The Inevitable Exchange Consolidation

As the last month or so has unfolded, it may seem to casual observers of the financial markets that the global stock market consolidation frenzy has appeared overnight. However, nothing could be further from the truth. What we are now witnessing is the culmination of almost two decades of technological advances and regulatory changes that will forever change the way we trade.

A Brief History

The last 25 years of the 20th century saw many changes in the equity markets. Specifically, the abolishment of fixed commissions, the move from physical to electronic trading floors and the development of electronic communication networks (ECNs) all have had substantial effects on how the world now deals stocks and on the professionals who facilitate those transactions.

One large change that has occurred with deregulation in Europe is the actual development of an equity culture. Prior to the 1980s, European firms largely relied upon debt capital to finance business activities, and there was little in the way of actual equity share ownership by private individuals. This is in contrast to the U.S., where equity financing and secondary markets for those shares have been popular and well-developed for many years. However, although the European equity markets were playing catch-up with the U.S. in the latter part of the 20th century, most eventually surpassed the U.S. technologically. By 1998, every major European stock exchange had gone electronic, beating the U.S. by almost a decade.

Drivers of Exchange Consolidation

Until the 1990s, exchanges around the world existed primarily under mutual ownership structures. In other words, the exchanges were owned by the members they served. Stocks were traded using open outcry or similar methods at posts on stock exchange floors. This structure worked reasonably well for a couple hundred years until the combined effects of a variety of factors began to break it down. Those factors for global stock exchanges fall into three categories: technical, competitive and regulatory.

The late 1990s and early 2000s have seen a flurry of technological advances that have contributed to exchange consolidation. Tighter market linkages, the advent of smart order routing and subsequent development of algorithmic trading and direct market access all have had major effects. Exchanges have been forced to deal with the increasing velocity of trading that has accompanied these advances. Those not capable of keeping up internally either have had to buy the technical expertise or consider merging with stronger players.

Competitive drivers also are playing a key role in market consolidation. Although advances in technology have spurred an arms race among exchanges trying to maintain their market share, these now-public companies also are subject to the pressures of shareholders wanting to see growth in the stock price (open table of competitive drivers).

From a regulatory standpoint, the Markets in Financial Instruments Directive (MiFID) in Europe and Reg NMS in the U.S. are having similar effects. Both MiFID and Reg NMS deal with best execution and specify that orders be sent to the market center displaying the best price. Both the U.S. and Europe have left the specifics of market linkage development mostly to the exchanges and other market participants. They will have profound effects on the capital markets landscape, and in the United States they already are driving the creation of new exchanges and alternative trading systems.

How Do Exchanges Grow and Compete?

Stock exchanges have several options for revenue growth. They can grow organically by increasing listings, developing and marketing new data products, and branching out into other asset classes, such as derivatives. They also can grow inorganically by acquisition of other exchanges, ECNs, clearing venues or technology companies. Germany's Deutsche Bourse is a perfect example of an exchange that has chosen to expand vertically within its country, owning both clearing and exchange technology firms as well as a derivatives exchange. Its European rival, Euronext, has chosen a more horizontal approach, merging several European markets onto one.

The drive to remain competitive and attract listings has had a major effect on the global equity markets. The chart (open here) illustrates the speed of consolidation since 2000. However, the listings business is just part of the revenue equation for exchanges, and there are substantial differences between the proportion of revenue derived from listings for electronic versus nonelectronic exchanges. For instance, while the NYSE derived 30.5 percent of its revenue from listing fees in 2005, the fully electronic LSE derived only 14 percent of its fees from listings, with transaction fees making up the largest portion of revenue at 38 percent. As trading becomes more commoditized, the value of a listing on a particular exchange declines since stocks can be more cheaply listed and easily traded in other venues.

The Asia/Pacific Outlook

The one area of the world where exchanges do not seem to be actively consolidating is in the Asia/Pacific region. That likely will not change in the near future, either. Many exchanges in that region are heavily protected against foreign ownership. What has emerged instead are cooperative agreements between national exchanges in areas that are not a direct competitive threat, as well as some consolidation within domestic markets.

The Singapore Exchange is a prime example of the utilization of cooperative agreements to gain incremental revenue. It presently has alliances with both the Australian Stock Exchange and the American Stock Exchange and is in the process of creating more alliances. Those linkages will bring in offshore order flow as well as allow Singapore market participants the ability to easily access products in those other markets.

Future Outlook

Consolidation in the U.S. and Europe will continue to be a fact of life over the next five to 10 years. As the largest exchanges become even larger through mergers, look for the smaller national and regional exchanges to find ways to remain relevant. This will occur either through partnering/merging with the larger exchanges or through development of technology that will give them an edge in wrestling away small pieces of the pie. The most recent examples come from the Boston, Philadelphia and American stock exchanges, and the International Securities Exchange; all of them have created new trading systems to take advantage of the more-level trading field that Reg NMS has created.

Likewise, MiFID likely will spur creation of new European ATSs in the coming months. Whatever the outcome of the exchange merger frenzy, at the very least it should be an extremely interesting and entertaining year in the global equity markets.

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About the Author

Randy Grossman is a research manager for for Framingham, Mass.-based research firm Financial Insights' Institutional Trading and Investment Management Advisory Service. He specializes in the use of technology to streamline trading and reduce costs.

Charts
Competitive Drivers of Stock Exchange Consolidation
U.S. and European Major Market Consolidation