The for-profit exchange model has so far delivered pretty good results. The performance of the FTSE/MV exchanges index of listed exchanges and exchange complexes shows them outperforming the global equity markets by a considerable margin since the creation of the index.
Volumes continue to grow year on year - especially at derivatives exchanges - and most analysts and institutions seem to be big fans of the exchange model. When times are good, they do well and when times are bad, they continue to do well.
Seems like the perfect business, so there must be something wrong with this picture. The storm cloud that threatens these blue skies is called 'competition'. An exchange's growth path is by no means assured in a competitive environment where too much success will invite serious competition. Natural growth within a particular space is fine for a true utility that holds a monopoly, but insufficient for a competitive business. The larger question is whether growth for an exchange is to come through expanding its existing space, or by moving into other similar markets - or both? In this article, we will consider a third alternative - exploring new avenues for growth outside the traditional exchange domain.
Even with strong internally generated growth, the temptation to diversify sources of revenue is always there. Any announcement that an exchange or an exchange-like entity is in play creates a commotion, with speculation that another exchange will annex it. When it was announced a little while back that Instinet - an ECN that trades equities - might be for sale, there was immediate speculation that the CME - a derivatives exchange whose sole relationship to the equities market is the stock index contracts that it trades - could be a buyer. It did not seem to matter at all that there was no obvious strategic logic to such a deal. The prevailing thought seemed to be: both entities trade things, so why shouldn't they merge? The CME announced (wisely, in this writer's opinion) that they had no intention of acquiring Instinet and that was the last we heard of it.
No doubt consolidation will continue. Exchanges will merge, some exchange will finally end up buying the LSE (if they have not already done so before you finish the last paragraph) and another derivatives exchange will buy a stock exchange and vice-versa. Each exchange needs to face the question: is it a utility, alternating between enjoying and enduring the business cycle; or is it an organically growing service organisation, constantly seeking new and interesting ways of serving its customer base? There is no right answer, and it is ultimately for shareholders to decide. However, for those that choose the latter path, there lies the danger that, one day, a for-profit exchange, in its desperation to diversify, will make a strategic blunder and blow its mountain of cash on something it shouldn't. In all business, mergers tend to destroy more value than they create (recent work by McKinsey & Co. shows that 65 to 70% of merger deals fail to enhance shareholder value).
One would like to think there are other choices available to the would-be entrepreneurial exchange. Do the seeds of growth and diversification exist within the current organism of an exchange? This writer thinks they do, and the key to germinating those seeds is to re-think what the exchange?s real customer base is.
A typical exchange today directly serves three sets of customers:
- issuers (for some stock exchanges, though not all);
- exchange participants; and
- data vendors.
Exchanges have made efforts to broaden their market through the sales of things like publications, software and key rings, but have not done anything that seriously opens up important new channels of business. Yet the potential now exists to broaden that customer base in a way that brings new forms of trading activity to the exchange. The opportunity exists because of the quality of access that exchanges could offer, if they choose, to investors and market professionals alike.
To understand the nature of this opportunity, it is helpful to look at what has been happening in Europe. There is a striking difference between developments in Europe and North America in the way that the trading public can interact with suppliers of liquidity. Banks in Europe offer trading platforms that allow investors to trade all kinds of financial instruments on-line through a common portal. It all began with foreign exchange in the late nineties, when currency dealers started to offer on-line access through the Internet. To the surprise of many who thought that the public would be averse to risking their money with an on-line stranger, the business took off quickly. Major banks eventually stepped in and began offering their own dealing services which have now grown to encompass all kinds of instruments: bonds, CFDs on equities and stock indexes, mutual funds etc. but none of these trades go anywhere near an exchange. Even orders for common stock are frequently internalised under this kind of operation, the bank acting as market maker.
All of this is done in a seamless manner - the large banks with market making capacity are providing prices and even offer APIs that an intermediary bank can route orders to. These are not exchanges: customer orders are being matched against proprietary quotes but the experience feels no different from trading on an exchange; in fact in some ways it feels better because of the instantaneous nature of the fills.
At the same time, online exchanges like Tradesports and City Index are not just handling sports betting - they offer contracts on a whole range of financial instruments. And in the US, HedgeStreet.com is pioneering the trading of new types of derivatives contracts based on underlyings that are not available at all in the regular exchange. However, because of much tougher controls in the US, HedgeStreet is regulated by the CFTC and has to deal with all the regulatory constraints that that implies.
How should an exchange respond to this? Jump into this space and open a CFD segment or a financial micro-bets subsidiary? The prudent answer would be 'no'. The skills required to build that kind of business, which involves marketing direct to individual investors, is not something that is native to the exchange environment. It is not an area where they have a particular competitive edge. Instead, there are two areas where exchanges do have a unique, competitive edge that can be exploited to develop a new model: these are counter-party risk management and extensive connectivity.
An investor, through his broker, is given access to an entire universe of potential counterparties and liquidity providers. When an investor executes a trade, he or she gives little or no thought to the risk of the counterparty; they neither know nor care who is on the other side. These two statements have been true for a long time. What is different today is the level of connectivity that exists, specifically the ability for all investors and liquidity providers in a marketplace to trade in the same liquidity pool with immediate access to each other's prices.
