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The situation faced today by exchanges and their service providers has much in common with the situation faced by national Telco's during and following deregulation. In particular:
Environmental changes have brought about the sudden introduction of competition. In the case of the telecommunications companies this was due to regulation. In the case of the central markets this is due to regulatory changes and the pervasive nature of the Internet.
Organisations with contemporary corporate governance models, no national responsibility, and little or no legacy or proprietary platforms enter the market offering innovative services and diversified product portfolios.
Anyone who has followed the progress of ex-national Telco's post-deregulation will understand the dramatic effects that these threats can have. The core business model of an exchange is under threat.
This article is concerned with the future of exchanges' products and services, and in particular the changes that may be motivated in one of the core services, electronic trading, by the new economic environment in which contemporary exchanges find themselves.
Why change?
Trading, electronic or otherwise, is rapidly becoming a commodity. All exchanges are faced with the threat of declining revenues from transaction fees. In addition, increasing competition from Alternative Trading Systems (ATS) is driving liquidity from exchanges. We believe the solutions to these issues are to 'renovate' and 'innovate' existing electronic trading services.
| Table 1 Categories of solution |
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Renovation |
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Objectives |
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To retain the existing customer base. |
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Methods |
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Re-thinking or supplementing existing services thus: |
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Innovation |
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Objectives |
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To gain new customers. |
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To become multi-product and/or multi-market. |
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Methods |
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Many exchanges have recognised that these solutions require a level of commercial nimbleness that a mutualised structure cannot easily achieve and have already or are in the process of demutualising. The aim of demutualisation is to produce a company with a modern corporate governance structure that is capable of the timely and high quality decisions required to compete.
Ultimately, such companies will wish to list, possibly self-listing. Either way, shareholder value will be king. The number of exchanges currently demutualising means that the market for exchange shares will soon be saturated. A saturated market means that there will be heavy competition for investors' (and their advisors') favourable attentions. Any exchange that has not renovated and/or innovated is likely to be branded 'a dinosaur', 'single product', or at best 'single market' (and a significant percentage of the revenue streams from that single market are under threat). This is not a good story for existing or potential investors.
Additionally, 65% of FIBV members believe that "the merger of exchanges will lead to a system of a few very dominant players, thus marginalizing smaller markets."
Any exchange that wishes to fair well during this process will need a strong balance sheet and good future prospects.
The above picture may seem bleak. Let us not forget, however, that exchanges are strong organisations with many existing strengths that can be capitalised on during the change.
What are an exchange's key strengths?
Our opinion on the key strengths of exchanges is given below.
| Table 2 Exchanges' key strengths |
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Brand |
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Exchanges are generally viewed within their home country, region, or globally as trustworthy, reliable organisations, as 'safe pairs of hands'. |
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Network (social) |
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As a national centre (and probably the national centre) for public listed companies, exchanges are very well connected. By definition, they already have a relationship with senior executives in their listed companies. |
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Technology |
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Electronic trading systems are respected pieces of technology. Demand for the real-time, fair markets that they implement is increasing. |
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Network (technology) |
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Many exchanges operate national, regional, or global, high performance, reliable, and secure private networks. This, and their service history (below) are likely to be valuable assets. |
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Service history |
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Contemporary exchanges are, in many respects, pioneers. They have some of the longest service histories for the reliable operation of secure network-centric applications, effectively offering trading services as an Application Service Provider (ASP). These abilities are currently in vogue. |
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Given the reasons for change, the objectives of change, and this list of key strengths, what are the options open to an exchange wishing to compete? |
What are the options?
The direction that any given exchange chooses to take should be a matter for serious debate on strengths and brand development. Presented in Table 3 and Table 4 are a few of the more general options that we are considering and discussing with our clients. These are categorised by whether they are renovating existing electronic trading services, or innovating based on the experience of providing such services.
The goal of the renovation strategy is the retention of existing customers, whether they are trading customers or listed companies. The tactics for the execution of any renovation strategy should be to:
- Capitalise on the strengths of the existing electronic trading system as much as possible. This may involve tightly integrating the solution with the base system, preferably in ways that cannot be achieved by external parties.
