Exchange Merger Mania
The frenzy of merger-related activity in the exchanges business shows no sign of abating. Last week, it was the turn of first BATS Global Markets and then NASDAQ/IntercontinentalExchange (ICE) to enter the fray — BATS with the announcement that it plans to launch a primary listings business, and NASDAQ/ICE with a counterbid for NYSE Euronext, following the latter’s proposed tie-up with Deutsche Börse.
On top of this, three other proposed mergers are in the pipeline — between London Stock Exchange Group and Canada’s TMX Group; Singapore’s SGX and Australia’s ASX (although that deal has now been apparently quashed by the Australian authorities); and the pan-European multilateral trading facilities, BATS Europe and Chi-X Europe.
Throughout all of this, the importance of building scale in derivatives trading — a higher-margin business compared to cash equities trading — has been well documented. In addition, requirements under Dodd-Frank in the U.S. and MiFID in Europe to move more derivatives trading onto exchanges, with contracts cleared centrally, have provided a fillip.
Regulation and Technology Are the Drivers
But the real stimulus for this activity stems from changes in regulation and technology over the past two decades. Regulation opened up the exchange industry to competition, and rapid technological developments enabled competition to flourish. Whereas once these businesses operated as national monopolies, with transactions executed between humans on the exchange floor, today they have evolved into amorphous electronic networks, with order flow generated and matched by computers at previously unimaginable speeds. In short, barriers to entry have fallen — and as a result, new trading venues have proliferated, competition has intensified, and liquidity has fragmented.
Another factor is the demutualisation of exchanges. The drive for profit, coupled with low barriers to entry, has meant that the success of the business has become critically dependent on scale. Technology has certainly helped in this respect — the speed and ease with which trades can be executed has enabled cash equity volumes to surge over the past decade. But the fragmentation of those volumes, combined with pressure on fees from competition, has dwindled margins. Hence the foray into derivatives.
Amidst all these changes, the key question, from a market integrity standpoint, is whether this consolidation is good, or bad, for investors. The extent of fragmentation, in both the U.S. and Europe, is such that the market can probably absorb a certain degree of consolidation without compromising choice and costs for investors. And in some respects, a less fragmented trading landscape may be easier to navigate. However, the balance between fragmentation and consolidation is a delicate one, and a return to a more monopolistic market structure is something that both investors and regulators should want to avoid.
One should also keep in mind the role of the banks in this story. Their development of execution facilities, such as crossing networks and dark pools, has provided another source of competition for the exchanges in recent years. The banks’ abilities to further develop exchange-like functions — and equally, perhaps, the ability of the exchanges to diversify into other areas — will ultimately be shaped by regulation. With the U.S. SEC and the European Commission both considering new market structure regulations, one thing is clear: what we have seen is just the beginning of the next phase of exchange evolution.
Related post: The Rush for Transparency Exemptions in Derivatives