In the bull run that the stock markets have experienced over the last three years, one of the most striking examples of success has been provided by the very locations where this growth has taken place.
The FTSE All-World Index nearly doubled in value between the first quarters of 2003 and 2006 - but the FTSE/Mondo Visione Index, which plots the share performance of listed exchanges and trading venues, grew four times as fast over the same period.
This was good news for those with the prescience to see the potential of this new sector, and the resolve to back their judgement with cash.
But the interesting question is, what does this growth represent? Is it a rational response by the markets to continual and sustainable improvements in profitability? Or has the growth now reached the point where it is a bubble that, sooner or later, must burst?
One of the major factors that has contributed to the growth of the FTSE/MV index has been the increase in merger and acquisition activity. Perhaps the most notable example has been the long-running and - at the time of writing - still unresolved battle for the London Stock Exchange, which saw its share price double over the first four months of 2006. But speculation has continued about a tie-up between Euronext and Deutsche Börse. Nasdaq has shown its aggressive intentions with its stake in the LSE. And the newly privatised NYSE Group is a large and unpredictable new beast in this particular jungle which, even as we write, has made its own move towards Euronext.
However, is this activity sufficient to justify the scale of increases in share prices that we have been seeing? One rationalisation for a predator company valuing its prey more highly than the markets - at least, until the markets catch the whiff of a potential purchase - is that the acquisition or merger will lead to cost savings and increased profitability. But is there really scope for such dramatic savings in organisations which, after five or so years of being run as private companies with an eye firmly on the bottom line, are now pretty lean and fit? There must be even more doubt about the possibility for savings in a merged organisation which is operating cross-border - let alone cross-ocean.
The other justification for the rapidly increasing share prices is that the exchanges sector has untapped potential for earnings growth. There's a lot to be said for this point of view. The flotation/IPO model for raising capital is now accepted almost universally, as indicated by the numbers of Russian companies listing in London and other Western markets, and Chinese companies listing in Hong Kong (see for example Hong Kong: A prime centre for Chinese companies in the primary IPO and secondary markets by Martin Wheatley, Chairman of the Hong Kong Securities and Futures Commissionk).
Equally, the secondary markets are firmly established in Europe and the US as one of the principal routes by which savers - especially those saving for their retirement - seek to achieve growth. With increasing affluence in the rest of the world, and increasing confidence in the stability and propriety of the markets, we can expect to see rising participation of 'saving' investors in countries where investment is at present mainly speculative.
So the demand is there. Once the investment in electronic trading systems has been made, substantial extra volume can be accommodated at little extra cost. And in most countries outside the US, there is just a single exchange with a monopoly position. Sure, there's much talk about possibility of cross-border competition. But in practice, most trade still seems to be done through the local exchange.
The situation is rosy. Or is it?
Those clouds on the horizon have two sources. One is technology, leading to the plummeting cost and increasing availability of sophisticated trading systems, outside the control of the traditional exchanges. The other is regulatory change - MiFID in Europe and Regulation NMS in the US - that establishes a framework in which the traditional control and reporting functions of the exchanges can be provided in other ways.
The storm that these clouds threaten is one in which the large buy and sell side participants, the exchanges' major customers, establish or utilise alternative mechanisms for carrying out their trades, especially the block trading that forms such a crucial component of overall liquidity. (Benn Steil discusses this further in his article The end of history and the last trading system). The predicted growth in trading would still occur - but it would by-pass the exchanges.
Faced with the loss of such a large part of their business, what would exchanges be left with?
Smaller retail trades? - but the competition for this business from internet-based organisations without the traditional overheads could be intense. How long before we see the launch of eBourse?
Regulation and listing, if the local regulator allows the exchange to continue with these activities? - but these are unexciting and offer little scope for earnings growth.
Settling and clearing? - but these are increasingly seen as utility activities that, in Europe, should be run on a continent-wide basis, like the DTCC in the US.
All of a sudden, the large and continually rising profit growth for exchanges that the increases in share price seem to predict looks a lot less certain.
The probability is that the clouds we envisage are more likely to cast a cold chill rather than produce a cataclysmic downpour. But they do raise questions about the wisdom of exchange managements which choose to use their shareholders' money to invest in other exchanges doing, essentially, the same thing, and subject to the same risks. Should they not be following the example of the Chicago Mercantile Exchange, by concentrating on their own business and seeking out new market areas? (Paul Bowes describes one of CME’s interesting initiatives in his article A new space for foreign exchange).
There’s no doubt that exchanges will remain an interesting and potentially lucrative investment. However, the levels of growth seen over the past few years are surely unsustainable. In the future, as in any other sector of the market, investors will need to pick and choose with care.