- Create barriers to entry. If the renovation is successful it should raise the base level of expectations customers bring to electronic trading services in the market addressed by the exchange. This will increase the level of technology and skills that potential competitors must have in order to compete, thus making it more difficult for competitors to enter the market.
Two of these options, CRM and B2B marketplaces, are now discussed in a little more detail.
Customer Relationship Management (CRM) services
CRM is the process of extracting the maximum value from customers. This involves managing all information that is known about all customers, using this information to make decisions about customers, and managing interactions with customers (including direct marketing).
CRM processes generally involve data-mining on large databases of customer interactions involving complex analysis in order to generate revelations on the behaviour of customers, identify patterns of behaviour, and predict future trends. This is generally a costly process. Not only are the systems themselves expensive, but the level of expertise and manpower required is significant. A sizeable percentage of this effort must be dedicate to 'cleaning' the data, i.e. ensuring that all the data that is input to the CRM tool is accurate, complete, and consistent.
However, compared to most manually entered database systems, the output of an electronic trading system is relatively clean, which means that the level of effort to clean it is relatively low, and an exchange could have such a system running relatively quickly. There are two broad applications for such tools:
- Using the systems internally, by providing management information to exchange executives, such tools could do detailed analysis on trading trends, potentially suggesting renovations to the trading product as they arise.
- Selling CRM services as an ASP by providing management information to trading customers' executives, such as the rating of the organisation compared to their anonymous peers (such as the average deviation of their trades from VWAP), down to the performance of individual traders or the trading patterns of individual clients (assuming the granularity of trading system data allows).
This level of investment required puts such systems beyond the reach of many organisations. The economies of scale of an ASP would put the service within the reach of many more, including many exchange trading customers. The exchange is the ideal centre for such a service, given that it:
- has all the raw data required to affect the analysis;
- has a trusted relationship with all parties;
- probably has secure network connections with all parties; and
- has access to deep expertise in the sector.
The basic CRM architecture is shown in this diagram.
Periodically (say daily or weekly) the system would accept data from the electronic trading system on all orders and trades executed since the last update. This data is placed in a data-staging area, where any cleaning or modifications is applied to the data before it is transferred to the analysis tools. The data is then amalgamated with the existing history of behaviour within the analysis database (known as a 'Datamart') on which the analysis tools can do any work to pre-prepare reports. The tool is then ready for use by users. The tool can therefore make available detailed and complex analysis on a picture of trading activity, whether it is a complete picture for exchange management or a partial picture of their data for exchange trading customers. On the diagram, access is shown to be via a browser style interface delivered via the Internet. This could just as easily be delivered via a private trading network, if required.
Such a service could also be offered to listed companies or in conjunction with others such as B2B marketplaces. In these circumstances, however, the exchange may not necessarily have the deep sector knowledge that makes the proposition above so attractive to them.
B2B markets
The Internet has spawned a range of new business models and routes to market. One of the more discussed is the Business-to-Business (B2B) exchange, predicted by many to be the paradigm that will completely change the way the world does business. Upon analysis, many of the B2B exchanges fail to be exchanges in the financial sense at all, but instead they merely enhance the automation of the ordering and procurement process between suppliers and customers as a cheaper replacement for EDI. Many, however, do offer variations on the auctions that are found in a financial exchange, and in particular in an order- or hybrid quote/order-driven electronic trading system.
B2B exchanges that become successful are as important to the suppliers and customers they serve as an exchange is to the security, commodity, or derivatives market that it serves. Performance, security, and reliability are key. Because of their auction content, network-centricity, and the community/industry-critical nature, financial exchanges with networked electronic trading systems already have a strong brand for the delivery of these services.
Why are there no exchanges offering B2B services?
It is a curious observation that, to the best of our knowledge, no financial exchange to date is offering services to B2B exchanges. There are various possible reasons for this:
- Exchanges are traditionally conservative institutions, whilst B2B exchanges, being Internet based, are generally not; there is therefore a significant culture gap and executives from the two worlds may never meet.
- Few exchanges have made the decision to diversify their product set, despite contemplating listing in the face of competition.
