Today Chicago, Tomorrow...

When Chicago Mercantile Exchange chairman Terrence Duffy met for dinner last summer with his Chicago Board of Trade counterpart, Charles Carey, the talk quickly turned to a third exchange chief, who wasn’t at the table: John Thain. In June the New York Stock Exchange CEO had struck a $10 billion deal to acquire Paris-based Euronext, turning the Big Board into a serious threat to both Chicago markets: In addition to its pan-European stock market, Euronext owns London-based Euronext.liffe, the world’s fourth-biggest futures exchange.

Thain’s move disturbed longtime crosstown rivals Duffy and Carey. The combined NYSE and Euronext would be the first transatlantic bourse to offer both stock and derivatives trading. It would also sport a gaudy market value of more than $21 billion -- about the same as the CME and the CBOT’s combined capitalizations -- making it an even bigger worry at a time of rapid global consolidation among exchanges.

The Chicago markets had toyed with tying up for decades, but internal politics and a legacy of long-simmering feuds got in the way. Still, as the exchange chairmen chewed their steaks on that humid August evening at local haunt Gene & Georgetti, they agreed that it was finally time to put those old antagonisms aside.

Just a few weeks later, on October 17, Duffy, Carey and other executives from the two exchanges gathered in a ballroom at the Hilton Chicago hotel and announced to the world that the CME was buying the CBOT for $8 billion.

The CME had already come a long way before the merger. After decades of playing second fiddle to the older CBOT, it embraced electronic trading in the 1990s and converted from a member-owned cooperative to a stock corporation. The moves spurred huge growth in trading activity and paved the way for one of the most successful initial public offerings in history: The company’s shares are up a staggering 16-fold since their December 2002 debut. The CBOT, whose members resisted electronic trading, has been Chicago’s No. 2 exchange since the CME passed it in 2001.

The merger, set to close by midyear, pairs bitter rivals whose business lines mesh beautifully, creating a powerhouse. The CME’s futures on short-term interest rates -- its Eurodollar contract, based on U.S. dollars deposited overseas, is the world’s most heavily traded -- dovetail nicely with the CBOT’s longer-term debt products, which include futures on the ten-year U.S. Treasury bond, the fifth-biggest futures contract globally. Just so, the CME’s Standard & Poor’s 500 index futures complement the CBOT’s Dow Jones industrial average contract. And the Board of Trade’s massive corn, soybean and wheat derivatives, together with CME futures on lumber and livestock, give the combined market a powerful presence in agricultural futures.

The merged company, to be called CME Group, will vault ahead of German-Swiss rival Eurex as the world’s biggest futures exchange by trading volume to become the undisputed leader in a white-hot industry that boasts $26 trillion in contracts outstanding and volumes that are growing at 25 percent per year. The new CME will execute 88 percent of all U.S. futures trades and have a market capitalization of $29 billion. It will be even more profitable than it is today: Not only will the CME add the CBOT’s $172 million in annual earnings to its own $407 million, it expects to save $125 million per year from cost cuts starting in 2008. The new entity’s core U.S. futures business will deliver pretax profit margins in excess of 50 percent, earnings growing at a remarkable 40 percent per year and trading volumes that continue to surge, fueled by the increased use industrywide of electronic trading and the growth of risk-hungry hedge funds.

Leading this big-shouldered colossus will be CEO Craig Donohue, with Duffy continuing as chairman, Carey as vice chairman and CBOT president Bernard Dan acting as a consultant. A reserved, detail-oriented lawyer who rose from the position of CME staff attorney to help oversee that exchange’s demutualization, Donohue succeeded former Morgan Stanley investment banker James McNulty as CEO in 2004.

Donohue, 45, has no intention of letting the CME rest on its laurels. Instead, the exchange will leverage its newfound heft to go on the attack, invading the much bigger, faster-growing over-the-counter derivatives markets while seeking to extract more business from overseas customers. “This merger represents the preparation for the world that’s coming,” sums up Donohue.

There are plans aplenty for this new world. Last month the CME received regulatory permission to list credit-event futures on three junk-rated U.S. companies. The contracts, essentially exchange-traded versions of OTC credit default swaps, will mark the CME’s first assault on a lucrative market that is growing by more than 50 percent annually.