At the moment, that model is being used to trade securities or, in derivatives markets, contracts that are pre-defined by the exchange. But does the exchange need to be the sole architect of what is traded? Certainly not. The proliferation of warrants issued by banks on third-party assets is a prime example of how the market can determine what is traded while the exchange hosts trading and monitors risk management. But this model can be extended much further to incorporate assets and paper that is normally marketed through the banks' own network. The exchange complex can be a distribution point that puts those banks in touch with the whole community of investors, not just those who happen to have an account with the bank. Conversely, investors would have the chance to select products from a whole range of liquidity providers - not just the bank that they have an account with.
What types of new exchange products might trade under this model? Almost any structured product or packaged investment vehicle could be distributed in this way. Banks have a wide range of investment products such as equity linked deposits that are sold to retail investors. Very often, these types of products are not really tradable. Once an investor has opened the deposit, it has to be kept to maturity and there is no way of realising its value prior to maturity. An exchange environment could provide the kind of liquidity that would facilitate trading of these products.
In time, more imaginative products could be made available through the network. Investors could even define dynamically what they are looking for and use the exchange infrastructure to find a counter-party that can supply it (or buy it, in the case of, say, a hedge fund that has a structure that it wants to offer to the market). Baskets of shares, commodity price-linked deposits, synthetic convertible bonds - there is literally no limit to the number of structures that could be created and distributed through an exchange infrastructure. Provided the product consists of fungible, well-defined components that are regulator-approved and subject to an appropriate risk management regime, such a service model can exist.
Clearly, there would need to be major changes to the current exchange trading model to allow such a service to be created, but incremental steps could be taken. For example, simple templates could be created that allowed users to insert the parameters of the profile they want to obtain for, say, a warrant on a stock. 'Market makers' (whether they are banks or other financial institutions) could then respond to that template to create the desired instrument. Over time, the template could be made more and more accommodating of different structures.
Would the banks sign up? Given that the effect of this model would be to widen their distribution (since it would be accessible by the whole investor base, rather than just the bank's customers), it is the author's belief is that they would.
Would the brokers support it? Anything which improves the chances of enhancing commission income and order flow would be attractive to brokers, especially in today's markets. There is no conflict in brokers supporting this kind of model; it simply gives their customers new reasons to use the broker's services.
It is interesting to note that this model is a case of re-intermediation, rather than disintermediation. This is not a bad thing: the disintermediation model was always going to be bad news for the exchanges. If intermediaries are cut out of the picture altogether they will take their revenge. Under re-intermediation as described here, every party has an important role to play. The bank (or other appropriate financial firm) provides liquidity. The broker masks the counterparty risk of the investor. The exchange (or central clearing) masks risk for everybody and - most crucially - provides the safe and common platform where all these products can be accessed, and compared, from one place.
To do this, exchanges have to radically re-think the types of trading platform they operate. There needs to be vastly more flexibility in how prices are accessed and distributed to end-users. In this universe, the numbers of symbols tradable would be in the thousands or hundreds of thousands, and even the concept of 'symbol' would change dramatically. A customisable contract can be defined on the spot. The currency markets have already done this: many platforms allow the buyer to define a currency option for any expiry day and any strike. The notion that this must be a 'contract' that is 'issued' by the exchange is redundant. It is an OTC contract whose terms are created on the fly by the liquidity provider in response to investor demand. But there is no reason why an exchange could not be the host for this service; in fact it is ideally placed to do just that.
When the exchange is viewed as a network that encompasses the whole community, many more things become possible. The exchange becomes the entry point for a whole host of trading and market information services for the investor. The investor becomes an exchange customer in a way that does not threaten the interests of financial intermediaries.
The derivatives exchanges are best-positioned to exploit this, given their generally more sophisticated risk management capabilities. They have the ability to vet liquidity providers and the creators of new contracts to make them 'safe' for investors to use and investors, trading through regulated intermediaries ('brokers'), pose no threat to the liquidity providers. It makes sense that the exchange should play this shop window role: the single location where a wide range of financial products that are traditionally sold directly by banks and other liquidity providers to their customers are instead made available to all potential investors, whether they are bank customers or not, by means of the broker intermediated service supplied by an exchange. The exchange becomes the place where the suppliers of liquidity meet the users of it and allows them to define what they want to trade.
In fact, the model described here already exists. eBay is a brand and a platform that hosts a network for buyers and sellers to come together. With few exceptions, it does not dictate what gets traded, it leaves that to the suppliers and the customers. At the time of writing, eBay's share price just dropped precipitously and its market capitalisation now stands at a mere USD52bn, about double the aggregate value of all the world?s listed exchanges. This may not be proof that exchanges should do the same thing, but it is evidence that the model delivers great results once a sufficient number of people have bought into it.
If and when the current growth trend ends, exchanges need to be ready with a service offering that attracts new kinds of business. Acquisition of other exchanges with the same growth problem is not going to be a solution. Long term planners at today's exchanges need to start thinking about alternatives by understanding what their true customer base is and how they can exploit the unique advantages the exchange network offers. The investment portal described here is one of those alternatives.
Mark Beddis is a Director of Alberta Market Solutions, Ltd., business and technology consultants to the capital markets. He can be contacted at mark.beddis@albertasolutions.com.
