The shoot-out in Chicago is part of a pattern of bold deals that are reshaping financial exchanges. In April the New York Stock Exchange (NYSE) completed its merger with Euronext, itself formed from the union of the Paris, Amsterdam, Brussels and Lisbon bourses. Germanys Deutsche Brse, which had wanted Euronext, has consoled itself by agreeing to buy ISE, an American options market, for $2.8 billion. And having failed to conquer the London Stock Exchange (LSE), NASDAQ is now eyeing up other exchanges on both sides of the Atlantic.
Financial exchanges are a booming business. This reflects the growth of capital markets, which expanded at twice the rate of global GDP from 1993 to 2004, according to McKinsey, a firm of consultants. As stock-, derivatives and bond markets get bigger, investors are shifting money into an array of tradable financial products.
Furthermore, cheaper-to-operate electronic markets are spreading at the expense of traditional open outcry trading floors. Hard-trading hedge funds have added to the explosion of activity. The value of shares traded worldwide increased by 28% last year, to $69.8 trillion. The unprecedented surge in competition has caused many exchanges to seek safety in size. Indeed, takeover speculation has sent the prices of shares in exchanges soaring (see chart 1).
But exchanges are also under pressure from regulators and clients. New rules on both sides of the AtlanticAmericas Regulation NMS and the European Unions MiFID directivewill require trades to be routed through the market offering the best price (or best combination of price and robustness). They also seek to improve transparency. NMS was introduced earlier this year and MiFID is supposed to be implemented by November.
The pressure from clients is a response to a decade of transformation. One by one, exchanges have shed their mutual status to become for-profit, publicly traded entities. This has obliterated the old set of relations between marketplaces, their users and their users clients, says Benn Steil, a financial-markets expert at the Council on Foreign Relations.
When exchanges were broker-owned utilities, they charged just enough to tick along. Innovation was not a priority. Now, they serve shareholders who want to maximise revenue. That means streamlining trading, developing new products and selling them widely. However, the picture is a complicated one. Many brokers continue to own stakes in exchanges and, in the more competitive environment, all of them have benefited from lower prices, new technology and product innovation.
Yet one sign that brokers sometimes see todays exchanges as foes is that they have been stepping up their investments in any new marketplace that promises to lower their costs. ICE, which was founded seven years ago, is backed by powerful Wall Street firms, including Goldman Sachs and Morgan Stanley. BATS Trading, a one-year-old electronic market based in Kansas City, has attracted investment from Lehman Brothers, Merrill Lynch, Morgan Stanley and Credit Suisse. It has cornered more than 10% of the trading in NASDAQ-listed stocks, forcing its bigger rival to cut prices for some clients.
Another way in which banks and brokers are circumventing the big exchanges is through internalisation: dealing with each other directly. There are now dozens of dark pools of liquidity, in which banks and institutional investors anonymously trade large blocks of shares. Computer software trawls through brokers order books looking for matches. When they are found, both sides are alerted. Banks have long traded directly with each other through their block desks, but the use of pools enhances this and technology makes it easier for the pools to link up. Last week, for instance, Credit Suisse and Instinet, a broker, signed a mutual access agreement for their dark pools in Japan. An estimated 10-15% of all stock trading is now done in the dark. As the head of one exchange puts it: The liquidity is no longer in the marketplace. Its on trading desks.
Alternative trading networks are most common in America, where they have helped to push the cost of trading relentlessly lower. Joshua Carter, an analyst with Goldman Sachs, expects the average transaction fee among the American exchanges he follows to fall by 2.4% annually over the next five years. In Europe, by contrast, upstarts have yet to make an impact. At least nine ventures have been launched, but the national exchanges still enjoy near-monopoly status in their own markets. As a result, prices have stayed highas much as 10 times the amount charged by American exchanges.
That may be about to change. For one thing, NYSE Euronext has vowed to shake up pricing in Europe. The NYSE has the lowest all-in trading costs for wholesale investors, according to a recent study by Elkins/McSherry, a consultancy. If it can bring some of that efficiency to Euronext, Frankfurt and London will have to respond with price cuts of their own.
Moreover, the MiFID directive will make it easier for new entrants. One is Project Turquoise, a pan-European trading platform being set up by a group of large banks that control more than 50% of the order flow in European equities. Interestingly, it is by adopting the old mutual model ditched by most traditional exchanges that Turquoise hopes to compete.
