Majestic Research

Advanced Trading

Exchange Consolidation Wave Is Expected to Continue in 2008

By Ivy Schmerken
Published: October 31, 2007

As 2007 draws to a close, industry analysts and traders say the exchange-consolidation buzz will continue in 2008. After a year in which exchanges prowled the globe for acquisition targets to diversify revenues and reduce technology costs, however, the next wave of merger activity appears to be shifting to the U.S. regional exchanges.

“As the larger global exchanges are getting snapped up and there are fewer global exchanges to acquire, the activity is beginning to come to the regional market,” observes Dushyant Shahrawat, research director of TowerGroup’s Securities and Capital Markets Practice in Needham, Mass.

At press time, in fact, several exchanges and trading firms were contending for the Philadelphia Stock Exchange (PHLX), which was valued at $600 million, according to reports. NYSE Euronext and Nasdaq, as well as a group of trading firms led by Goldman Sachs and Susquehanna International Group, reportedly were submitting bids. A combination with the American Stock Exchange also was raised as a possible outcome.

This latest activity comes on the heels of Nasdaq acquiring the Boston Stock Exchange’s assets in September. Now there is speculation that the activity will continue to spread to the other regional stock markets—including Chicago and the National Stock Exchange—which are struggling to grow their market share in U.S. stock trading in the face of competition from the NYSE Group and Nasdaq.

“There’s certainly this ongoing landgrab because the exchanges are publicly traded companies and they have to run on a profit motive,” notes Brad Bailey, senior analyst at Aite Group. At the same time, he adds, exchanges are facing intense competition in U.S. cash equity trading from alternative trading systems—dark books and the independent crossing networks, which account for 10 to 15 percent of U.S. stock volume. As a result, Bailey predicts, the exchanges will be looking for inexpensive ways to add volume in higher-margin businesses. There is even talk of only a handful of players—perhaps as few as three—dominating the buying and selling of securities on a global basis.

The process of consolidation already has shaken up the global exchange landscape, including mergers between Eurex, owned by Deutsche Borse and Swiss exchange operator SWX Group, and the International Securities Exchange; the London Stock Exchange (LSE) and Italian markets operator Borsa Italiana; and the Chicago Mercantile Exchange (CME) and its long-time futures rival the Chicago Board of Trade. Also this year, the New York Stock Exchange finalized its takeover of Euronext, forming NYSE Euronext, which owns exchanges in six countries.

The activity hit a frenzy in August when Nasdaq, after failing to snare the LSE, partnered with Borse Dubai in the Middle East to gain control of Stockholm’s OMX AB, the Nordic and Baltic exchange operator. As part of the deal, Nasdaq sold its 28-percent position in LSE to Dubai, which will wind up with nearly a 20 percent stake in Nasdaq.

“It’s a mad rush to go out and use stock price to acquire people,” says TowerGroup’s Shahrawat. But since public exchanges are using their high stock prices to acquire other exchanges, the activity likely will slow, he adds, predicting that exchanges’ valuations will come down by 2009.

Until then, however, exchanges will continue to pursue mergers as the shift to electronic trading makes it cheaper and more efficient to run multiple products on the same platform. “There are huge cost synergies in banging together two exchanges,” explains Doug Atkin, CEO of Majestic Research in New York. “You only need one trading platform, which is huge, and you take costs out.”

Diversifying to Survive

The question is: Which exchanges will be left standing in 2008? How will U.S. stock exchanges diversify and reinvent themselves to compete against the threat of dark pools and block crossing networks? And what factors will propel one exchange ahead of another?

“Obviously, it’s multi-country and it’s multi-asset class,” asserts Joe Gawronski, president and COO of Rosenblatt Securities, an institutional agency broker that recently opened an international trading desk. “Just being in equities or just being in futures isn’t going to cut it for the long term, other than for some niche players.”

Exchanges also are making investments in emerging markets. For example, NYSE Euronext bought a 5 percent investment in the National Stock Exchange of India and Deutsche Borse acquired a 5 percent stake in the Bombay Stock Exchange. “If you look at the five fastest growing exchanges, four are in Asia, two are in India and two are in China,” according to Gawronski.

