Good times rarely last

Dec 7th 2005
From The Economist Global Agenda

Financial exchanges are booming, but this is no time for complacency

TWO hundred and thirteen years ago, a group of brokers and merchants signed an agreement under a buttonwood tree in lower Manhattan. They thereby created a securities-trading system that was the forerunner of the New York Stock Exchange (NYSE). Until recently, the NYSE was a bastion of tradition, sticking to member-ownership and floor-based, face-to-face trading. Now it recognises that technology and speed rule the day. On Tuesday December 6th the exchange’s seatholders—who are also its owners—took a vote that will thrust it into the modern trading era, by merging it with Archipelago, a quoted electronic exchange, and turning it into a listed company.

The transformation of the NYSE is just part of the change sweeping through financial exchanges on both sides of the Atlantic. Technology is making trading faster and more automated. It is opening up new opportunities for some, but making competition more intense for all. Demutualisation has allowed some exchanges to raise pots of cash, but has also exposed their managers to sometimes unwelcome pressure from shareholders. And regulation is forcing many exchanges to reconsider long-established ways of doing business.

One upshot of all this is consolidation. The NASDAQ stockmarket, also in New York, plans to acquire Instinet, another electronic exchange. There is courting, if not yet consummation, in Europe too. Rumours have swirled for months: the potential combinations involve the London Stock Exchange (LSE), Germany’s Deutsche Börse, the pan-European Euronext and OMX, a Nordic exchange operator. Meanwhile, Australia’s Macquarie Bank has been looking for a partner to join it in a possible offer for the LSE. Britain’s competition authority has given the Australians until December 15th to bid or back off.

“The whole exchange space in Europe and the US is in play at the moment,” says Octavio Marenzi, chief executive of Celent, a technology research and consulting firm. That space is for the time being remarkably exciting and profitable. Volumes are booming, especially on derivatives exchanges. Profits are strong. Fox-Pitt, Kelton, an investment bank, expects that this year Deutsche Börse and the LSE will make returns on equity of more than 20%, with Euronext making a respectable 11%. Exchanges’ share prices have been soaring.

Yet amid the bounty, the changes swirling around the industry are also bringing challenges. Mr Marenzi predicts that an increasingly networked world will diminish exchanges’ centralising role of bringing buyers and sellers together. He thinks it could even disappear in 15 or 20 years, as more buyers and sellers trade directly on screen. Thanks to demutualisation, technological change and regulation, exchanges also face more immediate threats. Although the details vary between Europe and America, exchanges in both face strain on revenues and costs. The future may not be as lucrative as the recent past. Investors may even be sensing this. Those scorching share prices have cooled a bit in recent days.

On the revenue side, Ruben Lee, managing director of Oxford Finance Group, a consultancy, notes that many sources are already under threat. Membership fees have vanished as exchanges have gone public. Trading fees, a primary source of revenue, have fallen on a per-trade basis, although the effect of this has been offset by higher volumes. One result, says Mr Lee, is that more exchanges are subsidising transactions or are paying marketmakers to direct orders to them.

Meanwhile, in Europe there are questions about future competition in clearing and settlement, which is especially awkward for Deutsche Börse: 40% of its revenue comes from post-trade services. The European Commission has made noises about new regulation in this area.
Also in question are revenues from publishing prices and quotes. In Europe, views differ on how great the effect will be of a big, looming regulation, the Markets in Financial Instruments Directive (MiFID), which demands more transparency and competition in pre- and post-trade data.

Some—notably technology companies selling software—foresee an explosion of market-data services that will take the exchanges’ business. Mr Marenzi believes the LSE, which is active in this area, could suffer more than others. The LSE, which charges up to £2.75 ($4.75) per trade for its post-trade information, admits that margins are likely to be cut when MiFID kicks in in 2007, but says it is well placed to increase its market share. Mr Lee notes that few alternative systems have displaced primary exchanges in the past as providers of price and quote data.

More broadly, big exchanges say that MiFID ought to bring them more business, through the extension of “single passport” rules that will allow more investment firms to operate on a pan-European basis. The LSE and Deutsche Börse say that they do not expect to have to change their methods much to comply with the directive. Its effects could be more troublesome farther south, because France, Spain and Italy now have rules that drive all trades through exchanges. The directive in essence says that this should cease.

The price of progress

While revenues are under threat, technology costs have soared. The rise of electronic trading has entailed costly investments. That said, some exchanges, such as Euronext and OMX, have sold technology and software to others, which provides offsetting revenues.

Technology has in turn spawned internalisation of trades by big investment banks off-exchange, alternative trading systems, and automated block trading. The last—the lumping together of lots of small trades—has put pressure on fees by cutting the marginal cost of a trade, in effect to zero. Liquidnet, a fast-growing firm that anonymously joins buyers and sellers to negotiate trades without intermediaries, says that its average order size for large-cap stocks in the third quarter was 62,000 shares. With so many alternatives, the NYSE has seen its share of the trading in its own listed stocks fall below 75%, the lowest level in 29 years.

Fears about regulation extend beyond the Europeans and MiFID. In America, regulators are also forcing the more old-fashioned stock exchanges to modernise or die. Earlier this year the Securities and Exchange Commission approved a regulation known as Reg NMS, which emphasises the need for markets to be speedy. Some think it helps explain the NYSE’s eagerness to merge with an electronic exchange. Whether the American Stock Exchange’s plans for a part-open-outcry, part-electronic model will satisfy the rule remains to be seen. Reg NMS does not cover commodity exchanges, which allows the member-owned, floor-trading New York Mercantile Exchange to sustain its old ways—although competition from the all-electronic IntercontinentalExchange could also force it to change.

Meanwhile, the managers of public exchanges have outspoken shareholders to put up with. Activists have already driven out Werner Seifert, chief executive of Deutsche Börse, for being too keen to buy the LSE. Euronext’s Jean-François Théodore, has also faced demands that he explore other options, including a tie-up with Deutsche Börse, before making a formal offer for the London exchange. Shareholder pressure is pushing exchanges to look for new sources of revenue, in new asset classes or in foreign markets. So far, the first has been easier than the second.

With shareholders so jumpy and exchanges in need of profits, users naturally have wondered how they stand to gain from all the upheaval. In Europe, particularly, many have complained about exchange fees. Sensing the mood, Macquarie Bank has reportedly asked to meet investment banks as it ponders a bid for the LSE. In America, big investment banks recently took big stakes in the Philadelphia Stock Exchange, and are investing in a new, all-electronic Boston exchange in the hope of countering the NYSE’s power. Neither is much of a threat—at least not yet.

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