Financial exchanges ---- Buy, buy, buy

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Financial exchanges

Buy, buy, buy
May 24th 2007 | NEW YORK
From The Economist print edition

http://www.economist.com/finance/displaystory.cfm?story_id=9217849

As capital markets expand, the world's financial exchanges are booming and battling for global leadership

TRADERS cannot resist a bet, even on their own fate. Amid a bidding war over Chicago's derivatives exchanges, the US Futures Exchange, also based in the Windy City, has launched a “binary” contract which allows speculators to take a punt on whether the IntercontinentalExchange (ICE) can snatch the Chicago Board of Trade, America's oldest derivatives exchange, from the grasp of the biggest, the Chicago Mercantile Exchange (CME). Until recently ICE, a fast-growing electronic upstart from Atlanta, had the edge. Then the CME upped its offer to $9.8 billion and its chances of success—as measured by the binary contracts—leapt to over 70%.

The shoot-out in Chicago is part of a pattern of bold deals that are reshaping financial exchanges. In April the New York Stock Exchange (NYSE) completed its merger with Euronext, itself formed from the union of the Paris, Amsterdam, Brussels and Lisbon bourses. Germany's Deutsche Börse, which had wanted Euronext, has consoled itself by agreeing to buy ISE, an American options market, for $2.8 billion. And having failed to conquer the London Stock Exchange (LSE), NASDAQ is now eyeing up other exchanges on both sides of the Atlantic.

Financial exchanges are a booming business. This reflects the growth of capital markets, which expanded at twice the rate of global GDP from 1993 to 2004, according to McKinsey, a firm of consultants. As stock-, derivatives and bond markets get bigger, investors are shifting money into an array of tradable financial products.

Furthermore, cheaper-to-operate electronic markets are spreading at the expense of traditional “open outcry” trading floors. Hard-trading hedge funds have added to the explosion of activity. The value of shares traded worldwide increased by 28% last year, to $69.8 trillion. The unprecedented surge in competition has caused many exchanges to seek safety in size. Indeed, takeover speculation has sent the prices of shares in exchanges soaring (see chart 1).

But exchanges are also under pressure from regulators and clients. New rules on both sides of the Atlantic—America's Regulation NMS and the European Union's MiFID directive—will require trades to be routed through the market offering the best price (or best combination of price and robustness). They also seek to improve transparency. NMS was introduced earlier this year and MiFID is supposed to be implemented by November.

Another relationship
The pressure from clients is a response to a decade of transformation. One by one, exchanges have shed their mutual status to become for-profit, publicly traded entities. This has “obliterated” the old set of relations between marketplaces, their users and their users' clients, says Benn Steil, a financial-markets expert at the Council on Foreign Relations.

When exchanges were broker-owned utilities, they charged just enough to tick along. Innovation was not a priority. Now, they serve shareholders who want to maximise revenue. That means streamlining trading, developing new products and selling them widely. However, the picture is a complicated one. Many brokers continue to own stakes in exchanges and, in the more competitive environment, all of them have benefited from lower prices, new technology and product innovation.

Yet one sign that brokers sometimes see today's exchanges as foes is that they have been stepping up their investments in any new marketplace that promises to lower their costs. ICE, which was founded seven years ago, is backed by powerful Wall Street firms, including Goldman Sachs and Morgan Stanley. BATS Trading, a one-year-old electronic market based in Kansas City, has attracted investment from Lehman Brothers, Merrill Lynch, Morgan Stanley and Credit Suisse. It has cornered more than 10% of the trading in NASDAQ-listed stocks, forcing its bigger rival to cut prices for some clients.

Another way in which banks and brokers are circumventing the big exchanges is through “internalisation”: dealing with each other directly. There are now dozens of “dark pools” of liquidity, in which banks and institutional investors anonymously trade large blocks of shares. Computer software trawls through brokers' order books looking for matches. When they are found, both sides are alerted. Banks have long traded directly with each other through their “block desks”, but the use of pools enhances this and technology makes it easier for the pools to link up. This week, for instance, Credit Suisse and Instinet, a broker, signed a mutual access agreement for their dark pools in Japan. An estimated 10-15% of all stock trading is now done in the dark. As the head of one exchange puts it: “The liquidity is no longer in the marketplace. It's on trading desks.”

European dream
Alternative trading networks are most common in America, where they have helped to push the cost of trading relentlessly lower. Joshua Carter, an analyst with Goldman Sachs, expects the average transaction fee among the American exchanges he follows to fall by 2.4% annually over the next five years. In Europe, by contrast, upstarts have yet to make an impact. At least nine ventures have been launched, but the national exchanges still enjoy near-monopoly status in their own markets. As a result, prices have stayed high—as much as ten times the amount charged by American exchanges.

That may be about to change. For one thing, NYSE Euronext has vowed to shake up pricing in Europe. The NYSE has the lowest all-in trading costs for wholesale investors, according to a recent study by Elkins/McSherry, a consultancy. If it can bring some of that efficiency to Euronext, Frankfurt and London will have to respond with price cuts of their own.

Moreover, the MiFID directive will make it easier for new entrants. One is Project Turquoise, a pan-European trading platform being set up by a group of large banks that control more than 50% of the order flow in European equities. Interestingly, it is by adopting the old mutual model ditched by most traditional exchanges that Turquoise hopes to compete.

Some exchanges saw this as a bluff by their customers. But Turquoise has recently signed up the Depository Trust & Clearing Corporation, which handles trades for American exchanges, as its clearing house. It will soon unveil its trading platform, according to a spokesman. It has also launched a venture, known as Boat, that will try to loosen the exchanges' grip on the lucrative market-data business. NYSE Euronext earns as much revenue from selling data as it does from trading equities in Europe. Turquoise's backers predict it could quickly cut the cost of buying and selling European equities by half, which would encourage more trading. But not everyone is convinced that the seven banks will continue to collaborate successfully, given their longstanding rivalries.

Deutsche Börse and the LSE have so far failed to cut their prices by more than token amounts. “It has long been clear that they will only act when they absolutely have to,” says Bob Fuller, head of Equiduct, a new, pan-European stock exchange that hopes to be up and running by next February. He says the coming revolution will be to share dealing what the low-cost airlines have been to air travel in Europe. An Equiduct trade will cost a maximum of