The process of consolidation in securities trading venues, sparked by the demutualization of the major stock exchanges, is poised to reach Asia, according to Atul Arora and Advait Rege, two consultants in the Domain Competency Group at Infosys Technologies Ltd in Bangalore.
“The likelihood of an Asian exchange merging with another European/American exchange is not too far fetched,” they predict. “The issues involved are nationalistic in nature with each government treating the national exchange as their national pride. However as most of the countries have more than one exchange (Japan, China, India), it is very likely that one of the exchanges may merge with a larger global player. From a technology point of view also, although some exchanges (the large old exchanges like Tokyo, Osaka, etc.) need to play catch up, some others in countries like India, China, Singapore, etc. are using some of the latest available technology. Consolidation with the rest of the world is therefore not going to be a big technology challenge.”
The full text follows below.
1 Introduction
The origin of the stock exchanges can be traced back to the stock exchange in Antwerp (1460). However, for all practical purposes, the Amsterdam Stock Exchange is considered as the oldest Stock Exchange in the world. The Amsterdam Stock Exchange was established in 1602 by the Dutch East India Company (Verenigde Oostindische Compagnie or VOC). The company was the first in issuing the stocks and bonds on this exchange. Later renamed as the Amsterdam Bourse and was the first to begin trading in securities.
Over the years, more and more stock exchanges were setup across the globe with NYSE coming into existence in 1792, LSE in 1801, Tokyo Stock exchange in 1878 and NASDAQ in 1971. In the recent past, all these exchanges have moved from an open outcry system (floor brokers standing in the trading ring, showing their intent to buy/sell by shouting to others) to screen based trading systems. NYSE however still works partly on an open outcry system.
In the past few decades, exchanges have undergone a huge makeover. From being owned and controlled by the trading members to being independent legal profit making entities on one side and from working on an open outcry method to a highly automated electronic, screen based trading on the other, exchanges have come a long way.
The change process has gained further momentum in the past 8 to 10 years. Newer players like Alternative Trading Systems (ATS) and Electronic Communication Networks (ECN) have come into picture and have started challenging the monopoly that traditional exchanges had on the securities trading business. Business models are being relooked at. Sources of revenue that were once decreed by market practice or by law are being challenged. Newer sources of revenue are being explored. Highly dynamic nature of the regulatory environments in the US and Euro areas is adding to this chaos in the market place.
In the next few sections, we will analyze the recent trends in the exchange industry and the impact these trends have had on the way the exchanges are organized today. We will also analyze the new business models that the exchanges may need to adopt going forward.
2 Advent of ECNs
ECNs came into existence sometime in 1996-97 and have grown into stature and reach since then. These are computerized systems that automatically match orders between buyers and sellers and serve as an alternative to floor trading (the organized exchanges) and traditional market making [Over The Counter (OTC) market]. They are also the major vehicles for extended-hours trading.
ECNs are a hybrid between a market maker and an agent broker. Even though their main function is matching orders (i.e., as a broker), they can also post their bids and offers in the NASDAQ Quote Montage, thus behaving more like market makers. However, unlike market makers who are not allowed to charge fees but instead generate profits from the spread between bids and offers, ECNs charge a fee for each transaction
Initially developed as private trading systems for institutional investors and broker-dealers, ECNs have opened up their systems to varying degrees to include a greater breadth of institutions as well as retail investors. Today, individual investors can trade on the ECNs as easily as institutions.
Some of the key advantages that ECNs provide over the regular exchanges are ECNs allow big investors (BUY side institutions, hedge funds, high net worth individuals, etc.) to trade large volumes anonymously with minimal impact to prices. They have thus become the liquidity pool of choice. The cost of doing a trade on an ECN is lower than the cost of trading on an exchange (Source Celent report named ‘Evolving ECNs: The Alliance with Exchanges under Reg NMS’, dated December 2005). One of the reasons for the cost being low is the high level of automation that ECNs have achieved.