What’s Ahead for the Exchanges?

“What you’ll find is that a true equity exchange in itself probably won’t exist in the short term,” predicts Joe Cangemi, managing director at BNY ConvergEx Group. “It’s more about multi-asset class, multi-currency global functionality and technology. So the next clear winners will be those that have the global reach and technology and an infrastructure that is sound enough to be scalable.”

The exchange that emerges on top “is going to be an exchange that trades everything,” adds Kevin Chapman, managing director and head of international trading at Nicholas Applegate Capital Management in San Diego. “Why can’t you have everything traded on one exchange?”

One reason exchanges are entering multiple asset classes is to leverage technology synergies. “Once an exchange is running a technology platform, the cost of adding incremental products isn’t as expensive as adding the first product,” says Rosenblatt’s Gawronski.

More important, however, exchanges are diversifying their business mix to generate higher revenues. “U.S. equity exchanges like the NYSE and Nasdaq want to be multi-asset class because that’s where the growth is,” contends Gawronski. “The NYSE Euronext and Nasdaq want to grow by going into or expanding their futures and options offerings, and they want to grow into product classes that have been growing a lot faster.”

Gawronski points out that unlike equities and options, which trade on a multitude of exchanges, ECNs and dark pools, futures exchanges have proprietary rights over the products that are created on them. “Your intellectual property is protected, and the product that can be offered is only limited by one’s imagination,” as opposed to the number of companies willing to list, he says. Further, “The way the clearing works in futures, if you buy it on CME, you can’t sell it elsewhere,” Gawronski notes. “It’s not fungible like equities.”

But that doesn’t mean that CME Group, the world’s largest futures exchange, won’t look to get into other asset classes. “I would be surprised not to see the Chicago Mercantile Exchange get involved somehow, whether it’s buying the CBOE, the Philadelphia or the Amex,” says a buy-side trader who spoke on the condition of anonymity. “I would be surprised if they didn’t join the fray, if they didn’t get into equities or the cash end of the business.” In fact, the CME already is eyeing expansion into Latin America. In October, it announced plans to buy about 10 percent of Brazil’s BM&F derivatives exchange in return for a 2 percent stake in CME that is valued at about $700 million.

But just because the exchanges diversify doesn’t mean they will be successful. “After all these parties jump into these asset classes and into new countries, the question becomes how well they execute on their strategy, and that’s what determines which venue will become successful,” says Dimitri Galiametdinov, director, equities, at Advanced Execution Services (AES).

The Fastest Exchange Wins

As new players enter the field, buy-side traders say speed and technology is what matters most. “What it’s going to take is really speed of execution,” relates Nicholas Applegate’s Chapman. “If somebody’s system is faster than another’s, I think you’re going to gravitate there. That’s why Instinet has been so successful with Chi-X,” he continues, referring to the Pan-European alternative trading system that Instinet launched in London to take advantage of MiFID. Chi-X is 10 times faster than the LSE and the per-ticket charge is lower for the brokers that sponsor the buy-side trades, Chapman notes. “When the buy-side is implementing trading decisions, “the fastest is better,” he says.

“Alternative trading venues are putting the pressure on exchanges to adapt and upgrade their systems quickly [if they don’t], there’s going to be a grab of volume that they don’t get back,” says Chapman. “The NYSE is a perfect example. They didn’t adapt fast enough and now they’re losing liquidity big time. If I’m buying IBM and now I’m getting it on Nasdaq rather than the NYSE, I don’t care.”

But according to NYSE Euronext executives, the exchange has improved its speed and has plans in place to become much faster. “We’ve dramatically cut the latency down to about 110 milliseconds from over 200 not that long ago, and our goal is to be sub-10 milliseconds,” said Larry Liebowitz, NYSE Euronext’s EVP and COO, U.S. Markets, speaking at Lehman Brothers’ 5th Annual Financial Services Conference in September.