The CME is also aiming to clear trades of OTC interest rate swaps through Swapstream, a London-based entity it acquired in 2006. And later this year the CME and Reuters Group will launch a joint venture to bring OTC foreign exchange trading onto an electronic matching and clearing network. The companies have already lined up 16 of the biggest global forex dealers to use the system.

“We’re going to concentrate on the U.S. and London in the first phase, then expand into Asia,” says Mark Robson, CEO of the London-based joint venture, FXMarketSpace.

Donohue also aims to grow by launching new products in the U.S. and overseas. The CME rolled out futures on the Chinese and South Korean currencies late last year, and last month announced the debut of hurricane futures. But these efforts face a simple, ugly reality: Most new products fail. The CME hasn’t had a hit launch since 1997, and that was with a smaller, electronically traded version of its already thriving S&P 500 futures. The CBOT’s last big success was its DJIA futures, which also debuted in 1997. According to the Illinois Institute of Technology’s Center for Financial Markets, 43 percent of contracts introduced over the past half century disappeared within six years. An additional 51 percent barely survived, with annual volume of less than 1 million contracts each. (For context, the CME and the CBOT together traded 2.1 billion contracts last year.)

The exchange will need all of its heft and lots of agility to compete in the increasingly complex and cutthroat world of trading. The planned NYSE-Euronext combination is just one of many ongoing deals and discussions among exchanges bent on global domination. The Nasdaq Stock Market has been trying, thus far without success, to acquire the London Stock Exchange, which spurned Eurex parent Deutsche Börse as well. The German exchange also failed in a bid for Euronext.

Last month, Donohue began talks with the Tokyo Stock Exchange about forming an alliance to trade Japanese government bond futures. He is butting up directly against Thain’s NYSE -- which on January 31 announced a nonexclusive agreement with the TSE to develop new trading systems and investment products -- and also the LSE, which last month announced a similar pact.

Even smaller markets like the Philadelphia Stock Exchange and the American Stock Exchange are joining the NYSE in entering the futures business. Rivals including Eurex, the IntercontinentalExchange, the New York Mercantile Exchange and interdealer brokerages ICAP and GFI Group all have their sights set on providing electronic trading and clearing of OTC products.

The CME-CBOT merger must clear a crucial near-term obstacle: a U.S. Department of Justice antitrust review of the deal that is being conducted amid griping by smaller exchanges about anticompetitiveness. At issue is a U.S. law requiring that any trade of a futures contract be cleared and settled by the exchange that lists the contract, essentially giving futures exchanges natural monopolies on their own products. By contrast, stocks and options can be bought on one exchange and sold on another; they are all cleared by one industry utility. Some rivals grouse that the CME’s impending dominance of the most popular U.S. contracts, combined with its wholly owned clearinghouse, impedes the development of an open, nationwide market for futures trading similar to the national market system that links competing U.S. stock exchanges.

Donohue also must contend with alarmed customers who fret that the CME’s newfound power will embolden it to raise fees and cut out brokerage middlemen by catering directly to investors.

“With this merger pending, more people are thinking about having a plan B, just in case,” says Clark Hutchison, global co-head of exchange-traded derivatives at UBS, which owns the biggest U.S. futures brokerage. “Let’s say I’m glad there are other global markets.”

One such alternative might be Eurex’s U.S. division. Amid last summer’s wave of deal making, one of the CME’s biggest customers, U.K. investment manager and brokerage Man Financial, bought a 70 percent stake in the Eurex subsidiary and renamed it the U.S. Futures Exchange. Man plans to offer new products through the USFE and to invite other exchange users to become equity partners.

But Donohue’s challenges are not all external. He also must integrate the operations of two giant markets. His plan: Conduct electronic trading of all CBOT products on the CME’s superior Globex system while consolidating all floor trading inside the CBOT’s art deco building, a few blocks east of its new parent. Those moves will let members execute complex trades that involve both CME and CBOT products more efficiently than they can today. The consolidation will also account for a big chunk of the cost savings of the merger.

Ultimately, Donohue must find ways to maintain the CME’s spectacular growth -- the foundation of its lofty price-earnings multiple of 39 times estimated 2007 earnings -- once the current boom in U.S. futures trading volumes inevitably peaks.

