MARKETS - Almost Out of Options

Deutsche Börse’s Eurex unit and U.S. options-trading innovator ISE Group must prove to skeptics that their $2.8 billion combination can boost profits.

David Krell knew it was just a matter of time.

The International Securities Exchange, an all-electronic options market that Krell co-founded in 2000, revolutionized the clubby options-trading world and led the way for its floor-based, member-owned rivals to automate and go public. But for all its success, the ISE remained a small player in a fast-transforming industry dominated by global giants like NYSE Euronext and CME Group, whose market values were each more than five times that of the ISE. Knowing that he was unlikely to compete in such a market as an acquirer, Krell, the ISE’s 61-year-old CEO, pursued a sale to the right partner at the best possible price. The result: last month’s news that German exchange operator Deutsche Börse, through its Eurex derivatives unit, would acquire the ISE’s parent company for $2.8 billion.

“We didn’t see ourselves at the same size and scale as some of these other very large entities that are out there,” Krell tells Institutional Investor. “And we felt that there were any number of people who would see us as a good fit for their business.”

Among the reasons the ISE chose to link with Deutsche Börse is their kindred culture, says Krell. Both markets have been innovators. Deutsche Börse launched the world’s first electronic derivatives exchange in 1990; the ISE brought screen-based options trading to the U.S. in 2000. Krell also sees the partners’ complementary product lines and client bases fostering cross-selling, as Eurex’s mostly European users gain the ability to access the ISE — and vice versa.

But investors and analysts are skeptical about promises of higher revenue, and shares of the ISE and Deutsche Börse fell following the takeover announcement. Most exchange deals today are driven by the desire to cut costs by merging trading platforms. But Deutsche Börse and the ISE will maintain separate systems, which Krell says is a competitive advantage because the platforms are customized to the divergent needs of derivatives traders and stock traders.

Regardless of whether their combination delivers what Deutsche Börse and the ISE promise, it makes life harder on rivals. For big exchanges seeking to expand in U.S. options, the ISE is the most alluring target. It is neck and neck with the Chicago Board Options Exchange for the market share lead, and as a public company it stands out from harder-to-acquire targets like the CBOE, which is still owned by its members, and the Philadelphia Stock Exchange, which is fighting member litigation alleging that management sold the exchange to several brokerage firms for too low a price. The ISE’s impending disappearance is certain to spur potential acquirers into more deal making. The NYSE and Nasdaq are among the bourses expanding into derivatives, where volumes are growing faster than in stock trading. Whether they or another big market will try to outbid Deutsche Börse for the ISE is anyone’s guess, but one reason the German exchange agreed to pay a 50 percent premium over the ISE’s market value at the time of the announcement is to deter rival acquirers, observers say. Copycat transactions will likely take place.

“There are only two leading options exchanges in the U.S. and then a handful of also-rans,” says one investment banker. “There aren’t many targets left worth having.”

Nasdaq’s $3.7 billion agreement to acquire Stockholm-based exchange operator and technology vendor OMX, announced late last month, likely will preclude it from another big deal in the near future. It has, however, reportedly been in talks to buy the Philadelphia exchange, which handles about 10 percent of U.S. options trades.

As for the NYSE, CEO John Thain is confident in its ability to hold its own with the new ISE. “I don’t think it changes our competitive position,” he said, following an appearance at an industry conference a few hours after the ISE deal was announced. “We already competed with both the ISE and Eurex, and from what they’ve said about synergies, there won’t be much.” But he clearly also has further deals on his mind. “Anytime you’re trying to grow a business, you have the trade-off between growing organically, which tends to take longer, and acquisitions, which are faster but can be more complicated.”

More deals will come. It’s just a matter of time.