Tsx Group Inc. has fi-nally shown its hand in the slowly unfolding battle with the Montreal Exchange for control of Canada’s derivatives market. What is still very much open for debate is which of the two exchanges will eventually emerge as the victor.

The TSX, which owns the country’s main senior and junior equities markets, announced on March 5 that it had formed a joint venture with New York-based International Securities Exchange Holdings Inc. to form a Canadian derivatives exchange, to be known as the DEX. Launched in 2000, ISE is one of the largest options exchanges in the U.S.

The new DEX will launch in March 2009, when the TSX’s 10-year non-compete agreement with the ME expires.

The ME has been making its presence felt. In February, it formed a partnership with U.S. commodities trading giant New York Mercantile Exchange that will see Nymex take a 10% stake in the ME.

The two exchanges will also launch a new Calgary-based exchange to trade and clear futures and options contracts in crude oil, natural gas and electricity. That new exchange will compete directly with the TSX’s Natural Gas Exchange, also based in Calgary.

As well, in December, the ME announced its plans to go public.

The ME’s decision to partner with Nymex was widely regarded as the de facto spurning of any scenario under which the ME would link up with the TSX to create one equities and derivative trading powerhouse in Canada, a combination the TSX was understood to be seeking.

“I do believe we are facing a situation in which two derivatives exchanges will exist in Canada — at least, in the interim,” says John Aiken, an analyst with Dundee Securities Corp. in Toronto. “I don’t see them sitting across a table from each other and starting negotiations on how to combine operations. That’s not likely to happen in the near term.”

The TSX says it will have a busy agenda over the next two years as it sets up the technology for the new exchange and tests it, hires staff and completes the necessary regulatory steps.

“Two years, in some regards, sounds like a long time. But, given the amount of work that needs to be done, two years is about right,” TSX CEO Richard Nesbitt says.

Still, the fledgling DEX will face the danger of being too far behind the ME by the time it launches in 2009, Aiken says: “You have two more years in which the ME can increase its liquidity pool and build a greater defensive stance.”

The TSX believes one of the strengths of the DEX deal is the expertise that ISE brings in running a derivatives exchange.

“We would be very concerned if we were building this ourselves with no toe in the water until 2009,” says Rob Fotheringham, the TSX’s vice president of trading. “Having a partner that is operational, that is staying current, is a great advantage. It is more than a technology agreement. It’s an adaptation of ISE’s market ecology: its rule book, market structures and market-making capabilities.”

ON ONE EXCHANGE

The DEX, which will trade options, futures and options on futures, will be 52%-owned by the TSX and 48% by ISE. It will cost $26 million to set up, the partners say, divided according to share ownership. Fotheringham and Thomas Ascher, ISE’s chief strategy officer, will lead the project.

The TSX says Canadian investors will appreciate the opportunity to buy securities and derivatives on one exchange rather than two, as they must now do. “The TSX sees that as being a competitive strength,” Aiken says.

Both the TSX and ISE say the Canadian derivatives market is underdeveloped, and the new exchange will expand the market rather than just steal business from the ME. “We see the same opportunity in Canada that we saw in 1998 [when the ISE was conceived],” says David Krell, ISE’s president and CEO.

Adds Aiken: “If you take a look at what the ME trades, it’s still principally fixed-income derivatives. Presumably, the DEX will focus in on equity derivatives to start. That’s where it has the most synergies, and that’s what ISE’s forte is.”

Fotheringham acknowledges the link between ISE’s equity derivatives business and the TSX’s equity trading business, but adds that the DEX plans to carry a full suite of products, including fixed-income derivatives.

@page_break@How the two Canadian exchanges’ derivatives strategy will play over the next two years and beyond is anyone’s guess, Aiken says.

“It’s likely the ME will be able to defend its turf on fixed-income futures trading rather easily,” he says. “The question is how successful the TSX will be on equity options trading. I think that’s the area in which it will have the most success. Whether it will be the eventual winner, I don’t think anybody’s able to tell at this stage.” IE