Market research has shown that people maintain a particular affinity with the music that they listened to between the ages of 15 and 25. What is true with music may also be true of more general human behaviour – a yearning for some imagined ‘golden age’. This human tendency is often in direct contrast to what is actually happening – an acceleration in the pace of change and a steady spread of new ideas and processes into previously unconsidered areas.
The realm of exchanges is no different. Twenty years ago, when financial futures and options exchanges were rapidly emerging around the world, they were seen as the financial equivalent of the Wild West. Larger than life characters in brightly coloured jackets would win – and lose – fortunes on the ebb and flow of prices. The existing staid financial exchanges observed these goings on with barely disguised scepticism. ‘Futures and options – isn’t that just gambling?’. A succession of high profile frauds, insolvencies and market manipulation hardly enhanced the industry’s image. Doxford, Bunker Hunt, LHW, the Tin Crisis, Nick Leeson, Sumitomo – the litany is a long one.
What was more appealing to the mainstream financial establishment, however, was the high growth rate that these upstart exchanges enjoyed. Over a decade or so, derivative exchanges became mainstream as the rise of a new ‘derivophile’ financial generation encouraged recognition of the benefits that futures and options (F&O) brought, as well as their hazards. Most of the new generation of F&O exchanges were bought by existing national stock exchanges. (In the US, some commodity-based F&O exchanges had been established for nearly a century, and have continued to maintain their independent identities. The US regulatory split between CFTC-regulated commodity exchanges and SEC-regulated securities exchanges has also discouraged any closer relationship). This integration of F&O exchanges benefitted existing exchanges by the injection of new ideas, new methodologies, new revenue streams, as well as by increased order flow, as delta hedging in the underlying cash market could be executed on the same exchanges. ‘And the financial world lived happily ever after.’ Well...not exactly!
Demutualisation and competition
So what are the important current trends in the world of exchanges? Probably the single most important influence on exchange behaviour has been the recent wave of demutualisations, where exchanges have ceased being member-owned clubs and have transformed themselves into publicly quoted companies, with a shareholding including – but not restricted to – their members. In Europe. Deutsche Borse led the way in February 2001. It was followed later the same year by Euronext and the London Stock Exchange. Both the Chicago Mercantile Exchange (CME) and the Chicago Stock Exchange (CSX) have also demutualised, in 2002 and 2005 respectively.
The reasons advanced by the exchanges focused on three areas. Firstly, the desire to be more commercially nimble and respond to market needs more quickly, unimpeded by member committees and their often Byzantine politics. At the same time, conflicts of interest with members, who were, pre-demutualisation, also shareholders, could be avoided. What was good for an exchange as a whole was not always necessarily good for individual members. Secondly, demutualisation would give access to the capital markets for fund raising. Thirdly, being publicly quoted would also give exchanges and their management a clearer idea of what exactly they were worth.
Demutualisation has increased competition between exchanges for market share, as investors demand a return on their investment. For example, in 2003 both the London Stock Exchange (LSE) and Deutsche Börse mounted separate campaigns designed to win order flow from the Dutch market segment of Euronext. Earlier, in 2002 the LSE and Euronext had locked horns over the acquisition of Liffe, a contest that was won by Euronext.
Perhaps the clearest example of the competition between Europe’s three leading exchanges is the tussle surrounding the potential purchase of the LSE. Deutsche Börse’s desire to buy or merge with the LSE is well established, having been previously attempted in 2000. A merged Deutsche Börse-LSE would have created the largest exchange in Europe that would have been nearly twice the size of Euronext. Deutsche Börse’s 2000 merger attempt failed as a result of LSE member hostility. This time around, post-demutualisation, the competition for the LSE is playing out differently. Deutsche Börse has the financial resources to acquire LSE, but has fallen foul of pressure from its own shareholders that the purchase would destroy shareholder value and that surplus funds – Deutsche Börse’s much vaunted ‘war-chest’ – should instead be distributed to the shareholders.
This leaves the field open to Euronext, who at the time of writing have yet to make a formal offer. Created by the merger of four stock exchanges – Paris, Amsterdam, Brussels and Lisbon, Euronext is an acquisitive consortium with an aggressive pan-European perspective. The addition of the LSE to the Euronext fold would add a key high profile global market and create a grouping of similar size to Deutsche Börse. Not surprisingly, Deutsche Börse has stated that it may re-enter the fray – armed with freshly-raised capital – if someone else should make an offer. Finally, at the end of March, the LSE takeover saga was referred to the UK Competition Commission. No ruling is expected before the summer.