INDUSTRY GOLIATH IS A NEW ROLE for the Merc, as it’s known in Chicago. Since its origin as an egg-and-butter market that was spun off from the CBOT in 1874, it has mostly played a junior role to the older bourse. That began to change in 1972, when thenMerc chairman Leo Melamed persuaded CME members to list currency futures -- the first financial futures. That success was followed in 1981 by Eurodollar futures, another hit. In 1976 the CBOT launched its own financial futures, the popular U.S. Treasury contracts, and continued to post higher trading volumes than its little sister. The Merc, as a result, took more risks. In 1992 it introduced the all-electronic Globex system, which riled the floor traders who owned the exchange but laid the foundation for today’s dominance. By 2000 its 24-hour platform began to take off, executing 15 percent of CME volume. Today it is responsible for 75 percent.

To better compete with publicly owned electronic markets in Europe, the CME demutualized in 2000, streamlining its governance. Formerly run by 2,100 members serving on 220 committees, it reconstituted itself under the direction of 20 board members and seven committees. The moves set the stage for the CME’s wildly successful IPO, the first by a U.S. exchange. Other U.S. markets soon engineered similar transformations: the NYSE, Nasdaq and, in 2005, the CBOT.

Shedding their member-owned structures was crucial for the Chicago exchanges, which had fallen behind foreign markets like Eurex in the late 1990s, not least because of internal politics. Carey recalls one CBOT board meeting from that period during which directors debated the color of new carpeting for the corn futures trading pit.

The crosstown rivals discussed merging as early as 1981. In 2003, after years of on-again, off-again negotiations, they struck a common clearing agreement in which the CBOT agreed to settle all transactions through the CME’s clearinghouse -- a move designed to boost capital efficiency for customers doing business on both markets.

In June 2005, with the CBOT preparing its IPO, the CME again initiated merger talks. But with investor interest in exchanges surging, CBOT members sought a higher valuation by going public. The company’s shares more than doubled in first-day trading in October 2005; currently, they are up more than threefold from their offer price.

Duffy and Donohue retreated but continued to evaluate potential deals with the CBOT, Euronext and other exchanges. By last summer the CBOT had begun informal talks to buy the Chicago Board Options Exchange. Then came news of the NYSE-Euronext deal.

The fact that both of their exchanges were publicly traded made it easier to value the deal once Carey and Duffy got negotiations going after their August dinner. Carey told Duffy a CME bid would have to value the CBOT at a significant premium to its market price. On September 11, Duffy and Donohue wrote the CBOT’s leadership offering a 10 percent premium. The sides went back and forth until the CME upped the cash portion of its cash-and-stock offer from $2 billion to $3 billion and raised the total amount to value CBOT at $151 per share -- a 12 percent premium. Both boards swiftly approved the deal.

JUST AS THE CME UNEXPECTEDLY ROSE UP to supplant its onetime parent, Donohue has taken an unconventional route to running this new behemoth. Historically, leaders of the Chicago markets have hailed from the floor, where a big frame and a bigger voice can be a trader’s most important assets. Duffy and Carey, for instance, are both gregarious souls who grew up on Chicago’s hardscrabble South Side and made names for themselves in the trading pits. But Donohue befits the new era of global, publicly owned exchanges. The son of a truck driver and a bookkeeper in Des Plaines, Illinois, a middle-class suburb northwest of Chicago, Donohue thought big from a young age. He triple-majored in history, political science and philosophy at Drake University in Des Moines, Iowa, before earning a law degree at Chicago’s John Marshall Law School and a master of financial services regulation from IIT’s Chicago-Kent College of Law. In 1989, after two years at Chicago law firm McBride Baker & Coles, Donohue took a pay cut to become a CME staff attorney. By night he worked toward yet another degree -- an MBA from Northwestern University’s Kellogg School of Management, which he earned in 1995.

By 1998 he had advanced to general counsel and head of strategic planning. That was a turning point in his career, as it thrust Donohue deep into the process of demutualization -- an experience that positioned him well when in 2004 the CME board sought to replace outgoing CEO McNulty (now, incidentally, an NYSE director).