The speed of execution is said to be 10 times faster in case of ECNs (source: Finextra news article ‘Instinet vows to undercut European exchanges with new Chi-X platform’, dated 2nd October 2006). Where an order takes 20 seconds to get executed on a regular exchange, the same can be achieved in an ECN within a couple of seconds. ECNs never close for trading unlike organized exchanges where the trading can happen only during specific hours, generally not exceeding 8 hours a day. Nov. 2, 2006 – BATS Trading Inc. set a volume record Wednesday with more than 113 million shares traded, a 5.45% share of Nasdaq volume and BATS ECN’s third record in the past six trading sessions (source: BATS news release). Because of these reasons, ECNs today account for approximately 38 percent of all NASDAQ transactions (majority of stocks traded on ECNs are NASDAQ listed securities) and almost 100 percent of extended-hours trading.
The competition that ECNs bring to the market place has altered the securities trading ecosystem once and for all. Many of the changes that the traditional exchanges have undergone in last 6-8 years can be directly attributed to the emergence of ECNs. The pressure is therefore on to improve the profitability in the face of increasing IT spend and shrinking per transaction margins.
3 Recent trends and how they impact the market place
3.1 Members taking stake in the exchanges
The consolidation, as being pursued by the exchanges is giving jitters to the powerful broking community. There is a rising concern that the dominant exchanges in the US – NYSE and NASDAQ – could use their increasing market power to raise trading fees. This fear is giving rise to a completely different trend. Brokers are taking strategic equity stakes in the smaller regional stock exchanges, hoping to have a say when the trading fee is decided. Brokers are therefore hedging their interests in this form. Once again, some of the recent events prove this point beyond any doubts.
In September 2006, National Stock Exchange (NSX) confirmed that Wall Street banks Bear Stearns, Citigroup, Credit Suisse and Merrill Lynch, along with e-trading firms Bloomberg and Knight Capital have acquired a majority equity stake in its business. Each firm was expected to take a 10% stake in NSX for around $5 million apiece.
In June 2006, Bank of America, Bear Stearns, E*Trade Financial and Goldman Sachs made a combined $20 million equity investment in the Chicago Stock Exchange.
In 2005, Morgan Stanley, Citigroup, UBS, Credit Suisse, Merrill Lynch and Citadel Derivatives each acquired minority stakes in the Philadelphia Stock Exchange (PHLX).
In October 2006, Credit Suisse acquired a minority stake in Missouri-based ECN operator BATS Trading. Credit Suisse is the third Wall Street firm (after Lehman Brothers and Morgan Stanley) in a month to invest in BATS, which is the owner of the BATS (Better Alternative Trading System) electronic communications network (ECN). How genuine is the concern of the brokers and how much of leverage these strategic holdings will provide them in influencing the decisions regarding the trading fees is something to be seen. In the face of growing competition from alternate liquidity pools and the current regulatory thinking, the trading charges and fee, for the time being, seem to be heading south.
3.2 Players floating alternative liquidity venues
Brokers and other market players are adopting another strategy to counter the perceived threat from the exchanges. They have started coming together to float alternative trading platforms, in the process driving down trading costs even further thereby improving their own bottom line. Look at the recent developments on this front.
A group of seven global investment banks have agreed to establish a pan-European equities trading platform that will compete head-to-head with the region’s domestic stock exchanges following the introduction of MiFID. The group, comprising Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS, will be shareholders in a new company, which will have its own independent management team.
US investment bank Goldman Sachs is gearing up to launch an off-exchange automated trading platform, dubbed Sigma, that will provide its European clients with access to dark liquidity pools. Sigma will provide traders with access to deals that are not offered publicly on any exchange. The move comes ahead of changes that will be introduced following the implementation of the EU’s MiFID. As the proportion of off-exchange deals go up, the relevance of this platform will also go up.
