Nasdaq OMX-ICE Deal Has Merits

Even though NYSE Euronext has rejected the Nasdaq OMX and InterContinental Exchange’s offer on the grounds that it would face anti-trust objections from regulators, the deal has merits and could benefit the trading community.

While it’s more popular to bash the deal based on the view that Nasdaq OMX is trying to drum up fears about selling the Big Board to a foreign owner, I’ve spoken to sources that see benefits in the Nasdaq-NYSE combination.

For starters, Nasdaq’s plan to buy the Big Board would create the largest U.S. equity-trading venue, centralizing market share within the U.S. listed and Nasdaq stocks. NYSE Euronext accounted for 27 percent of U.S. equities volume in the first quarter, compared with Nasdaq OMX’s 19 percent, according to data compiled by Barclays Plc.

While this may flag anti-trust concerns with U.S. regulators, it also could address the concerns of U.S. institutional investors that have complained that there are too many U.S. equity exchanges and dark pools and that liquidity is extremely fragmented. This would also address concerns about price discovery: Currently, institutions are using algorithms to shred their large orders into 100 and 200 share lots and hiding their orders in dark pools to avoid leaking information to high frequency traders. They are inevitably removing liquidity from the lit markets and from the price discovery process, while sending order flow to dark pools that don’t discover price.

Point No. 2: A merger between Nasdaq and NYSE would reduce technology costs. Nasdaq and ICE claim they can produce cost synergies of $740 million annually. Closing data centers is part of the strategy. Today, if a firm wants to access 80 percent of the U.S. equities markets, they need to connect to NYSE, Arca, Nasdaq, BATS and Direct Edge. “Everyone of those connections costs you money because they all use different technology interfaces. They also need different collocations, so you have to buy five different lines,” says Yuriy Shterk, VP product development at CQG, a provider of a global order routing to cash securities and futures markets.

By combining Nasdaq and NYX, brokers have one less venue to worry about, and the market is still fragmented enough that no one player could raise rates, since they still have BATS and Direct Edge, he contends. If Nasdaq eliminates one of the collocations it has in the U.S., “they will streamline access to their combined liquidity pools for the trading community which I think is valid and important to regulators,” says Shturk. If two of the biggest equity pools come together, that could spark a new cycle of ECNs, he suggested.

NYSE Euronext has also rejected the Nasdaq-ICE deal because its strategy has been to become a global transatlantic exchange operator across equities, options and futures, fmultiple asset classes and geographies. The Nasdaq/ICE offer would break up NYSE Euronext’s equities and derivatives businesses, sending the U.S. and international equities to Nasdaq and giving the Liffe futures piece to ICE.

Two sources told me they think the specialization is interesting. While everyone is watching the drama unfold between Nasdaq and NYSE, ICE is worth watching on the derivatives side.

If ICE were able to combine with Liffe’s futures and options business, then ICE would gain access to a broader European derivatives business. ICE offers energy, currencies and soft products, but Liffe offers interest rates, other currencies that ICE doesn’t have, and also futures on European equity indices. Nasdaq owns IDCG for interest rates clearing which it might sell off, a source suggests.

All of this aside, there are financial considerations weighing heavily on the outcome. The board of NYSE Euronext rejected the joint bid from Nasdaq OMX and ICE because it wouldn’t create as much long-term value for shareholders. Nasdaq OMX is arguing that its hostile offer of $11.3 billion is superior to DB1’s $10.2 billion deal. Today, Reuters is reporting that NYSE Euronext would want as much as a $2 billion in a so-called reverse break-up fee from Nasdaq OMX before it was willing to discuss a merger of the two exchange operators.

Meanwhile, NDAQ may sell NYX’s Amex, a listing venue for small companies, to address anti-trust concerns with U.S. regulators, according to Reuters this morning.

If the Nasdaq-ICE bid falls apart, the NYSE Euronext-DB deal may face regulatory obstacles of its own. DB1 may be forced by the EU regulators to open up its derivatives clearing business to competition even before a ruling on its takeover bid for NYX is settled, according to Keefe Bruyette & Woods’s report. So, the drama is far from over.