To reinvent itself, the NYSE has gone more electronic—85 percent of trading now is automated—and it has consolidated the floor from five rooms down to two in a relatively short time. “The floor is a microcosm of the big picture,” says BNY ConvergEx’s Cangemi. “Now the centralized auction market is just in place to complement an infrastructure that is highly scalable, global in reach and intellectually sound. So it has a very astute business plan built for the exchange functionality of the future.”

As a result of the transatlantic merger between NYSE Group and Euronext, U.S. cash equity trading now represents 10 percent of NYSE Euronext’s revenues, while 21 percent is derived from derivatives trading and 16 percent from European cash trading. “John Thain has saved the NYSE from shutting its doors,” says Aite Group’s Bailey. “When they look at the revenues and the money they’re making, it’s coming out of derivatives.”

Maintaining Market Share

While exchanges are scrambling to go global, they also are fighting to keep their market share in their core U.S. equity trading business. “What’s troubling overall for exchanges is how much market share they are losing to the other venues that are innovative technology venues,” says Bailey. While there’s been an overall pie growing in terms of volume, “We’ve seen relatively strong growth in the alternatives—the dark pools—competing with the exchanges.”

To compete with the dark pools, “There’ve been some strategic moves on the part of NYSE and Nasdaq—they saw what they needed to do to survive,” Bailey says. For example, NYSE Euronext was due to launch NYSE Matchpoint, a point-in-time crossing network for portfolio-based trading.

However, many sources note that Nasdaq also has been stealing volume from the NYSE, which now has just a 60 percent market share in its own listed stocks while the other exchanges control 20 percent and the dark pools have 15 percent. To recapture some of the order flow that it’s losing to Nasdaq and ECNs such as DirectEdge and BATS ECNs that pay aggressive rebates to traders, effective Oct. 1, the NYSE changed its pricing model for both NYSE Arca and NYSE Hybrid.

But “Economics is only one piece of the equation,” contends AES’ Galiametdinov. “You also need to have good technology and liquidity. What’s important to traders is liquidity, speed and performance in terms of stability. The venue has to be stable.”

Nicholas Applegate’s Chapman agrees. “The exchanges that are going to win are the ones that have technology behind them, that are going to be the fastest, most stable and provide access to equities, derivatives or fixed income.”

Given that technology is one of the success factors, many observers say the winning exchanges will be those that simplify their trading platforms and provide access into all their products.

“Think about the proliferation of alternative venues globally. Not only do firms trade globally and in other asset classes, but they also spend on connectivity to an expanding number of venues,” notes AES’ Galiametdinov. “An exchange that provides a single point of entry would be a great help, and that would be a success factor.”

As for which exchanges will be the winners in 2008, sources tend to agree that the two main rivals, NYSE Euronext and Nasdaq are on the short list. “They have the pieces to the puzzle,” says BNY ConvergEx’s Cangemi, referring to NYSE Euronext. “The sooner they get the pieces together and the faster they can make those pieces harmonize, the more out front they will be.”

Similarly, Nasdaq’s partnership with OMX puts it on the same track as the NYSE, suggests Cangemi. “Though OMX does not have the breadth of trading of Euronext, the infrastructure that it has to support these markets gives Nasdaq the opportunity to branch out and compete on a global level. It’s not about an overnight issue. It’s about how fast they can transition,” he continues. “To say that the NYSE is not a clear cut front runner is short sighted, but to say there is not significant competition out there is also short sighted.”

On the other hand, with the closure of the Boston Equity Exchange (BeX), and the sale of the BSE’s assets to Nasdaq, there is speculation that regional stock exchanges aren’t going to survive. “Regional stock exchanges are in serious trouble. Boston is an example,” says Aite’s Bailey. “That whole play up to Reg NMS and the volume they are going to get is not proving to be anything.”

In the end, analysts, traders and brokerage executives are predicting more consolidation ahead for exchanges. “I don’t know if there will be three or five survivors,” says BNY ConvergEx’s Cangemi. “The way it looks, five may be surviving and three may be critical.”