A consortium of nine banks – ABN Amro, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, Merrill Lynch, Morgan Stanley and UBS – is collaborating to create a platform for reporting OTC equity trades, in direct competition with the LSE which currently holds a virtual monopoly in this area. In the past, concentration rules gave little choice to participants but to post, at a cost, all OTC trade data via the LSE or the national exchange of their respective country. The Markets in Financial Instruments Directive (MiFID) is however set to shift the balance when implemented on November 1, 2007. It removes the concentration rule that insist that OTC trades negotiated privately must be posted on an exchange, allowing for the development of new platforms.
Creation of these alternative liquidity pools will put further pressure on the top line as well as the bottom line of the traditional exchanges.
3.3 Increasing competition/price wars
The quest for higher volumes is leading to the increased competition and the price wars that have not been witnessed in the past. All this is dragging down the profitability of the exchanges. Some of the recent news on this front is captured below.
NASDAQ plans to launch an equity and index options market in 2007 in a move that will pitch it against arch-rival NYSE which introduced its new options trading platform (NYSE ARCA) in August. The new options market – which is expected to be launched in the third quarter of 2007 – will utilize the equities trading system acquired when NASDAQ bought out the INET ECN last year.
In the US, NASDAQ has seen its share of trading of NYSE-listed stocks increase due partly to reduced tariffs on its electronic trading platform. As per some estimates, the fees that NASDAQ charges are already half of those charged by NYSE.
SWX group (owner of the Swiss Stock Exchange and the screen based exchange Virt-x) has announced reduction in the trading tariff for international equities, effective 1st January 2007. The fee has been completely waived for a 3 month period starting 1st October 2006. The move could force rival exchanges to make similar price cuts ahead of the introduction of MiFID.
The OMX Nordic Exchange has promised to slash trade reporting fees in Stockholm, Copenhagen and Helsinki early next year, and to extend the system across European markets with the advent of MiFID in November 2007. The Exchange says fees for trade reporting will be harmonized and reduced by approximately 50%. Management at OMX says the fee reduction is a first step in introducing products for trade reporting under MiFID. Next step for the OMX trade reporting offering would be to extend it to securities from all over the European Union and further simplify the reporting facility.
Interagency broker Instinet is to launch a new automated trading system for European equities dubbed Chi-X. Instinet boasts internal benchmark tests that show the new platform to potentially be 10 times faster and significantly cheaper than Europe’s traditional equity exchanges.
Competition and growing trading volumes are forcing the exchanges to continuously upgrade their trading infrastructure. This obviously needs spending on technology on an ongoing basis and hence directly impacts the bottom-line. A very recent example of this is The Tokyo Stock Exchange, which has picked Fujitsu to develop a new trading system it will introduce in 2009.
The exchange had to shorten trading hours for more than three months in 2006 after heavy trading threatened to swamp its systems. It has earmarked 30 billion yen ($250 million) for the new system. The bourse is hoping to revamp its image amid rapid growth in online trading and an explosion in the number of investors and has earmarked an additional 17 billion yen for developing back-up systems to upgrade capacity.
3.4 Adverse impact of new regulations
Some of the proposed regulations, especially in Europe, are going to hit the exchanges quite badly. Some of these impending changes and their impact are discussed below.
Internalization of trades: As part of the MiFID directive, the brokers are allowed to internalize as many trades as they can and not execute them on the regulated markets. This, in a single stroke, will take away as much as 30% of the daily trading volumes. Repealing of the Rule of Concentration: Once again, as a part of MiFID directive, the Rule of Concentration will cease to exist. As per this rule, a country identifies the primary exchange and encourages, by way of regulations, more and more trading activity (execution and reporting) on this primary exchange. Once this rule is repealed, brokers would be free not only to trade on alternative venues but also to report such trades at any public place. This will take away a substantial part of the revenue that the exchanges today earn out of the reporting activity. 4 What should the exchanges do?
