a number of factors that might push up FX futures volumes once the deal completes.

“In general, a lot of spot FX participants do trade on the CME, or would like to. One of the reasons why there hasn’t been more trading of futures is simply because in a bank it’s difficult to get margin onto the spot desk. This has long been a problem and it’s something that FXMarketSpace was trying to address years ago,” says Sinclair.

He continues: “If you’re on a spot desk you don’t necessarily have access to the collateral needed to access the futures exchange and bringing those two together inside the structure of a bank has proven challenging. But there is a demand to do exactly that. For example, people that trade AUD also tend to trade gold futures because they’re correlated. So yes, there are synergies between CME and the cash markets, it’s how to bring the two together and make that really work that has been challenging.”

But rather than envisaging a scenario in which both the futures and OTC FX markets grow together symbiotically, Bernegger argues that the banks are under “massive” pressure from both a cost and reputational perspective, and that this will in fact push more OTC flows towards the listed and cleared markets.

He says that while the FX Global Code of Conduct, fines for misconduct, and new regulations such as MiFID, Basel III and MAR, have pushed compliance costs up for banks, these firms are simultaneously suffering from shrinking direct customer volumes, due to the increased aggregation capabilities of their customers, and low market volatility.

“Banks must recoup these costs and therefore allow exchange trading and clearing to become a competitive (cheaper) solution for the client. With the exchanges being ‘in charge of clients’ now, due to their investments, they will not hesitate to push ‘their version’ directly. At the end, it will be the customer that directs the flow to the ‘fairer and cheaper’ channel,” says Bernegger.

He adds: “Once exchanges move the banks out of the role of FX liquidity provider (OTC model), the exchange volumes will increase dramatically as ‘internalising’ by banks will be much less possible. Such internalisation has been a volume killer for ECNs over the past decade and therefore also an income break.”

The debate about whether FX will move to an exchange model is a very old one, there are lots of reasons why the market has remained predominantly OTC and these reasons, on the whole, have not changed. But will these increased cost pressures prove the impetus to actually alter market behaviour? Much will depend on how successful CME is at penetrating new parts of the FX market and how it ultimately structures its FX business post-acquisition.

  1. Could this deal provide more competition to LCH in the cleared FX space?

LCH certainly seems to have stolen a march on other clearing houses when it comes to clearing OTC FX products, but once one of the largest OTC FX platforms is put under the same roof as a major clearing house that already clears FX futures products, will this remain the case?

On the press call, Spencer was asked about the role of TriOptima, part of the NEX Group that offers compression services, following the proposed merger and whether the combined CME/NEX entity would look to challenge LCH.

After talking about how NEX has a very close relationship with LCH and how he, personally, has known its CEO for many years, Spencer insisted that TriOptima will continue to be an open platform for compression that will work with many different clearing houses, including LCH.

While Spencer’s claims regarding TriOptima may be accurate, it’s easy to see how this deal could create a challenge to LCH on the FX clearing side. Coming back to this idea of the exchange operating a vertical, silo model, it seems likely that CME will eventually try and push NEX’s growing forwards and NDF business into its own clearing house rather than letting the trades go to LCH. And for firms already using CME Clearing, the capital efficiencies they can achieve only increase the more products that they put into the clearing house, creating an incentive for them to use it.

“The holy grail is to clear multi-asset through one platform because that can have major consequences on the capital side,” says Shah. “Right now firms have to hold different pockets of capital at different clearers, depending one whether they’re trading fixed income, equities, commodities, etc. Don’t get me wrong, the majority of FX will still trade OTC through the banks and will not necessarily go to the CME for clearing, but having one of the largest FX venues via NEX and the largest futures venue via CME, offers cross-margining opportunities on the clearing side. Then you have the cash bonds on BrokerTec and the Treasury futures on CME that can be cross-margined as well. It’s not necessarily a slam dunk that they can get this happening tomorrow, but there’s a definite rationale for doing this and I think this is the trajectory the CME is shooting for.”

Similarly, when it comes to competing with LCH on the OTC FX clearing side, Paz says that the NEX tie-up gives the CME “a much better leg to stand on”, adding, “I think that up until now, the CME was looking for a greater share of the interdealer market, and this is something that they are all of a sudden going to be able to acquire on both the fixed income and the FX side. So there’s a synergy play in these markets, and I think that this puts the firm in a good place to come up with creative solutions for the banks from an economic perspective and I think that’s one of the key rationales for the deal.”

LCH has worked hard to build out is OTC FX clearing business, and given the progress that it has made recently in terms of volumes, it could prove that its lead is unassailable already. That being said, OTC FX clearing is really still in its infancy and given the potential growth opportunity there, it’s hard to imagine that the CME won’t be looking at ways to leverage its new acquisition to exploit it, assuming the deal goes through, of course.

galen@profit-loss.com
@Galen_Stops
@Profit_and_Loss

Colin Lambert

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