Some exchanges saw this as a bluff by their customers. But Turquoise has recently signed up the Depository Trust & Clearing Corporation, which handles trades for American exchanges, as its clearing house. It will soon unveil its trading platform, according to a spokesman. It has also launched a venture, known as Boat, that will try to loosen the exchanges grip on the lucrative market-data business. NYSE Euronext earns as much revenue from selling data as it does from trading equities in Europe. Turquoises backers predict it could quickly cut the cost of buying and selling European equities by half, which would encourage more trading.
But not everyone is convinced that the seven banks will continue to collaborate successfully, given their longstanding rivalries.
Deutsche Brse and the LSE have so far failed to cut their prices by more than token amounts. It has long been clear that they will only act when they absolutely have to, says Bob Fuller, head of Equiduct, a new, pan-European stock exchange that hopes to be up and running by next February. He says the coming revolution will be to share dealing what the low-cost airlines have been to air travel in Europe. An Equiduct trade will cost a maximum of 0.90 ($1.20) and take a mere 10-15 milliseconds. It has already signed up 1,300 stocks from 30 countries.
One response of the big exchanges has been to buy electronic networks that pose a threat, as the NYSE did with Archipelago and NASDAQ did with INET. This also brings in technology and fresh thinking. John Thain artfully used the Archipelago deal to revamp the New York exchange, where he is chief executive. He saw that it could be a catalyst for cultural change, injecting entrepreneurial spirit into a stuffy 215-year-old institution, says Nelson Chai, NYSE Euronexts chief financial officer (who came from Archipelago).
The big exchanges have begun to compete more vigorously with each other. The NYSE and NASDAQ used to operate in largely separate worlds, the NYSE in blue-chip stocks and NASDAQ in technology firms. Now they fight for every transaction. NASDAQs share of trading in NYSE-listed stocks has risen to over 15%. In an effort to poach listings, NASDAQ has even begun offering a service that finds prospective board members for its companies.
Whereas the NYSE has the stronger brand, NASDAQ likes to think it has an edge in technology. Robert Greifeld, NASDAQs chief executive, believes that the future pecking order will be determined not by whether your market trades round the clock, as some thinkhe may have Mr Thain in mindbut by how successful exchanges are at creating efficient transaction-processing machines. Its not sexy, but its crucial. Once you have invested in a trading platform, the cost of running extra transactions over it is minimal. So the secret will be versatile systems that can support high volumes and a variety of securities, from stocks to options.
That is easier said than done. Some within NYSE Euronext remain to be convinced that equities, derivatives and other products can be squeezed onto a single trading platform. Even if such a platform can be designed, the big exchanges are finding it harder to stay ahead of the gadflies, thanks to the falling cost of technology. Whereas the software and hardware needed to set up a trading system used to cost hundreds of millions of dollars, it can now be assembled for $10 million or less. BATSs systems cost a mere $7 million to set up and run in its first year.
This helps the small fry to assemble top-notch technology and make money from renting it to others. OMX, a Nordic exchange, has done this in neighbouring markets. The Montreal Exchange, hardly a colossus, has successfully marketed its impressive SOLA trading system to bourses in Asia. Bostons options exchange already uses it. The new and the small are todays agents of change, says Philippe Loumeau, Montreals chief operating officer and a former Paris bourse executive.
Even the most robust systems will be tested as never before when trading volumes rise. The delays seen at the NYSE and other exchanges on February 27when a wall of sell orders sent the Dow tumbling and overloaded messaging systemsdemonstrated how quickly a snowfall can turn into an avalanche when so much trading is generated by computers. Larry Tabb, a consultant working with exchanges, points out that messages sent by brokers (or their trading programmes) in the American market have risen from 25,000 to 300,000 per second in a little over two years.
Exchanges are racing to stay ahead. But upgrading or merging their systems will not be enough in itself. With margins on stock trading dragged down by falling trading costs, exchanges know that their healthy return on equity26% a year on average for American bourses between 2001 and 2005will be hard to sustain. So they are looking to new markets, particularly Asia, and new products, such as bonds and derivatives, to keep shareholders happy.
Asias attraction is its spectacular growth (see chart 2) privatised. Many of these firms now prefer to list at home. Trading on the regions stockmarkets jumped by 37% last year.
American and European exchanges are desperate to do deals in Asia, but there is not much on offer. The NYSE has gone furthest, signing alliances with Tokyo and Indias National Stock Exchange. But these fall far short of mergers. The Japanese exchange is not even planning to demutualise until 2009. Most of the deals struck so far in Asia are little more than agreements to be friends, says Mr Tabb. Still, there is hope that China will look for a partner for its exchanges, once it has finished the more urgent task of mending its banks.
