Exchanges Must Choose Between Domination or Irrelevance

The global trading landscape is getting interesting. In July the London Stock Exchange (LSE) dropped out of the bidding for the Toronto Stock Exchange (TMX) to allow the Maple Group, a consortia of local Canadian banks and pension funds, to be the lead bidder. In April Australian regulators blocked a bid from the Singapore Exchange (SGX) to take over the Australian Exchange (ASX).

Just a few months ago, the SGX was bidding for the ASX, the LSE for the TMX, and the Deutsche Borse for NYSE Euronext. What a difference a few months make. Are exchanges headed for world domination, or will governments stop their local exchanges from becoming the trinkets of a global exchange aggregation scheme?

And, why are the exchanges consolidating, anyway? What do they gain from consolidation, and what do they lose by staying independent?

Exchanges consolidate for a number of reasons. While exchanges have become for-profit entities needing to drive shareholder value, U.S. and European regulators have pushed greater competition for (predominantly) the equity exchanges, challenging their profitability. Meanwhile, a cyclical shift toward indices, resources and commodities has increased the demand for futures, which tend to be vertically integrated thanks to combined trading and clearing. Exchanges have realized that clearing can be a way to increase profitability while managing competition. In addition, exchange operators are trying to develop a more robust and resilient business strategy by adopting a multi-asset-class/multi-geographical operating model.

The Best Laid Plans

While the draw of a global multi-asset-class footprint has pushed exchange consolidation, however, it is not easy to execute. Driving synergies across merged businesses always has been difficult, no matter what the industry, and many mergers do not work as planned.

Obtaining cross-border and multi-asset-class synergies is problematic. Getting equity traders to trade assets across borders has not really worked, and providing a mechanism for commodity traders to trade bonds or equities has been problematic as well. In addition, rationalizing staff across jurisdictions, especially in Europe, is challenging. And finally, many exchanges went public with such high valuations that even if cross-asset and geographic synergies were extracted, getting the market to respond accordingly has been no easy feat, especially given the low trading volumes we have seen in the past year.

So where does that leave us? Mergers should be beneficial; but they are hard to execute, and it's even harder to drive financial synergies. But what if ...

What if the Deutsche Borse is able to merge with NYSE Euronext? The deal could leave many markets significantly behind. The merged entity would be the largest exchange operator in terms of market cap, volume and profitability. It would be one of the two largest futures exchanges and the largest equity exchange, it would control 40 percent of the U.S. options business, it would own three major trading data centers and a global order routing network, and it would be a dominant ICSD (international central securities depository), not to mention, it would own the lucrative STOXX index business.

If the combined entity could pull off the integration, reduce its cost structure, create a harmonized market data feed, develop a colocation/community technology distribution business, develop a vertical clearing model across products, and in general make the multiple entities into a single business -- it could conceivably draw liquidity from not only the regions that it trades in but from other regions around the world through cross-listings and the development of synthetic products such as ETFs. It may be easier to move the financial products to the liquidity than take the liquidity to the financial products.

Big 'Ifs'

But those are major "ifs." Gaining historic synergies, like the ones mentioned above, are difficult to accomplish within a market, let alone across technology platforms, jurisdictions, continents and regulators.

Nonetheless, Australia and Canada are making difficult bets. While both markets are trying to remain insulated, it is increasingly difficult to do so in a wired economy. Money is portable, ideas are fluid, liquidity is temporal and location has become immaterial. If the Deutsche Borse and NYSE can pull off this historic transaction, it will force other markets to consolidate, leaving independent markets increasingly isolated. And then, the big will get bigger and, unfortunately, the small may become increasingly irrelevant.