Having seen the trends that are putting pressure on the profitability of exchanges, let’s now try to understand what exchanges are doing and can further do to deal with the situation.
4.1 Consolidation
With the demutualization (exchanges becoming publicly held corporate entities), profit has become the prime cause for existence. This structural change, coupled with the pressure on both costs and revenue front, is forcing the players to look for inorganic growth. Mergers and acquisitions are therefore the need of the hour. Consider the following happenings in the recent past.
Takeover of Euronext by NYSE for EUR 10.9 billion. The takeover was approved by the shareholders of Euronext on 20th Dec 2006. And if this was not enough, Euronext has expressed its willingness to integrate with exchanges in the “Asian time zone” also. This merger will give the NYSE a foothold in Continental trading, not only for equities, but for exchange-traded funds (ETFs) as well.
In December 2006, NASDAQ launched a 2.7bn hostile bid for the London Stock Exchange and is appealing directly to LSE shareholders after its first two takeover offers were rebuffed by the UK market operator. The US exchange is now posting its offer document to LSE shareholders and has set 11 January 2007 as the first closing date of a final 12.43 per share cash bid. It may be noted that NASDAQ already holds close to 25.1% stake in LSE.
Some reports in the media also indicate that NASDAQ is interested in buying out OMX (Nordic and Baltic market operator) for GBP 2.43 billion cash. OMX owns exchanges in Nordic (Stockholm, Copenhagen, Helsinki) and Baltic region (Riga, Tallinn, Vilnius). In October 2006, Nordic and Baltic market operator OMX acquired a 10% stake in Oslo Bors Holding, the Norwegian stock exchange, for SKr287.5 million. A month before that, OMX said it had signed a letter of intent to buy Iceland stock exchange operator (ICEX) in an all share deal worth SKr250 million.
Exchanges are viewing size as an advantage and hence are in the process of consolidating their position. Ability to provide their clients with a 24 hour trading day may help them salvage some of the business they have lost to the ECNs.
4.2 Newer revenue models
While regulations are taking away some of the traditional revenue streams, they are also presenting the exchanges with opportunities to adopt newer revenue models. MiFID itself throws up one such opportunity.
MiFID directive will force the brokers to always provide best possible execution to its clients, with price being the single dominant criteria in determining execution quality. Inherent latency that comes with the market data feed being provided by aggregators like Reuters and Bloomberg may force the brokers to source the market data directly from the exchanges. This may enable the exchanges, especially the larger ones, to negotiate better price for the market data feeds with their clients.
4.3 Achieving operational efficiencies
World over, exchanges are investing in technology like never before. Part of the reason is to beat competition and part to manage ever growing volumes. This, although involving heavy initial spend will in the long rung result in more efficient operations and hence lower costs.
5 Will Asia be left out?
As can be seen from the instances cited in the discussion above, most of the action seems to be concentrated in Europe and North America. What about Asia, the fastest growing region in the world today and projected to remain so in the decades to come?
The likelihood of an Asian exchange merging with another European/American exchange is not too far fetched. The issues involved are nationalistic in nature with each government treating the national exchange as their national pride. However, as most of the countries have more than one exchange (Japan, China, India), it is very likely that one of the exchanges may merge with a larger global player.
From a technology point of view also, although some exchanges (the large old exchanges like Tokyo, Osaka, etc.) need to play catch up, some others in countries like India, China, Singapore, etc. are using some of the latest available technology. Consolidation with the rest of the world is therefore not going to be a big technology challenge.
6 Take away
Traditional stock exchanges are facing assault on the twin fronts of revenue and profits from multiple sources. Survival is at stake.
The exchanges have already started putting remedial measures in place. Consolidation is being looked at aggressively and alternate sources of revenue are being evaluated.
The churn has just about started and the intensity is only going to increase in the times to come. Just like in any other sector, weaker players will give way to stronger ones, making the markets more efficient in the process.