- Few stock exchanges have the governance model that supports such decisions.
- Exchanges are currently too busy to think this far 'out of the box'.
- Some exchanges may have tried and failed or investigated and decided against trying due to the lack of convergent standards.
What are the similarities between B2B exchanges and traditional exchanges?
The similarities between the two markets are strong. These are listed below.
- Community based
Each market seeks to address the needs of a community of interest (i.e. investors, companies, and capital markets' intermediaries, or for example food manufacturers, food consumers such as individuals or restaurants, and intermediaries, such as supermarkets or distributors).
The provision of services to a community requires the delivery of a community system. Before the system can be delivered, a consensus must be reached on the requirements of the system. In the past, this need has been addressed by forming organisations owned and controlled by the community with the needs of the community at heart, such as a stock exchange or food standards bodies. Current thinking is moving aware from this model, and seeks to address the needs through for-profit organisations using commercial issues to drive success. These new organisations will live or die on their ability to meet the needs of their customers who they attract from a community.
- Market requirements
Both types of market address the same core requirements:
- bringing buyers and sellers together in a fair, controlled, and predictable environment that is conducive to commerce;
- guaranteeing a quality price through real-time price discovery mechanisms; and
- risk-free fulfilment.
- Technology
The technology needs of financial and non-financial markets have a significant overlap:
- Network: both require pervasive networks to reach their customers.
- Security: both involve the exchange of value - all forms of security are therefore a prime concern.
- Payments: both require some form of payment technology.
- Trading: both require various flavours of trading technology.
- Market structures
There are also significant commonalities between market structures. An example of this similarity is given below.
Market structure similarity - catalogue aggregation and hybrid quote/order-driven markets
One market structure common in B2B exchanges is that of a Catalogue Aggregator. Such a market is aimed at highly standardised product sets that are bought frequently in small quantities. The market operator takes online catalogues from a variety of suppliers offering similar or identical product sets and amalgamates these into one unified 'shop-front'. Potential buyers then may choose from sellers' offerings, typically choosing the cheapest supplier for any product or set of products.
The commonalities between such a market and a hybrid quote/order-driven market are shown in Table 5.
A catalogue-aggregating market is therefore a subset of the more general quote-driven market as implemented by many financial trading systems.
So what is the challenge?
The delivery of such services, even considering the similarities and the relevant organisational experience of an exchange, is still clearly non-trivial. The market for such systems is large, however - the exact figure depends on which research you believe, but they are all impressive - so the motivation is there. Listed below are the two main difficulties:A reliable counterparty
B2B exchanges are fashionable and there is no shortage of writers who are predicting great things. Certainly the cost savings achievable are compelling. As a result there are a large number of B2B exchanges either looking for funding or already live; many are attempting to maintain their head above the water. Any exchange interested in taking this route must find a reliable counterparty with sound knowledge of the sector in which they intend to operate and a solid business plan. An exchange will have all market and related knowledge to operate the system once it is live; the gap that must be filled is deep knowledge of the target sector, which, by definition will be non-financial. Once a partnership is established, the trustworthy brand of the partnering exchange should be an asset for fund raising purposes.
Compatibility of systems
There are currently no standards common between financial order routing protocols and B2B protocols. The use of XML in both of these areas is already fairly sophisticated, in particular the evolution of the FIX standard into FIXML, and the development of the Commerce One and Ariba catalogue definition standards, xCBL and the cXML respectively. These standards maintain the financial and non-financial divide, however. To our knowledge the idea of converging such standards to support both non-financial and financial products leads the thinking in this area.
In our opinion, despite the difficulties, the commonalities between the requirements of the two environments are compelling and this remains an untapped market for exchanges looking for a path to diversification
Conclusions
There is no doubt that exchanges are facing difficult times. The changes to the environment, pressure on transaction revenues, the entrance of new competitors, and the need to maintain shareholder value and confidence are significant challenges for any business. However, exchanges have a breadth and depth of experience and a brand that should both be leveraged. This article has shown that there are opportunities for capitalising on these strengths and facing these challenges.
