London Metals Exchange On The Block

Jeff  Carter
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Posted: Jan 13, 2012 12:01 AM

The LME is on the block. Stymied by banks in the last couple of years to grow their business through new innovation, exchanges are being forced back into the consolidation market.

Once exchanges went from member run non for profit entities, to for profit shareholder run entities, the stakes of the game changed. For years, the CBOT and CME ($CME) would date each other and talk about a merger. It made perfect financial sense. It wasn’t until after each exchange went public that a real merger could happen.

In LME‘s case, they have an established business with very long term network effects. Like other exchanges, they changed their corporate structure. Unlike other exchanges, they didn’t offer their shares to the public markets. However, they offered stakes to other well heeled investors. Sort of like a Private Equity play in a way.

JP Morgan($JPM) is the largest shareholder, with a 4.7% stake.

One thing that no one really foresaw is that the old line network effects that were established over decades of time in the open outcry markets would re-establish themselves in the computerized era. Once an exchange becomes the go to place for a contract, it is virtually impossible to wrest control of it and take it to another exchange. For game theorists, it is a great academic ground to test theories. It seems established contracts are in some sort of Nash equilibrium.

There is pressure on LME to allow investors to monetize their investment. Outside pressure also exerts a force. New banking regulations that will force banks to raise capital are making those same banks counsel the LME to bring a liquidity event to the table. Banks are carrying loads of bad debt on balance sheets. Selling off assets that are not core to their business is a compelling idea to raise needed cash.

There isn’t a large pool of likely buyers for the LME. It’s basically exchanges. However, the exchange world is hyper competitive. It’s much easier and cheaper in the short run to buy liquidity than try to start a new contract and grow it. When making a decision, it’s also much simpler to look at historical liquidity, apply the fees you can charge to it, come up with a net income model, extrapolate some implied growth over time, discount that figure back and compare a cash outlay for an existing exchange with some other use of that capital.

That brings us to the likely buyers. They are CME, ICE ($ICE), and NYSE/LIFFE ($NYX). More may emerge depending on circumstances. Perhaps someone from Asia like the Hong Kong Exchange looking to broaden its reach.

It is unclear who will win, but there are synergies and strategic reasons each might want to own LME.
For CME it’s easy. They have the strongest metals futures complex in the world. LME is a tight strategic fit. CME also has started a clearinghouse in London, and LME becomes a good partner for that. Strategically, because of the Greenwich time zone, it is important for an exchange to have deep ties in that geographical area. For all the exchanges, LME deepens those ties. ICE has a London clearing operation.

ICE doesn’t have a good futures market for metals, but it does have an active OTC market for all the commodities that LME trades. It’s a good strategic match for them as well, but the math ICE will use versus the math CME will use is different. Between the two exchanges, it would be tough to see the other buy the LME at a good price, so strategically they might bid slightly higher to make the competitor pay a painful price for winning. NYX is in the mix for a couple of reasons. One, their bid to merge with the German Deutsche Borse was scuttled by regulators. They also have a good foothold in London through their ownership of LIFFE.

The NYX purchased the CBOT metals complex from CME when CME bought NYMEX/COMEX. US regulators forced the sale. The LME fits with their futures complex similar to CME. Like the others they too have an OTC clearinghouse they are trying to establish in Europe. LME avails them with a nice partner for that clearinghouse. After the failed deal with DB, they might be licking their chops to try and expand their business in other ways. LME offers them a perfect opportunity.

It’s clear that LME is going to attract a premium price and the investors in LME are going to do well. Depending on the price paid, one exchange is going to get a feather in their cap, or a white elephant.

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