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Introduction by the Editor - 2002 Edition

Date 25/06/2002

The pace of change in the world of exchanges seems to be hotting up. There are many who argue that a wave of mergers and rationalisations is imminent, leading to far fewer exchanges. Many more are confident that electronic trading will soon dominate, and that the end of the floor is nigh.

And yet, the changes so long predicted are still, in the main, little more than that -- predictions. This edition of the Handbook lists 258 exchanges and ECNs, actually eight more than last year. And the most dominant physical trading floors, such as the New York Stock Exchange for equities and the Chicago exchanges for derivatives and commodities, continue to transact a large proportion of the world's trade.

But despite these signs of continuity, our feeling is that those who foresee change are -- and must be -- correct. The situation in the exchange industry today is similar to that with the Eastern bloc shortly before the collapse of the Berlin Wall. It is clear to many observers that change is inevitable. What is not clear is when or how that change will come; but once it starts, it is likely to happen very fast, with some consequences that are predictable and others that may be completely unexpected.

This is not to compare highly efficient floor-based exchanges with ossified communist regimes. But it is to warn against the danger, that the best exchanges are alert to, of complacency -- of feeling that "change won't affect us because we are too big, with our floor providing all the liquidity in vital sectors". Liquidity is indeed the virility symbol of an exchange; but liquidity, like virility, can be here today -- gone tomorrow. Ask, if you dare, the management at Liffe, who saw their dominant trade in German Bund futures disappear to Deutsche Terminbörse (now Eurex) almost overnight.

Liffe's response to this dramatic setback makes an interesting case study. It had to decide whether to cling to its old ways of doing things or to change -- and it chose change. Within a relatively short time it had closed down its pits, switched over exclusively to electronic trading, and thrived. Certainly, Liffe has now become the latest addition to the Euronext stable, but very much on its own terms.

Another stimulus for change is coming from the new ECNs and other alternative trading systems. This is taking the form of increased competition, but also through direct collaboration between the old and new ways of doing things. During the last year, the International Petroleum Exchange in London became a subsidiary of the IntercontinentalExchange (ICE), an Internet-based commodities market, making the ICE the first electronic exchange to take over an established floor-based market. In equities trading, the fully electronic Archipelago Exchange is breathing new life into the Pacific Exchange -- though again, at the cost of PCX's trading floors. As Leo Melamed says in his article in this edition of the Handbook (Derivatives exchanges in a changed world order): "It has been clear for a very long time that screen-based trading will overtake the traditional pit-trading environment. It is axiomatic."

But the ECNs aren't the only challengers to the traditional exchanges. As Paul Arlman suggests (Europe's Exchanges), internalisation of order flow at the big securities houses is accounting for an increasing proportion of trading. Internalisation still requires a market to provide reference prices -- but if JPMorgan or Goldman Sachs, say, felt that ownership of an exchange would be a good fit with their internalisation business, then that ownership is likely to happen.

Challenges may also come from outside the industry. Even Dick Grasso, Chairman and CEO of the New York Stock Exchange, has recognised that there is no real difference at the operational level between the business of NYSE and that of eBay, the internet auction house. Could eBay start to trade shares? If it can satisfy the regulators, why not?

It's too soon to say whether one (or more) of the new electronic upstarts will be able to grow a business to compete with the traditional exchanges. Or whether bringing outsiders into an old-established family will strengthen the gene pool and produce vigorous new offspring -- albeit, perhaps, ones who don't always know their place. But it's not too soon for all in the industry to be going back to the fundamental question: what is an exchange?

At base, an exchange needs to offer four things. A place (real or virtual) where buyers and sellers can meet. The ability to capture pre- and post-trade information -- and facilitate the widest possible dissemination of this information to all investors, efficiently and without discrimination. Rules that are enforced, not so much as to stifle trade, but sufficient to provide reasonable protection for the naïve against the unscrupulous. And finally, protection against counterparty risk.

With these in place, the challenge for an exchange is then to minimise execution cost and maximise liquidity. Benn Steil (Why do exchanges demutualise?) offers some remarkable figures about costs. He estimates total trading costs to be 28-33% higher through NYSE and Nasdaq traditional broker members than through ECNs, and suggests that European trading fees would fall as much as 70% if European exchanges were to move to an ECN model, eliminating membership and allowing direct investor access.

The requirements and challenges facing exchanges are the same today as they have been for the last hundred years -- only the technology has changed. And it's the technology that's crucial. As we in the UK know only too well, colourful pageantry doesn't help to make the trains run on time. Floor trading may be picturesque, but there's no point in continuing with it if it can be reproduced more efficiently on a computer. Just about every other business has learned that survival, never mind success, depends on finding better ways to meet customers' fundamental needs, not simply tweaking the existing product. Why should exchanges be different?

So change -- perhaps even a revolution -- will come. For example, 2002 should see the introduction of the SuperMontage trading system, Nasdaq's response to the rise of the ECNs. Will this see off the threat of the newcomers? And what will it mean for the future of Nasdaq's Amex subsidiary? The game of musical exchanges looks set to gather pace, with fewer contestants remaining as the chairs get taken away.

For those that remain, the difference between an exchange, an ECN and indeed an internet auction house will become increasingly difficult to detect. Once the trading floors have disappeared -- or, like the Chicago Stock Exchange Trading Room in the Art Institute of Chicago, become part of a museum -- interested observers may start to feel like those survivors of another revolution, the animals of Animal Farm:

"The creatures outside looked from pig to man, and from man to pig, and from pig to man again; but already it was impossible to say which was which."

George Orwell, Animal Farm

Many of the articles in this edition of the Handbook refer to the effect of the terrible events of September 11, 2001. We would like to offer our sympathy to all those whose family, friends and colleagues were killed and injured in the tragedy.

Herbie Skeete
Editor
The COMPAQ Handbook of World Stock, Derivative and Commodity Exchanges