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Why ICE is the only deal that makes sense for NYSE

December 20, 2012: 3:11 PM ET

ICE paid a high price for the NYSE because it wants to become a major player in the growing derivatives space, not because it wants to manage a glorified TV studio on Wall Street.

By Cyrus Sanati

nyse_building2FORTUNE -- The proposed acquisition of the New York Stock Exchange (NYSE) by the Atlanta-based InterContinental Exchange (ICE) at first blush appears to create a national exchange with broad reach, ensuring Wall Street's dominance in the financial world. But while the financial exchange supermarket that the two would create would make life easier for traders, it doesn't make much sense for investors, especially for ICE investors who will plunk down a sizable premium for the $8.2 billion acquisition.

No, today's deal is more about running the Big Board through the chopping block. It's sad to say, but the NYSE is worth much more sliced up than it's worth as a whole. ICE is most likely going to keep the NYSE's European derivatives business, NYSE Liffe, and jettison the rest in a combination of sales and spin offs, including the iconic "floor" of the exchange, to the highest bidder.

The NYSE (NYX) has had a "For Sale" sign on its door for a very long time. Duncan Niederauer, the chief executive of the NYSE, had been trying to cook up some sort of deal to sell the company and cash in almost since his first day on the job. If it wasn't for the market tumult of 2008, he would have probably sealed the deal by now. But it wasn't just the markets that were against him. So was Washington, and to a certain extent, Wall Street.

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His plan to sell the iconic NYSE outright to Germany's Deutsche Borse last year would have created a $10 billion transatlantic trading titan. But European regulators balked at such an ambitious deal. Not for the equity trading part of the deal, but because it would give the combined company a virtual monopoly in the European derivatives space. While that might seem like an esoteric part of the deal, it was actually the entire point of it. At the time, fees from derivatives trading comprised a third of the NYSE's total net revenue and 40% of its profits. Much of that came from its NYSE's Liffe derivatives platform based in Europe. Unlike with equities, where margins have eroded over the years due to new entrants and dark pools, derivatives still had a bit of protection from new upstarts. Indeed, Liffe's only real competition in Europe was Eurex, which was half-owned by Deutsche Borse.

Meshing Liffe and Eurex together would have been a gold mine as it would have given the combined company almost total dominance in trading and clearing European derivatives. Keenly sensing that such a deal would never pass regulatory muster in Europe, the Nasdaq (NDAQ) and ICE (ICE) proposed a joint takeover deal for the NYSE. The Nasdaq would get the NYSE's equity trading and listing business and ICE would get the NYSE's derivatives business. Niederauer wouldn't even talk with the American interlopers, though, hoping to seal the carefully crafted deal he had put together with Deutsche Borse.

No one would win this round. European regulators, of course, crushed the Deutsche Borse deal due to the derivatives monopoly. On this side of the Atlantic, US regulators weren't too enthused about the idea of combining the Nasdaq with the NYSE as the combined company would dominate the US equity listing market.

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The one part of the deal that did work was combining the NYSE and ICE. The business lines of the two companies didn't overlap as ICE had neither an equity trading platform in the US nor a big presence in the European derivatives market. The reason ICE teamed up with Nasdaq was because it needed to make a big bid to counter Deutsche Borse's $10 billion bid. The deal allowed ICE to keep the European derivatives business and immediately hive off the NYSE's equity trading and listing business.

Thursday's announcement solves all the regulatory problems and gives ICE what it truly wants – access to the European derivatives market. The company didn't waste any time, issuing a separate statement in addition to the merger announcement noting that ICE's clearinghouse in London would begin clearing trades for NYSE Liffe. Jeff Sprecher, ICE's chief executive, said on the conference call Thursday that it was "just a happy circumstance" that Liffe is trying to develop its own clearing opportunities. Such a move would remove any "uncertainty around the completion of a potential clearinghouse" and allow the two companies to "very quickly turn [their] attention together" on the interest rate derivatives space.

"Happy circumstance," it wasn't – it was pretty much why the deal happened. The combination makes ICE a powerhouse in the European derivatives space as it will be able to both clear and facilitate trades, most notably interest rate swaps and credit default swaps, which will begin moving onto the exchange soon. ICE has no use for an equities platform in either the US or Europe. It paid a high price – 35% premium to where the NYSE last traded Wednesday - because it thinks it can become a major player in the growing derivatives space, not because it wants to babysit a bunch of servers in New Jersey and manage a glorified TV studio on Wall Street.

When asked what he will do with the other parts of the NYSE, Sprecher was vague. He did note that the company was mulling a spinoff of the NYSE's European equities business. That should be expected as soon as the ink is dry on the merger agreement, which should take most of next year to clear the regulatory gauntlet.  Similar spin-offs of the rest of the NYSE will likely follow. There are a number of large and small exchanges that could want NYSE's equity trading unit, from big players like the London Stock Exchange to smaller ones like BATS and DirectEdge.

So while it looks like the fight for control of the floor of the NYSE is over, it is most likely still on.

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