One of the many interesting aspects of putting together each year’s edition of the Handbook is observing the arrivals and departures. The new entities that have been launched with vigour and enthusiasm to increase competition (and, incidentally, to make a little money). And the markets that have disappeared, because competition has made them unviable, or because their success has made them a target for a merger or takeover.
This year, for the first time for many years, the London Stock Exchange is NOT in immediate danger of ceasing to be an independent entity (at least, as I write). But elsewhere competitive pressures continue to encourage exchanges to come together. Major mergers have been completed in Australia and across the Atlantic. As we go to press Eurex has announced the purchase of International Securities Exchange. And the Chicago Board of Trade must shortly make a choice between the Chicago Mercantile Exchange and IntercontinentalExchange, which has already swallowed the New York Board of Trade and the International Petroleum Exchange. Looking ahead, further rationalisation of the Japanese exchanges seems probable.
These merged organisations hope that their large size will fortify their competitive position. But there is no shortage of optimistic newcomers willing to take them on. BATS Trading and the Boston Equities Exchange hope to emulate the success of Archipelago. The CBOE Stock Exchange and ISE Stock Exchange are attempts by existing exchanges to extend their services into other areas. Plus in the UK and AXE in Australia are set to offer an alternative to their dominant national equities markets.
When placed alongside NYSE Euronext’s average daily trading value of around USD100bn, these new entrants make Don Quixote’s competitive designs on the windmills look carefully thought out and well worth a modest investment. But what is giving the existing exchanges pause is that many of these new entities are being launched in conjunction with their own major customers, such as the investment banks, broker-dealers and hedge funds. In the case of Project Turquoise in Europe, the banks are taking the initiative themselves. With such powerful backing, the problems that most new markets face in attracting sufficient liquidity are significantly reduced.
So the competitive pressures in the industry are only likely to intensify in the coming years, and it is interesting to speculate about the changes that these pressures will bring about. In particular, they refocus attention on the perennial question: what is an exchange for?
One area that may be affected is the behaviour of participants. Competition between participants is at the core of what an exchange does, but there is a common understanding that this competition needs to be kept within bounds. Citigroup caused widespread anger in 2004 when its traders carried out a ‘Dr Evil’ strategy on MTS, the main trading platform for euro-denominated government bonds. The dealers sold EUR12.9bn of bonds in one minute, then repurchased around a third of them after prices had dropped, netting a profit of millions of dollars.
Many other market participants (especially those who had lost money) felt that, whilst what Citigroup had done was not illegal or even technically wrong, it was not in the spirit of the market. Eventually, the UK’s Financial Services Authority imposed its second-ever largest fine of GBP14m on Citigroup for failing to conduct its business with ‘due skill, care and diligence’, though
Citigroup was not charged with the more damaging ‘market manipulation’.
Exchanges under competitive pressure face a dilemma when confronted with behavour of this sort. On the one hand, speculative deals like these bring much-needed liquidity (and transaction fees). On the other, if participants feel that they are in too much danger of losing money they will stay away. Is it part of the role of an ‘exchange’ to curb the behaviour of its more exuberant (aka successful) participants? Or (as in the case of MTS) should it leave this unpleasant business to the regulators?
MTS features in another of the issues being raised by increased competition: who has the right to trade? Originally, trading rights on exchanges were limited to their members. As exchanges demutualised and trading became electronic, the reasons for rationing access disappeared. Nevertheless, most trading platforms have rules about who can and cannot use them, effectively limiting the right to trade.
Currently, access to the eurozone government bond trading that takes place on MTS is limited to the banks who act as primary dealers. Investors, such as hedge funds, who want to access the bond market have to operate through the dealers. In 2006 a number of hedge funds asked MTS for permission to connect directly to its trading platform so that they could use their algorithmic trading systems to carry out deals, as they have with other inter-dealer platforms such as eSpeed and BrokerTec.
Once again, this presents a dilemma. Evidence suggests that direct access by investors pushes up volumes. But existing traders will then be facing competition from their erstwhile customers – and very well organised competition, at least from some of the hedge funds. These traders may demand concessions or even threaten to take their business elsewhere.
Faced with this problem, it would seem essential that exchanges stay strong and are not tempted to fall back into the club-for-members mentality of the mutual era. Access should be available to anyone who can demonstrate adequate resources, experience and standards – and if the liquidity and transaction fees are right, the participants will follow.
One other area of competition, particularly relevant to equity exchanges, relates to the degree of responsibility that an exchange has for the companies that are listed on it. In comments at the beginning of 2007 John Thain, chief executive of the New York Stock Exchange, was critical of the London market, and in particular the AIM market for growth companies, for lacking stringent corporate governance requirements for its listed companies. Other US comment has been critical of the FSA’s efforts to combat insider trading.
Whilst it might be tempting to dismiss these views as sour grapes, prompted by the US’s falling share of international listings, they do focus attention on the danger that competition could drive down standards. Indeed, in the US itself, plans are being considered to relax the requirements of the Sarbanes-Oxley Act: a sensible adjustment of over-stringent regulation, or an admission of defeat in the face of competitive pressures?
Whatever the answer, there must surely be agreement that one of the most important things an exchange is for is to protect the interests of all its participants – and in particular, the investors who provide the money raised by the listed companies and the orders carried out by the traders.