In his three years at the helm, Donohue has driven the CME’s success as a public company. He has boosted efficiency by cutting costs and investing in technology, helping the CME achieve a 2006 pretax profit margin of 59 percent, compared with the CBOT’s 44 percent. And Donohue has spearheaded the CME’s nascent push into OTC markets, orchestrating the FXMarketSpace and Swapstream deals while overseeing implementation of the CBOT common clearing link. Under his leadership annual earnings have soared 234 percent.

Donohue confers closely with Duffy and Melamed, who still chairs the board’s steering committee. “Craig is a very intense guy, a very focused guy,” says Duffy. “He doesn’t try to be an overpowering personality.” Adds Melamed, “Craig is a very capable administrator who knows every nook and cranny in the place.”

DONOHUE’S EFFORT TO EXPAND OVERSEAS and into OTC markets, where swaps and other derivatives are traded off exchanges by banks, won’t be easy. To date, the most significant of the CME’s efforts is FXMarketSpace, which plans to offer trading in ten currency pairs, such as dollar-yen and euro-sterling, in the spot market, complementing the CME’s strength in currency futures. The venture will have to displace EBS, a 14-year-old consortium of the world’s biggest forex dealers that GFI and ICAP acquired in June. EBS executes about 20 percent of forex trades, according to Citigroup equity analyst Donald Fandetti. In clearing, FXMarketSpace must vie with CLS Bank International, another consortium, which settles 40 percent of forex trades.

The Merc expects its venture to break even in 2008. By Fandetti’s estimates, that would give it a market share of just 2 percent -- far from the dominant position the CME enjoys in its core business.

“The CME and Reuters program will probably have some adherents but will remain a small player,” predicts Marc Chandler, global head of foreign exchange at Brown Brothers Harriman & Co.

Donohue’s move into clearing OTC derivatives through Swapstream holds promise yet faces similar challenges. Swapstream provides a single clearing platform for trades of euro-denominated interest rate swaps between dealers. Centralized clearing eliminates counterparty risk from OTC trades. Today banks clear most OTC trades; their solid credit ratings minimize but don’t eliminate counterparty risk. Banks and investors might embrace a single clearing platform because it would mean maintaining one pool of margin and collateral rather than multiple ones with different counterparties, says Michael Henry, who tracks exchanges for consulting firm Accenture.

“It’s something that we’ve all sought for quite some time,” says Steve Rodosky, a portfolio manager at bond fund giant Pacific Investment Management Co. “A big reason people were drawn to exchange-traded derivatives was the clearing.”

But Swapstream also faces a crowded field. In December, ICAP and GFI each acquired a minority stake in Clearing Corp., which settled trades for the CBOT before the Chicago common clearing agreement in 2003. Both firms will gain seats on the Clearing Corp. board and develop clearing services for OTC instruments. The ICE, which began in 2000 as an electronic platform for OTC energy trades, already clears 80 percent of the OTC trades it executes. Jeffrey Sprecher, the exchange’s CEO, hopes to clear other OTC instruments, particularly now that the ICE has bought the New York Board of Trade, a marketplace for futures on coffee, cotton and other commodities.

“Clearing is an underappreciated asset in commodities trading today -- and maybe even trading of all asset classes,” says Sprecher. “OTC is the more interesting market, with more opportunities for growth and innovation.”

Donohue still needs to articulate a strategy for offering electronic trading to other OTC markets. The CME already trails ICAP, which this year will launch a system for for trading European interest rate swaps.

Next month the CME will launch credit event futures; the first contracts will be listed on speculative-grade companies Centex Corp., Jones Apparel Group and Tribune Co. This area also is rife with competition. And no wonder: Credit derivatives are the juiciest of OTC markets, with a notional value outstanding of $26 trillion and annual growth of more than 50 percent. Eurex this month is introducing futures based on the popular ITraxx Europe index of credit default swaps, a product that could dilute interest in the CME’s single-name contracts. The CBOT last year expressed interest in a similar product, but Eurex won the licensing rights. Euronext.liffe plans to launch a listed credit derivatives product by the summer; it is not disclosing the details yet.

“The OTC market is the natural breeding ground for exchange-traded products,” says Mehtap Dinc, a product strategy executive at Eurex. Adds Fraser Cowie, Euronext.liffe’s head of marketing, “All the exchanges are looking at this.”

