This edition of the Handbook, like previous editions, reflects the rapid changes taking place in the global exchanges sector - in particular the increasing numbers of exchanges which have taken the decision to change from mutual, member-owned organisations to demutualised, shareholder-owned companies, with their shares listed and freely traded.
Unlike so many trends in the financial markets, this one didn't start in the US. Instead, it was exchanges in Europe and the Pacific rim who took the lead. But at the end of 2002, the US finally caught up. The Chicago Mercantile Exchange became the first publicly traded US financial exchange in December, when the shares of its parent company were listed on the New York Stock Exchange.
So with this seal of approval for the concept from the world's largest economy, it's an appropriate time to be asking: what's the investment case for exchanges? Why should an investor put her hard-earned cash into Euronext or the TSX Group, rather than a more conventional investment - and what are the risks if she does?
With such a new sector there's not much historical evidence to go on - but what there is, is encouraging. The FTSE/MV Exchanges Index (the joint venture between FTSE and Mondo Visione, publisher of the Handbook, which tracks the share performance of listed exchanges) was launched in August 2001. At the end of April 2003 it was up 5.5% since launch - at a time when the FTSE All-World Index was down by 20.9%. The FTSE/MV has been ahead of the All-World since November 2001. And there are encouraging signs that exchanges will rise faster in a rising market: between March 13 and April 30 this year, the All-World Index rose 10.8%, while the FTSE/MV rose 21.7%.
So the sector as a whole seems healthy. But the prudent investor of course wants to understand what is driving this growth, where the potential threats may lie, and which of the individual stocks making up the sector are likely to be winners and which losers.
It is in order to answer these questions that Mondo Visione is launching World Exchanges, a quarterly review of the outlook for the global exchanges industry and an investment analysis of its leading representatives. (The management summary from the first edition (June 2003) is available for download here. See also the article Outlook for European exchanges and equity trading by Huw van Steenis and his colleagues.)
The review identifies the following as some of the key drivers for the industry:
Liquidity. The importance for traders of having access to a large pool of liquidity, increasing the likelihood of discovering the true market price and reducing the bid/ask spread, is likely to result in continuing consolidation and linking of systems, rather than fragmentation of trading across multiple venues.
Technology. The rapid advances in communications technology will continue to have a major effect on exchanges. The continuing move to electronic trading is likely to boost volumes and reduce costs, whilst increasing the threat to exchanges from ECNs and other alternative trading systems. At the same time those exchanges with advanced systems can exploit them as a lucrative additional source of revenue.
Regulation. Exchanges must comply with the usually expensive and sometimes unpredictable requirements of their regulators. These problems are likely to increase as exchanges pursue cross-border transactions, sometimes seen as the best route to growth for an exchange that is dominant in its domestic market. For European exchanges, the final form of the new EU Investment Services Directive will be especially important.
Internalisation. The matching of orders in their own books by large broker-dealers is seen by some as one of the biggest threats to exchanges - contributors Ruben Lee (The evidence on fragmentation, internalisation and market transparency) and Tony Kirby (Internalisation and Best Execution: How might exchanges respond?) explore this issue further in their articles for the Handbook. Internalisation still requires an exchange for price discovery, and may attract the attention of the regulators, but it has the potential to remove considerable volume from exchanges.
Globalisation. Cross-border listings are becoming increasingly common and an increasingly important source of revenue for those exchanges able to attract them. Exchanges are also keen to foster the cross-border trading made possible by technical advances - though as mentioned already, this is not without regulatory cost.
These and many other factors will be monitored by World Exchanges over the coming months and years. But what are they likely to mean in practice for individual exchanges and the sector as a whole? Both Peter Bennett (Who needs stock exchanges?) and Tee Williams (Do we need exchanges?) present some typical trenchant and challenging views later in this Handbook. Here are some of mine.
The exchanges best able to withstand the threats from internalisation, ECNs and the like will be the derivatives exchanges such as CME and Euronext.liffe. The ability they offer to hedge risk will continue to grow in importance (notwithstanding the concerns expressed by Warren Buffet about "derivatives as financial weapons of mass destruction"). And their complex, innovative products will be much harder for upstart ECNs to reproduce than simple cash trades.
The New York Stock Exchange will bow to the technological inevitabilities and, sooner rather than later, become fully electronic and close its trading floor. Then it will merge with the London Stock Exchange (if it is still available), finally making an honest woman of the exchange that has been linked with so many other suitors in recent years. It may be a shotgun marriage - but it is potentially one made in heaven.
The shotgun may be wielded (whether they realise it or not) by the UK government and electorate, as a result of their continuing apparent reluctance to embrace the euro. Outside the eurozone, the LSE's ability to compete for European business with Deutsche Börse and Euronext may be hampered. However, it will continue to punch above its weight by accidents of history and geography, and by the importance in capturing a pool of talent of being in a place that people find exciting and stimulating to live in (compared with, say, and at the risk of seeming unbearably chauvinistic, Frankfurt).
For the smaller exchanges, though, life is going to get more difficult. The exchanges that have consistently underperformed the FTSE/MV index are the Athens Stock Exchange and (after the high water mark of its bid for the LSE) OM, the parent of Stockholmsbörsen. Their managements may resist consolidation, but - and this is the inevitable logic of demutualisation - shareholders may have other ideas.
Above all, demutualised exchanges are going to have to come to terms with the idea that they are a business like any other. If they are not to be subsidised, they must be efficient. In the short term they may be continue to be subsidised and protected by inefficiencies in the market place, but the combined effects of globalisation and technical advance will, sooner or later, sweep those away.