Sunday, February 13, 2011

The New York Stock Exchange-Deutsche Boerse Derivatives Merger

The proposed merger between the New York Stock Exchange and Deutsche Boerse would reportedly create a combination that earns at least half of its net income from trading derivatives. See The derivatives trading is probably concentrated in financial derivatives, like futures and options for U.S. Treasury securities or stock indexes. (Commodities futures are a relatively small part of the derivatives business.) The stock trading business, facing competition from smaller, faster dark pools and other operators, is evidently in decline.

The derivatives business is about risk management and risk transfer. When the leading exchange in America and the premier exchange in continental Europe join together to form a big risk management market, things are changing and not in a good way.

The fundamental role of the financial markets has historically been to facilitate capital formation. Capital formation consists first and foremost of the sale of stocks and bonds issued by business ventures to savers who want to share in the hoped for profits of those ventures. In other words, capital formation is about taking risks: investors taking risks to help entrepreneurs and established businesses take risks. When major financial markets combine to seek their futures in trading risk management products, one wonders how much capital is being sidetracked from growth oriented investment to speculation.

There is a historically valid role for commodities futures contracts in mitigating the risks of farmers, producers and manufacturers. But when Western financial markets focus more on swapping or selling risks, and less on facilitating capital formation, it's not that hard to understand why Asia is becoming an economic powerhouse while North America and Europe lag. Capital formation is booming in Asia. Fortunes are being made (and sometimes lost). Asia will do well over the next 50 years and perhaps longer because a lot of business risks are being taken, and surely some of those risks will pay off. (After 50 years, Asia's demographic profile will begin to resemble the industrialized world's--more older people and fewer younger people--and no one knows how that will play out.)

Very possibly, the combined NYSE-Deutsche Boerse will be stronger than the two exchanges individually. But its success doesn't necessarily signal prosperity for Western economies as a whole. Economic growth doesn't come from swapping risks. It comes from taking them. The Dutch didn't attain lasting prosperity from trading tulip bulbs. And the combination of the NYSE and Deutsche Boerse is ultimately, not that big a deal. What matters much more is boosting the flow of capital to pimply-faced kids huddled over computers in garages and college dorm rooms, nimble, tech-oriented machine tool companies, specialty steel companies, and other tinkerers and entrepreneurs from sea to shining sea.

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