The Canadian derivatives market continues to follow the “two solitudes” approach to modernization and expansion. Regulatory reform proposals and market development efforts are running parallel in Ontario and Quebec.

Ever since the agreement to restructure the Canadian securities exchange landscape was struck in 1999, Quebec has enjoyed a monopoly on derivatives trading and Ontario has had a virtual lock on equities trading. In March 2009, the standstill agreement that preserves that scenario comes to an end, and TSX Group Inc. will be free to jump into the derivatives trading business.

So far, the TSX is planning to do just that. Through an agreement it has with the U.S.-based International Securities Exchange Holdings Inc. , the TSX will launch its own derivatives market, which will be known as the DEX. It further solidified that intention when it negotiated an exclusive contract with Standard & Poor’s Corp. to license the use of the S&P/TSX composite index beginning in 2009, a deal that will leave the rival Montreal Exchange without a product based on the benchmark Canadian equity index.

With the prospect of competition looming in the derivatives trading arena, the question becomes: will the two exchanges actually slug it out, or will they get together? As with many facets of the Canadian capital markets, there’s the common-sense answer and then there’s the realistic answer.

Common sense suggests that the Canadian market probably isn’t big enough to sustain two derivatives exchanges, despite the fact that the segment is growing rapidly. The reality is that a merger doesn’t appear to be a realistic prospect just yet.

The possibility of a deal was broached with the CEOs of both the TSX and the MX at an industry conference in mid-September.

TSX CEO Richard Nesbitt said he remains open to the possibility of a deal with the MX, and added that nothing the TSX has done to prepare for building a derivatives business of its own precludes a deal with the MX in the future.

For his part, Luc Bertrand, CEO of the MX, said the MX’s guiding principle is that by doing what’s right for the markets, it will be doing what’s right for the exchange. In other words, he’s not ruling out a deal, either, if that’s what the market demands. He added that although the MX has initiated talks with the TSX in the past, no discussions are currently underway.

Notwithstanding the lack of ongoing talks, analysts have been kicking around the idea of a merger, too. A merger would be good for the TSX, CIBC World Markets Inc. analyst Stephen Boland suggests in a recent report. It would enable the TSX to reduce its dependence on equities trading at a time when the exchange is facing increasing competition in that area from a variety of alternative trading systems, most ominously the dealer-sponsored effort known as Project Alpha. A merger would also protect the exchanges’ monopolies: the TSX’s in energy trading and the MX’s in derivatives trading.

Although traders probably don’t want to see trading monopolies solidified, the exchanges have recently witnessed the negative effects that competition can have on their franchises, forcing them to cut fees and invest in expensive systems to meet the upstart ATS threat.

The profit-reducing effects of competition could become even more acute in the years ahead. Boland suggests that if Alpha is successful in the equities business, it could extend its reach into the derivatives market, too.

There are clearly good strategic reasons to get a deal done, but that doesn’t mean it will happen. For one thing, there’s the question of whether the numbers work. In a report of his own, Dundee Securities Corp. analyst John Aiken suggests that they don’t at present. At current prices, he says, it would be impossible for the TSX to buy the MX without diluting earnings.

This doesn’t mean a deal can’t happen without destroying shareholder value, Aiken maintains. But the combined firm would need to trade at a significantly higher multiple than the TSX does right now for shareholder value to rise. It’s hard to see how that would happen, even if the exchanges combined to create a dominant national player.

Boland’s report likewise recognizes that the threat of earnings dilution is an issue. However, he estimates that there are enough cost and revenue synergies available that the two exchanges could make a deal that would be at least earnings-neutral, by pulling out an estimated $21 million in cost synergies and generating another $12 million in revenue synergies.

@page_break@Speaking at the industry conference, Nesbitt didn’t put a precise number on possible cost synergies that could be achieved in a TSX/MX deal. However, he did suggest that the merger of the Australian Stock Exchange and the Sydney Futures Exchange — which sought to save between AUS$15 million and AUS$20 million — is a comparable situation to a TSX/MX deal.

However, Aiken’s report cautions, it could prove difficult to cut costs in the Canadian exchanges’ major cost centres — their trading engines. Although there will surely be opportunities to reduce back-office and support costs, there may not be many opportunities to trim costs on the technology side.

Also, if both exchanges come to the conclusion that a deal is a necessity, they will probably have to do so fairly soon — preferably before the TSX gets too far down the road to developing its own initiative. “Our thesis is that as March 2009 approaches, and the derivatives product lineup is developed, there may be an inflection point at which the TSX considers the increased revenue potential of the MX not worth the cost,” says Boland’s report. “Therefore, we believe a potential merger would most likely need to occur within the next six months.”

But even if the exchanges decide they can make the numbers work in a merger, any deal would probably also carry political considerations. A combined exchange would create a national champion, but that might leave some in Quebec wondering why they gave up their equities trading business in 1999. Bertrand recalls that the MX took a great deal of heat for that move at the time.

So, to stickhandle through the thorny political issues, the two may be pressed to do less cost-cutting than they would otherwise. That prospect raises the bar even higher on the financial hurdle that must be cleared for the deal to make sense.

For now, it appears that the TSX and MX are proceeding down their own tracks in the derivatives business — and the provincial authorities are in much the same mode.

Earlier this year, Ontario’s government tabled a report from a committee that was charged with reviewing the regulatory framework for the derivatives market in Ontario. The panel concluded that the existing system is outmoded and should be replaced by an entirely new, principles-based regime.

Such an overhaul would require new legislation and so the report was referred to a legislative committee in the spring. However, the committee did not deal with the report before the legislature was dissolved in preparation for the provincial election on Oct. 10.

According to Carol Pennycook, chairwoman of the review committee, the report has been permanently referred to the legislative committee, which will decide how to deal with it after the election, once the legislature is reconvened.

She suggests that it’s possible the committee will follow the same basic procedure it did for the recent review of securities legislation, in which it held two days of public hearings seeking input from the government, members of the advisory committee and others before making its recommendations to the legislature.

Quebec has been proceeding with its own overhaul of derivatives regulation. And the provincial regulator that has been handling the effort — the Autorité des marchés financiers — is also calling for a new principles-based regime to regulate its market. However, it appears to be a bit further down the line toward actually adopting a new regime than Ontario.

The AMF published a comment paper on the subject last year and, in August, released a proposed framework for further comment — including proposed legislation, regulations and policy statements that would be required to implement the new system. As in Ontario, the AMF’s proposed framework would still need to go through the legislative process because the framework reflects the work of the AMF, not the government. But it is a step beyond the effort in Ontario, which presented legislators with a series of recommendations but no draft legislation.

The AMF’s proposed framework is out for comment until Nov. 8. It retains the idea of a principles-based approach to derivatives regulation. And it proposes a broad definition of derivatives that would give the AMF authority over the over-the-counter market as well as the exchange-traded market.

This was one area that generated a fair amount of comment on the initial concept paper, with many market players calling for a narrower approach.

The Ontario committee recommended focusing on the exchange-traded segment of the market, and that the government come up with some way of protecting retail investors in the OTC market. The AMF takes the opposite approach — claiming jurisdiction over the entire market, and then granting exemptions for institutional OTC trading.

The AMF’s proposed framework also retains the novel idea of allowing regulated entities (such as exchanges and clearing firms) to self-certify their rules. It remains to be seen if the government is receptive to these ideas.

From both a business and a regulatory standpoint, the derivatives markets of Ontario and Quebec seem to be evolving in the same general direction. Time will tell if the demands of efficiency carry the day and the markets converge, or if fragmentation has the upper hand, as it often has in the Canadian markets. IE