What You Need to Know About NYSE Merger

CNBC has confirmed that the board will consist of 17 members—10 of which will come from the Deutsche Borse, seven of which will come from NYSE Euronext.

Both boards will be meeting tomorrow morning before the opening of trading at 9:30 am EST to vote on the deal.

NYSE trader
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NYSE trader

Here's what else you need to know:

1. It's not so much about cash equities, it's about derivatives—options and futures. It pains me to say this (I've been covering cash equities on the NYSE floor since 1996), but it's true. This is largely about the fact that cash equities has become a high volume, low-profit commodity business, and derivatives are not—yet.

How did this happen? Because over a decade ago the SEC decided they wanted to promote competition for the NYSE and Nasdaq . They acquiesced in allowing alternative exchanges to develop, and to allow trading in pennies which made possible high-frequency trading. The result: the stock trading business is barely profitable today.

When you are dealing with a commodity business, it's scale that matters. Making a few pennies on billions of shares traded. Utilizing more volumes in your existing pipeline costs you very little. You need to get bigger, or your profits do not grow.

While derivatives may eventually end up in this boat as well, for the moment they offer higher profits, partly because they are more customized products.

2. The combined company would be a derivatives powerhouse. In options, the combination of the NYSE Arca and NYSE Amex with Deutsche Boerse's ISE unit would make it the biggest options player in the U.S., bigger than CBOE. In futures, the NYSE will soon be launching a futures business to compete with the CME.

And the combined company will be a derivatives powerhouse in Europe as well: the NYSE already owns LIFFE, the European options and futures business, while the Deutsche Boerse owns Eurex.

3. There's probably only about two dozen players who really matter in the exchange world. With assets that scarce, it's clear we are moving toward a world where there will ultimately be perhaps a dozen major players and a larger number of smaller, regional competitors.

4. Political risk is real, on both sides of the Atlantic. The facts are simple: U.S. regulators should approve the deal because the NYSE Euronext is already substantially owned by foreign interests. And the regulatory structure will remain intact. The part of the business done in the U.S. will remain under the control of U.S. regulators.

Still, this is not necessarily about facts—it's about politics. Republicans could very well make hay about the giving away of an iconic U.S. brand name.

A more important point is the sheer workload of the regulators. The big issue in the U.S. is that regulators already have their hands full dealing with OTC derivatives, market structure, and Dodd/Frank. That's why approval in the U.S. could take time—a year of more.

Europe may also be an issue. The European regulators will scrutinize the concentration of the derivatives business—LIFFE from the NYSE Euronext and Eurex from the DB. But there are political issues as well. Of particular concern is Paris. The French have made it clear they do not want Paris to further lose its position as a financial hub; while France's direct leverage is limited, there is a pan-European regulator that could be influenced by Paris.

5. The NYSE floor will remain open, despite the cynics. Cynics claim that it is an outdated trading mechanism that does not add value. Despite garnering only 28 percent of total NYSE volume NYSE officials long ago recognized the floor as a brand differentiator. The NYSE is investing substantial sums to update and modernize the floor.

6. What's next? Will there be a competing bid at the last minute? There is some speculation that the CME will team up with Nasdaq to make a last-minute bid for the NYSE-Euronext. The logic is that the CME does not want the cash equities business; they want LIFFE, the European derivatives business. Under this (unlikely) scenario, CME keeps LIFFE, and the rest goes to Nasdaq. The beauty of this is that it will be easier to get regulatory approval.

Assuming the proposed NYSE Euronext-Deutsche Boerse deal happens, what becomes of the competition? The CME may not feel the need to do anything because it may not dramatically change their competitive landscape in futures. It is a lot tougher for the CBOE—they will now have a very big competitor, they will be a natural target, with Nasdaq as the natural buyer. But it would be expensive and highly dilutive for Nasdaq—a real problem.

Down the road, an LSE-Toronto deal for the Nasdaq may make sense, because it is more of the same: cost savings—combine the platforms and you only support one of them, which allows you to compete more effectively.

As for Asia, much has been made of pan-Pacific deals, but don't kid yourself: countries like Japan are ferocious regulators, and Hong Kong is likely too big (it is the largest exchange by market cap in the world).

Other observations:

1) Cost synergies are being touted, in the range of 300 million euros, but it may be tougher to realize than anyone thinks ... especially in Europe. That's because much of the savings will come from eliminating duplicative staff. Ever try to fire anyone in Europe? No? Are you in for an education.

2) Two people feeling very vindicated right now: David Krell and Gary Katz, who left the NYSE about a decade ago after the NYSE folded its derivatives business...just before that business dramatically expanded. Both went on to co-found the ISE, now owned by Deutsche Borse and the largest equity options exchange to date.

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