The recent evolution of the world’s exchanges is a story of dynamic transformation.
Until the 1980s exchanges would, in their essentials, have been recognisable to a merchant who was trading in the fourteenth century when they first came into being. But the advent of computers made the trading floor redundant, eliminating the need for proximity and the constraints on scale and duration of trading that proximity imposed. (Ironic, then, that concerns about trading delays caused by latency are now leading to demands for firms’ order-generating computers to be placed with greater proximity to exchanges’ trading systems. See Tee Williams’ article Oh dear! I’m queued! It’s latency! in this edition of the Handbook for a discussion of this issue.)
At the same time, a fundamental change has been taking place in the legal structure of exchanges. Until recently, almost every exchange was essentially a club, owned by and run for the benefit of its members. But in recent years many exchanges have corporatised, demutualised and sought a public listing. These corporatised exchanges behave like any other public company. In other words they are driven by the need to satisfy the demands, often short-term, of their new owners, the investors.
The other transforming force influencing exchanges has been competition. During most of the 20th century, many stock exchanges had a monopoly of trading in their city and region, if not their entire country. But during the 1990s, especially in the US, significant new players emerged in the form of alternative trading systems (ATSs) or electronic communications networks (ECNs). These new players attracted substantial trading volume away from the established exchanges, which responded by developing similar order-driven systems or by taking over some of the most successful of these new entities.
We are now seeing new players entering the market in Europe, driven by the European Union's Markets in Financial Instruments Directive. MiFID, which became effective in November 2007, harmonises rules across member states while requiring investment firms to seek best execution in most asset classes (see Robert Barnes’ review of some of the changes MiFID is bringing about). These new rules have given rise to new trading venues such as Turquoise – owned, significantly, by some of the major customers of the incumbent exchanges.
Nor is change restricted to the cockpits of Europe and North America. In Australia, for example, we find Liquidnet and AXE seeking licences to compete with the Australian Securities Exchange. The established exchanges argue, as one might expect, that a single exchange has benefits in terms of a greater pool of liquidity and that a fragmented market will hurt small investors. But while ultimately it will be the decisions of the big investors that are crucial, it seems that the competition being engendered can only be in the interest of their small customers.
Competition has forced exchanges to invest substantial capital in new technologies as they have mostly moved from a floorbased trading environment. Substantial investment in the latest electronic trading systems continues unabated. NYSE Euronext recently acquired Wombat, a deal which is important for next generation trading systems as the speed of quote and trade traffic is measured in sub-milliseconds.
Exchanges are also embracing off-exchange trading (sometimes known as dark liquidity pools). NYSE Euronext has announced plans to link to two different dark pools, BIDS Trading in the USA and SmartPool in Europe. Elsewhere in Europe SWX Group, operator of the Swiss stock exchange, has announced that its SWX Europe subsidiary has teamed up with Nyfix Millennium, operator of US dark liquidity pools, to run a venture in Europe for Swiss blue-chip stocks.
A further area for growth has been the range of instruments and product types that can be bought and sold. The 1997 Kyoto Protocol led to the emergence of a new breed of exchanges which provide a platform for trading excess emission credits (limits fixed for emission of CO2). This market is poised for huge growth once global benchmarks have been set for transparency and risk assessments. Whilst still a relatively young area, there are already about 15 markets trading or about to trade in carbon, both at existing exchanges and new entrants. (Eric Bettelheim and Gregory Janetos have provided a comprehensive review of these exchanges for this edition of the Handbook.)
Finally, competition is encouraging exchanges to move out of their traditional areas and to develop or acquire new products and services. NYSE Euronext has launched a new Web-based pricing service to help buy-side firms place market valuations on their complex structured products and illiquid securities. CME Group is one of many exchanges that is interested in the large over-the-counter market and has recently acquired Londonbased Credit Market Analysis, a provider of credit derivatives market data. These are services that five years ago one would never have associated with an exchange.
Another result of the transformation of exchanges from member-owned to investor-owned organisations has been the wave of consolidations and mergers sweeping across the sector in recent years. In summary, all significant exchanges are now ‘normal’ companies and, as with any other company, the ones that do best are those that combine relentless innovation with great marketing and great management.
So how are they doing? How have those sleepy, conservative organisations fared when transformed into companies without the safety net of member ownership, and exposed to the fierce winds of the modern economy?
One of the best measures is provided by the FTSE/Mondo Visione Exchanges Index. The Index, a joint venture between FTSE Group and Mondo Visione established in 2001, was the first in the world to focus on listed exchanges and other trading venues. The FTSE/Mondo Visione Exchanges Index enables investors to track 19 publicly listed exchanges and trading floors and provides a reliable barometer of the performance of the exchange sector.
And this barometer shows that the performance of the sector has been very sunny indeed.
Since its inception in August 2001, the FTSE/Mondo Visione Exchanges Index has increased by almost 740%, while the FTSE All-World Index increased by only 69% – although the recent sub-prime crisis has (at least, up to the end of February 2008) hit the Exchanges Index harder than its more general cousin.
Neverthless, this remarkable growth has been a tribute to the effectiveness of the new managements of these exchanges, as well as to the foresight of those who recognised the value locked into those members’ clubs. It remains to be seen how this sector, like others, will cope with the current chilly economic climate – but the transformation has been successfully accomplished.