Even as the CME jockeys for position, many OTC professionals express doubts about whether their markets really need exchanges and exchangelike services. Some believe that the rise of standards for once-esoteric products like credit derivatives means there’s no longer a reason to launch exchange-traded equivalents.

“You’ve got deep, liquid markets, a standardized product and electronic processing,” says Sunil Hirani, CEO of Creditex Group, a big interdealer broker and a competitor of the CME. “It’s unclear to me what the benefits of an exchange-traded product would be.”

A more impartial observer is Arthur Steinmetz, who heads fixed-income investments at OppenheimerFunds. He thinks OTC markets are too big to have their credit risks handled by an exchange’s clearinghouse. “I don’t think it’s practical, and I don’t see the need,” he says.

One reason Donohue is pushing into OTC markets and new products is that challenging competitors’ existing contracts is exceedingly difficult. Such moves hardly ever succeed, because traders are loath to try new markets when existing, liquid ones offer them a high probability of filling orders at good prices. The rare exceptions have involved cheaper, more efficient electronically traded contracts besting floor-based ones. Eurex became the dominant market for German Bund futures in the mid-1990s by introducing an electronically traded version of Euronext.liffe’s floor-traded Bund contract. Eurex later mounted a similar attack on the CBOT’s U.S. Treasury futures, but the Chicago exchange successfully defended its franchise by expanding electronic trading and matching the discounted fees that Eurex offered.

“Our strategy has been very much not to attack other exchanges on their liquid products,” says Donohue.

THE CME’S LEADER ALSO HAS TO PROTECT HIS flank at home. Even if the CBOT deal passes an antitrust review with minimal or no conditions, it is drawing attention to issues that could spur a restructuring of U.S. futures markets, potentially weakening the CME’s dominant position.

Two issues preoccupy competitors and customers. First is the law mandating that a futures contract must be cleared by the exchange that lists it: Futures contracts aren’t fungible. Second is the fact that once an exchange builds a critical mass of liquidity for a given contract, it becomes all but impossible for rival markets to launch competing contracts. These factors, critics argue, combine to give futures exchanges virtual monopolies over their established products; the tendency of customers to stick with established liquidity pools represents an insurmountable barrier to entry.

The lack of fungibility is particular to futures. As stock and options markets get into the futures business, they are crying foul about having to play by a different -- some say less fair -- set of rules. “Clearing is central to what creates nonfungibility and a noncompetitive situation,” says Meyer (Sandy) Frucher, CEO of the Philadelphia Stock Exchange, which is resurrecting its long-dormant Philadelphia Board of Trade futures market. “The liquidity at a combined CME-CBOT would keep an upstart from launching competing products.”

Meanwhile, the absence of competing products, according to the deal’s critics, will allow the CME to raise prices at will. Last month the Futures Industry Association, a group of brokerage firms, issued a statement expressing concern that the merger would reduce competition among U.S. exchanges and heighten barriers to entry.

“They can charge what they want because you can only get futures in one place,” says Steven Sanders, head of business development at Interactive Brokers Group, a big stock and derivatives market maker.

Adds another executive at a big futures brokerage, “I think you’d be hard-pressed to find a brokerage firm or significant customer that is not concerned about CME Group’s pricing power.”

Consider the CBOT’s experience in fending off Eurex’s attack in 2004. The Chicago market cut its average rate per Treasury contract, from 67.6 cents per contract in January 2004 to 39.3 cents in April 2004. Eurex U.S. grabbed only about 1 percent of the market from the CBOT and essentially gave up in mid-2005. The CBOT hiked its average rate per contract to 53.7 cents in December 2005 and 57.1 cents last fall.

Donohue says it’s not in his interests to raise prices, as the exchanges benefit much more from increased volumes when fees are affordable. He has repeatedly assured the market that the company will pass on half of the merger’s $125 million in annual cost savings to customers as lower fees.

Still, knowledgeable people say the DoJ, which has made a second request for information on the merger, is taking a hard look at the clearing-trading connection. Its investigation, these sources say, is being led by attorneys who studied the lack of competition between options exchanges in the late 1990s. (In 2000 the Securities and Exchange Commission and the DoJ reached a settlement of potential antritrust charges with four options exchanges, censuring them in connection with a gentleman’s agreement that had divvied up popular listings among them instead of allowing competition. Since then a new competitor, the International Securities Exchange, has entered the field and used electronic trading to become the country’s biggest options market.)

