Merger Mania: Bigger Is Not Always Better

Ever since the London Stock Exchange (LSE) announced a deal to acquire the Toronto Stock Exchange's parent, TMX Group, merger mania has rocked the exchange space. Stirring up national passions and regulatory obstacles, a slew of cross-border deals that threaten the survival of national stock exchanges are in the works. In early February, NYSE Euronext, operator of the New York Stock Exchange, revealed that it was in talks to merge with Frankfurt-based exchange operator Deutsche Borse. The news set off a media frenzy and immediately spurred questions about which exchange would be next. Many of the rumors have focused on Nasdaq OMX's need to join forces with CME Group or IntercontinentalExchange in an attempt to keep up with the NYSE-DB behemoth. In fact, as Advanced Trading went to press, the LSE reportedly was mulling a takeover of Nasdaq OMX, after the London exchange completes its deal for the TMX Group.

"What is the commercial imperative behind these global stock exchange mergers?" asks Steve Grob, director of strategy at Fidessa. "Why are they all happening now?"

In a video filmed inside Tesco, a giant U.K. supermarket chain, Grob explores why national stock exchanges are joining up with international partners to create super exchanges. As the cameras point to racks of clothing, cereal and fresh produce, he tells us that super exchanges are the global equivalent of creating a financial multi-asset supermarket with cash equities located in Aisle 1, derivatives in Aisle 2, and FX, fixed income and OTC products somewhere else in the store.

According to Grob, exchange mergers are motivated by the same factors that drive U.S. mega stores such as Walmart and Target to sell food, toys and appliances under one roof. Facing intense competition at home from alternative trading venues, including multilateral trading facilities in Europe, stock exchanges have decided they need to bulk up. By getting bigger, exchanges can offer their customers economies of scale and deeper, more diverse pools of liquidity, argues Grob. They also can offer their customers new products - like derivatives - that can generate higher fees, he points out.

Will It Work?

But I'm somewhat skeptical of whether transnational exchange mergers are necessary and, frankly, whether they will even work. They won't catch on unless they simplify trading and offer volume discounts to brokers, asset managers and hedge funds.

In today's global trading environment, exchanges have become nodes on a high-speed global network. Do high-frequency traders and institutional investors really care whether the Germans or the Brits own the underlying exchange? The answer is no.

With low-latency networks connecting matching engines, high-frequency traders can position their black boxes in neutral data centers that also house competing exchanges' matching engines. Their orders can travel at the speed of light via optical fiber networks and undersea cables. Traders care about best execution, technological speed and capital efficiency - not exchange ownership.

On the other hand, regulators care about competition, as evidenced by Europe's MiFID, which led to the proliferation of pan-European trading venues, and the reforms aimed at OTC derivatives under the Dodd-Frank Act in the United States. As a result, regulators are likely to scrutinize these deals for anti-trust issues, and it's not yet clear if they will allow these exchange consolidators to devour their competition.

Meanwhile, the high-frequency trading community wants to see as many alternative trading venues as possible in order to create more arbitrage opportunities, Grob says. Even as a few exchanges flex their muscles, upstarts such as BATS and Direct Edge have successfully eaten into the NYSE's and Nasdaq's market share in U.S. stocks. In addition, BATS recently acquired Chi-X, the pan-European trading venue that has been a thorn in the LSE's side.

So while the global exchange merger frenzy is bound to continue, don't count out the value of niche players. In the eat-or-be-eaten world of exchange consolidation, some innovators won't be on the menu.