A Fierce Fight for CBOT

After ICE's sweetened buyout offer, the Chicago Merc may up the ante in its bid to buy its crosstown rival

The final battles are being fought in the war to take over the Chicago Board of Trade (BOT), a struggle that could reshape the fast-growing derivatives market.

Many believe the CBOT's original suitor, the Chicago Mercantile Exchange (CME), still holds the upper hand. That's despite the fact that the other outfit in the CBOT hunt, Atlanta-based Intercontinental Exchange (ICE) is offering as much as 10% more for the company.

In March, the upstart IntercontinentalExchange shocked traders by bidding for the CBOT a couple months before it was to complete a deal with its crosstown rival. The ICE bid delayed approval for the CME-CBOT merger, and the CME was forced to raise its bid.

This week, the U.S. Justice Department cleared away a key worry about the CME-CBOT merger by saying it wouldn't object to the deal on antitrust grounds. Some traders worry a new huge Chicago exchange could unfairly dominate U.S. derivatives trading.

On Wednesday, ICE changed its bid for CBOT. It didn't raise its price, already higher than CME's bid, but it did include a cash component in the previously all-stock offer.

Many are surprised that ICE is even in a position to compete for CBOT.

When it made its surprise bid, ICE had just completed a merger with the New York Board of Trade. Its stock had soared as revenues grew 101% in 2006. Analysts expect revenues to keep growing at much of that pace in 2007.

Many exchanges have seen profits soar as trading volumes increase. Derivatives are increasingly popular financial tools, and ICE is the leading market place for many energy futures, a volatile and thus popular commodity to trade. And, while many other futures exchanges still use human traders, ICE champions rapid electronic trading, which helps volumes grow even faster.

Analysts say the competition over CBOT may be decided by factors other than price. The value of both deals, pegged to stock prices, fluctuates from day-to-day, but ICE's bid was about 10% higher at current prices.

ICE makes several arguments for its bid. It promises to keep the historic Chicago Board of Trade name and relocate the firm's headquarters to Chicago, where it will keep open the trading floor but expand electronic trading. It warns the combined CME-CBOT would trade almost 90% of the U.S. derivatives market, compared to one-third for a merged CBOT and ICE. That means the new firm could put the squeeze on future traders, many who own shares in CBOT. Like other exchanges, the CBOT is still making the transition from a members-owned nonprofit to a for-profit corporation.

ICE included $2.5 billion in cash to its all-stock bid in part "to mitigate the concerns of some CBOT members that ICE's stock is over-inflated," Deutsche Bank analyst Rob Rutschow said in a June 12 note. The deal exchanges 1.42 ICE shares for every CBOT share. The new offer also caps trading fees for CBOT members until 2011.

Advocates for the CME-CBOT deal say it doesn't need to match ICE's offer. There are too many other long-term advantages that one giant Chicago exchange would enjoy.

For one thing, a bigger exchange would be a major player on the world stage. That's a key factor as big exchanges, such as the merged New York Stock Exchange (NYX) and Euronext, make deals to compete globally. A bigger exchange could also compete better with the over-the-counter market, where the vast majority of derivatives trade.

Both CME and ICE execs say their mergers could offer many new derivatives products and would result in millions of dollars in cost savings. The CME also says the merged firm will launch a $3.5 billion buyback program, which could retire up to 12% of the new company's shares.

Many warn a CBOT-ICE merger faces more integration risks than the CME-CBOT merger. The new CBOT would have to compete directly with CME during its integration. "It might open a door for CME to take market share from BOT during this period, which would be very hard to recapture," Bank of America analyst Christopher Allen wrote June 12.

Thus, many think CME doesn't need to match ICE's higher offer. It may, however, choose to adjust its offer one more time before CBOT shareholder vote on the deal in early July.

"We feel a new offer that is within 5% of ICE's offer would likely be a winner," Rutschow wrote.

"At the end of the day, we believe everything ICE laid on the table can be matched by CME," Allen wrote. (Bank of America does banking business with the CME, COBT and ICE; Deutsche Bank makes a market in all three, and owns shares in CME.)

Even if it eventually wins the CBOT, CME executives must wish ICE never got involved. Rutschow notes that an adjusted CME bid would be 20% to 25% higher than its original proposal.

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