The move into derivatives has produced more tangible results. The NYSE got the London-based LIFFE futures market through its merger with Euronext. It also recently set up an options exchange, which already has more than 11% of the American market. If Deutsche Brse gets its way, it will add ISE to its well-regarded Eurex derivatives market. NASDAQ plans to open its own options market, if it does not buy one (it has held talks with the Philadelphia exchange, which has had some success switching from stocks to options). As with the fight in Chicago, derivatives are fast becoming the bloodiest front in the battle for global dominance.
The attraction of moving into futures, options and swaps is that derivatives markets tend to command higher valuations than those that trade only shares. There are a number of reasons for this. Growth has been spectacular: trading on the CME, for instance increased at an average annual rate of 36.4% in 2000-05, compared with 14.5% on the NYSE. Hedge funds are attracted to derivatives as a way to manage risk and punt with borrowed money, whether economies are stagnating or booming. Whereas growth in stock trading is constrained by the number of firms listednot to mention regulations such as Sarbanes-Oxleyderivatives are limited only by the capacity of financial eggheads to concoct new contracts.
Andr Cappon of CBM Group, a financial consultancy, points to two further factors. One is scarcity value. There are only a dozen or so derivatives exchanges of any size. The other is the firm grip such bourses have on their own products. Whereas a stock exchange can poach trade from rivals, futures markets have ownership rights over many of the contracts that trade there, thanks to licensing agreements with the owners of the underlying indices, such as the S&P 500 and the NASDAQ 100. That said, new exchanges are free to introduce contracts that are similar, but not identical, to existing onesas ICE did so successfully with oil futures.
The derivatives exchanges with the tightest lock on trading are those that have their own clearing houses such as the CME and Eurex, since they can offer clients cheaper and swifter settlement. Such vertical integration is controversial and may not last. In the past the European Commission has hinted it might force Deutsche Brse to shed its clearing operations, although the pressure seems to have eased for the moment.
One other reason for exchanges to own their own clearing houses, says Antonio Riera, of the Boston Consulting Group, is so that they can offer the back-office services their users are clamouring for. Collateral management, for instance, involves things like cross- margining, in which offsetting exposures are lumped together, allowing investors to reduce the overall amount of capital needed to be set aside to cover positions. It means more bets can be made with a given dollop of capital.
Moreover, because of their expertise in designing, trading and settling complex instruments, exchanges that own their own clearing houses feel confident that they can wrest some business away from the giant over-the-counter (off-exchange) derivatives markets. The CME has had some success with its centrally cleared markets for foreign exchange and swaps, for instance, though both ventures are at an early stage. Mr Carter thinks that, as contracts become standardised, exchanges could grab a big chunk of the market for credit-default swaps, worth a massive $29 trillion in notional value and traded mostly privately. This is likely to antagonise the banks that currently dominate that market.
Spotting who will come out on top in all this is not easy. If the CME succeeds in taking over the Chicago Board of Trade, it will move far ahead of the competitionso far, indeed, that some are calling for the deal to be blocked on antitrust grounds. (The CME counters that its competition comes from the over-the-counter market, as well as other exchanges.) If ICE wins, the industrys balance of power will shift back towards Wall Street. The CME might then turn its attention to another target, such as the New York Mercantile Exchange, a commodity-futures market.
Nor is Deutsche Brses offer for ISE certain to succeed. The hedge funds that own half or more of the German group would prefer to see cash returned to shareholders. One of them, Atticus Capital, with a stake of over 11%, has expressed fury at an emerging pattern of ignoring shareholder concerns and input. Meanwhile, some of the hedge funds that own perhaps 10-20% of the LSEwhich has already seen off four suitorsare quietly nudging it to seek a better offer. Exchanges, it would seem, have cut their old links to brokers only to see them replaced by an even more demanding set of owners.
The pressure to do deals is not coming from poor performance. Indeed, the LSE beat expectations with a 55% rise in operating profits before exceptional items for the year to March. Instead, it is being driven by a fear of being left behind and a belief that exchanges, parochial for too long, need to catch up with the rest of the globalising financial industry.
Mr Thain thinks the future belongs to a handful of exchanges offering a basket of productsequities, bonds, exchange-traded funds, futures, options and moreacross several time zones. He is probably right. And with companies worth $30 trillion trading on its platformsfour times more than its nearest rivalNYSE Euronext is well placed to become one of the giants. But would you bet on it Time, perhaps, for the US Futures Exchange to cook up more of those binary futures.
The Economist Newspaper Limited 2007