Away from the feeding frenzy induced by the LSE, exchanges elsewhere are also regrouping. Oil futures exchanges have been particularly active. In 2001 the Atlanta-based electronic Intercontinental Exchange (ICE), catering to over the counter (OTC) oil traders, took over the International Petroleum Exchange (IPE), a futures exchange based in London. In London, the IPE, alongside the London Metal Exchange, was one of the remaining bastions of open outcry trading, and had become home to many locals after Liffe went completely electronic. In April the IPE also went electronic. In parallel to these developments, rival exchange New York Mercantile Exchange (Nymex), keen to capture European order flow, established an open outcry trading facility in Dublin with which to woo displaced IPE floor traders. Since then, Nymex has signalled its intention to carry its competition to IPE’s home turf by renting a trading floor in London, and plans to offer open outcry trading as soon as regulatory approval has been granted by the UK’s Financial Services Authority (FSA).
Apart from these intercontinental oil wars, US exchanges have been experiencing other significant changes in the commercial landscape, the product of a powerful mixture of for-profit exchanges, competition for order flow and international ambition. Launched in 2004, Eurex US – a wholly owned subsidiary of Eurex, in turn owned by Deutsche Borse and SWX Swiss Exchange has made an aggressive play for the customers of the Chicago Board of Trade’s (CBOT) interest rate complex, encouraged perhaps by its successful vanquishing of Liffe’s Bund business in 1997. Fee holidays, incentive schemes and legal challenges have abounded in a drama that would make a convincing soap opera. CBOT trades had been cleared for 78 years by the Board of Trade Clearing Corporation (BOTCC), an independently owned organisation. CBOT was keen to secure either an exclusive agreement with BOTCC, or full control of it, having become nervous after BOTCC’s earlier agreement with rival interest rate order matching platform BrokerTec and the possibility of a similar deal being struck between BOTCC and Eurex. Unable to achieve either of these aims, CBOT then transferred its clearing to the clearing arm of its rival the Chicago Mercantile Exchange (CME). In turn, BOTCC and Eurex reached an agreement whereby BOTCC would clear Eurex US contracts. Eurex has enabled BOTCC to continue as an independent clearing house (in return for a 15% shareholding), and also offer its services to other exchanges – the ‘utility’ business model that CBOT found threatening. BOTCC has since changed its name to The Clearing Corporation (Ccorp).
In a fiercely contested battle, played out in the best traditions of no-holds-barred US capitalism, Eurex US has yet to make significant inroads into the CBOT’s order flow, but has signalled its commitment to the long run. Eurex US hopes for an increase in market share once the second stage of its transatlantic clearing link is in place, allowing Eurex’s European clearing arm to clear US dollar products. This would also likely generate attractive margin savings for users. Regulatory approval from the US Commodity Futures Trading Commission (CFTC) is awaited. Eurex also points out the benefits that are likely to accrue when it can offer European products to the US. Although inconclusive in its outcome so far, Eurex US’s aggressive moves have served to remind US futures exchanges that there is another world out there beyond the committee rooms, and stirred them to greater efforts on behalf of their users.
Away from financial futures, the US exchanges offering securities options are also witnessing significant changes. Up until 2000 the exchanges that offered options on securities (all cleared by the Options Clearing Corp (OCC)) were the Chicago Board Options Exchange (CBOE), the American Stock Exchange (Amex), the Pacific Exchange (PCX) and the Philadelphia Stock Exchange (PHLX). In May 2000, the International Securities Exchange (ISE) joined the group, wholly electronic and dedicated to greater competition and lower fees. It quickly proved its worth and in January 2005 accounted for a 29% market share, with former industry leader CBOE accounting for 27%. The ISE’s success story was further underlined by its successful initial public offering in March 2005, which was priced at the top end of the range, reflecting good demand. Another electronic exchange to recently join the OCC-cleared group was Boston Options Exchange (BOX). BOX, jointly owned by Boston Stock Exchange, Montreal Stock Exchange and Interactive Brokers, opened its doors for trading in February 2004 and accounted for 4% of total volume in January.