The DoJ won’t discuss the probe, but industry experts cite a number of possible conditions the government could impose on the deal, including a spin-off of the CME’s clearinghouse or the imposition of fungibility of futures contracts. However, both of those outcomes are unlikely. A forced clearing spin-off would probably be a deal breaker, as the CME derives about 17 percent of its revenues from clearing fees, according to Bear, Stearns & Co. analyst Daniel Goldberg.

“To a certain extent the cat’s already out of the bag; the clearing is already consolidated, and that really locked up clearing in the U.S.,” says Gary DeWaal, general counsel at futures brokerage Fimat Group. “The merger just etches that in stone.”

Moreover, the exchange is very friendly with lawmakers who oversee the futures markets. Duffy is close to former U.S. House of Representatives speaker Dennis Hastert, who in November organized Illinois’s 17-member congressional delegation -- Democrats and Republicans -- to write the DoJ in support of the merger. And the change in leadership in Congress is not likely to turn the tables. Since the 2000 election cycle, the CME has made $1.7 million in campaign contributions, with 41 percent going to Democrats, according to the Center for Responsive Politics. In January the new Senate moved oversight of futures markets to a new Appropriations subcommittee, Financial Services and General Government, which is chaired by Illinois Democrat Richard Dur- bin, a longtime ally of the Chicago markets.

Brokerage firms worry that the combined exchange will seek to bypass them and appeal directly to some investors. In July, for instance, the CME set up a special unit of staffers to encourage hedge funds to connect directly to the exchange at reduced fees. R.J. O’Brien & Associates, the 15th-biggest U.S. futures brokerage, has already lost several hedge fund clients to the exchange. To make up for the loss, the firm plans to expand its retail clientele and buy a rival that will plunge it into the OTC derivatives business. “Scale will be the name of the game,” says Colleen Mitchell, R.J. O’Brien’s president.

Not every customer will fold its hand and shift its strategies. Man Financial’s acquisition of a majority stake in the USFE, formerly Eurex’s American arm, could create a rival. If Man succeeds in luring enough worried CME customers to the new venture, clients will have another place to send their orders and could create liquid markets that might actually compete with the CME’s.

Some see parallels between the potential impact of the planned CME-CBOT marriage on the futures market and Wall Street’s reaction to two big stock-exchange mergers: Nasdaq’s December 2005 acquisition of the INET electronic communications network and the NYSE’s purchase last March of Archipelago Holdings. The deals consolidated volume in the hands of Nasdaq and the NYSE, essentially creating a duopoly. Since then big brokerages have invested millions in competing exchanges -- from tiny regional markets in Boston and Philadelphia to all-electronic upstarts like the ISE and BATS Trading, which has taken 10 percent of Nasdaq’s market share and is now mounting an attack on the NYSE.

“There are new exchange-type entities emerging in equities,” says Randy Frederick, director of derivatives at Charles Schwab & Co. “Ultimately, the CME-CBOT merger will give rise to new entrants and competition in futures.”

The proliferation of competing stock exchanges in recent years led the SEC to pass rules, effective this month, that establish a national market system for equities. The new structure requires trades to be executed at the best advertised prices, regardless of where those prices are quoted. This throws the NYSE and Nasdaq’s dominant market shares up for grabs to whichever markets have the right combination of technology and liquidity to most often quote the best prices.

Were the government to consider a similar structure for futures trading, it could render a seemingly dominant CME vulnerable to a host of hungry competitors that argue that they currently are unable to compete with the giant exchange in its most popular products. For now there’s no evidence that authorities are considering such a revamping. Even if it were to come to pass, the CME would still be well positioned, with its considerable capital resources and technological savvy. But the exchange might also expect to lose some market share, hurting earnings, market valuation and its long-term competitive position.

More deal making, then, could be the ultimate strategic response. The CME may choose to diversify into energy trading by approaching the Nymex or the ICE, for instance. Or it could buttress its position in OTC markets -- and get around some of its toughest competition -- by seeking to acquire an interdealer broker like GFI.

“We haven’t ruled that in or out,” Donohue says. “We’re always looking at new ways in which we can grow.”