For many observers of Canada’s financial markets, a marriage between Montreal Exchange Inc. and TSX Group Inc. is a no-brainer.

After all, the two exchanges have complementary businesses and the Canadian market seems just too small to have two competitors punching it out. Besides, in the rest of the world, the exchange industry is consolidating.

But the MX and the TSX can’t seem to get along. If anything, they seem to be growing farther apart as the deadline for the end of the non-compete agreement between them approaches.

The official position of the two exchanges is that they’re both open to discussing a merger. But their respective CEOs — Luc Bertrand at the MX and Richard Nesbitt at the TSX — will have to overcome some bad blood if they’re going to get a deal done.

Bertrand revealed recently that merger talks between the two had been held over the summer and pointedly added it wasn’t the MX that had broken off those discussions.

For his part, Nesbitt has promised the TSX will enter the lucrative and fast-growing derivatives trading business in 2009, when the non-compete agreement with the MX expires. The non-compete was part of a 1999 deal that saw the MX give up its stock listings in return for becoming Canada’s sole derivatives exchange.

The TSX, parent of the Toronto Stock Exchange and the TSX Venture Exchange, has already signed a deal with the International Securities Exchange to create a new Canadian derivatives market. It’s to be called DEX and will be 52%-owned by the TSX and 48%-owned by ISE.

Relations between the MX and the TSX weren’t helped this summer when the TSX scored a coup over its Montreal rival by signing an agreement with Standard & Poor’s Corp. for exclusive use of the S&P/TSX equity indices starting in 2009. That was a blow to the MX, which currently has futures and options on the S&P/TSX indices.

But the MX has its own deep-pocketed U.S. partner — the New York Mercantile Exchange, which took a 10% stake in the MX this year. The MX and Nymex have agreed to launch a joint venture in Calgary to trade and clear futures and options contracts — collectively known as derivatives — in crude oil, natural gas and electricity.

Despite all this activity, equities analysts covering the two exchanges have been pushing for a merger — and investors apparently agree. When Bertrand announced in September that talks had occurred but had broken off between the two, the MX’s stock plunged.

National Bank Financial Ltd. analyst Robert Sedran says a merger makes good sense but that doesn’t necessarily mean it’s going to happen before 2009. He suggests there might be a period of competition between the exchanges first.

“There’s a lot of moving parts when you’re trying to put two companies together. And if it doesn’t end up working in time, we may end up seeing direct competition between the two,” Sedran says. “I don’t think that’s the most favourable overcome for either company.

“The TSX is moving full speed ahead in building it’s own derivatives exchange,” he adds, “and with every step it takes down the road, it makes direct competition in 2009 between the two exchanges a more likely scenario.”

Politicians are also taking a keen interest in developments — perhaps too keen, in the case of reaction in Quebec to a media report about the breakdown in merger talks. Radio-Canada reported that the TSX had aborted the talks because of resistance to the idea of having a Montrealer as the CEO of the combined entity.

Quebec Finance Minister Monique Jérôme-Forget was quoted in the report as saying the breakdown reflected “Toronto acting a little superior toward Montreal.”

Former Parti Québécois finance minister Bernard Landry quickly got into the act, comparing the alleged anti-francophone attitudes at the TSX to other incidents of discriminations he dredged up from the distant past.

A spokesman for the TSX called suggestions of anti-Quebec or anti-francophone bias outrageous, a position bolstered by the fact that Bertrand is a perfectly bilingual Franco-Ontarian from Cornwall, in eastern Ontario, who has worked in the Toronto brokerage industry.

That tempest quickly blew over. But lost in the controversy was the fact that Jérôme-Forget, who has the power to veto a merger, has said nothing to discourage a combination. While trying to sound tough for the nationalist electorate in Quebec, she has nevertheless left the door open to a MX/TSX tie-up.

@page_break@Federal finance minister Jim Flaherty has gone one better. He actually urged the MX and TSX to return to the bargaining table “in the best interests of Canada.”

At an MX-sponsored dinner in Montreal recently, Flaherty noted the boards of directors of the exchanges have an obligation to consider opportunities on behalf of their shareholders, including the possibility of a merger.

After the speech, the finance minister maintained he wasn’t endorsing a merger of Canada’s two publicly traded exchanges, then all but did so. “I encourage them to pursue those negotiations. I think it’s in the best interests of Canada,” Flaherty said. “All I’m doing is just encouraging them along the path to succeed.”

In response to Flaherty’s comments, Bertrand told the Montreal Gazette that a deal couldn’t be done with the TSX unless both sides wanted one. He noted Canada’s exchanges were able to work together to engineer a sweeping reorganization in 1999. “You can only get these things done if there’s a strong willingness,” he said.

The willingness to do a deal may increase in the coming months, even though there appears to be a personality clash between Bertrand and Nesbitt and big cultural differences between the two companies.

It’s hard to believe the TSX’s board relishes the prospect of entering the derivatives markets and trying to wrestle liquidity away from the MX. That’s especially true because the TSX is already facing competition in its core equities business from upstart alternative trading systems, including one being set up by the big banks along with other major brokerages and institutional investors.

At the same time, the bloom is off the rose at the MX after its blockbuster début as a public company in March. On its first day of trading, the exchange was rewarded with a market capitalization of almost $1.5 billion, quite a number for a company that generated just $79 million in revenue last year.

Since then, however, volume has tanked on its flagship BAX short-term interest rate futures contract and the MX’s stock has fallen.

So, the time might yet come when these two reluctant partners start to tango. But if they don’t accept the invitation to dance, they may quickly find themselves in the arms of other suitors. IE BY DON MACDONALD