The impact of ISE’s electronic trading model on other US securities options exchanges should not be underrated. Amex and PHLX announced extensive electronic trading programmes in October ’03 and May ’04 respectively, and Amex now executes more than 75% of its options electronically. The Pacific Exchange, which accounts for about 17% of the market, went completely electronic in 2002 and was recently bought by electronic trading platform Archipelago which has since announced a merger with the New York Stock Exchange (NYSE).
Futures and options exchanges and their members have recently run into the issue of patent enforcement – not normally something that is seen with intangible financial products. One large vendor in the order routing market has been aggressively defending its copyright. It contends that much of the success of F&O exchanges can be directly attributable to its software and have proposed that exchanges pay them a levy. The vendor has also pursued brokers that have infringed its patents. Commentators have seen these moves as restraints on the free flow of innovation. At the same time, many market participants have reached the conclusion that using other order routing system suppliers will enable them not to put all their eggs in one basket.
The success of ISE’s IPO is likely to stimulate the plans of other exchanges for demutualisation, namely CBOT, CBOE and, further down the road, the Amex. Perhaps as a precursor to this potential move, Amex’s members recently re-established it as an independent entity by buying it back from the National Association of Securities Dealers (NASD), who purchased it in 1998. In New York, Nymex is said to be considering an IPO and is also in talks with New York Board of Trade (Nybot) about a possible merger that would create an exchange covering energy, precious metals and soft commodities. And the NYSE Group, formed by the merger of NYSE and Archipelago, also plans to go public.
Of course, not all news from exchanges is upbeat. One of the exchanges that has failed to deliver its hoped-for potential is the single stock futures exchanges NQLX, 100% owned by Euronext.liffe. Single stock futures activity is now centred on rival exchange OneChicago, leaving NQLX ‘dormant’. Euronext.liffe has indicated that it may trade other contracts on the exchange in the future. Another exchange that fell by the wayside was Jiway, the online exchange that aimed to deliver one stop shopping for European equity investors by integrating cross-border trading, clearing and settlement. Originally established by technology and exchange operator OM and Morgan Stanley, OM invested EUR86m in the venture, latterly as sole owner, and decided to close the exchange in October 2002 in the face of mounting losses.
But if not every exchange thrives in the developed markets, new exchanges continue to emerge in the fertile ground of Eastern Europe, India and the Far East. Warsaw Stock Exchange has a cross-access agreement with Euronext. Austrian exchange Wiener Börse, as part of a larger consortium, has just taken a majority stake in the Hungarian Stock Exchange. US exchange Nasdaq is in conversation with Russian exchange RTS regarding possible co-operation. The Dubai International Financial Exchange plans to develop a global financial centre between the London and Far East time zones and recently announced September 26 as the day when it will open for trading. The emergence of a significant middle class with higher disposable incomes in eastern Europe, Russia, India, China and Korea is giving rise to the launch of new exchanges and strong growth at existing ones. In just the same way that exchanges initially developed to respond to the capital needs of industrial companies – and in return deliver dividends to investors – so the political and economic changes that have swept the world in the last 20 years have created a benevolent environment for the extension of exchanges to other countries. This is of course easier when markets are rising. A prolonged slowdown would be bad news for exchanges and encourage further consolidation and initiatives to reduce costs.
One area that could show significant promise for exchanges and clearing houses is the extension of clearing house methodology to asset classes that are traded over the counter (OTC); exchanges have long been jealous of the success of the OTC market. This initiative places a central counterparty (CCP) between the buyer and seller. Instead of buyer and seller contracting directly with each other, they contract with the CCP, which acts as buyer to every seller and seller to every buyer, Key benefits flowing from CCP include confidentiality, economies of scale, risk reduction and capital efficiency. Capital efficiency appeals to market users as different products can then be offset to reduce margin liabilities (margin is the deposit that a market user pays when trading to guarantee fulfillment of the contract). CCP initiatives are at relatively early stages. Specific exchanges and clearing houses – notably LCH.Clearnet and also Eurex Clearing – have started significant initiatives. In essence, exchanges and clearing houses are extending the proven methods of futures and options markets into other asset classes.
Challenges
The global expansion of exchanges that is taking place paints a rosy picture. There are however important challenges facing exchanges. First of these is the rivals that exchanges have for their order flow. Specifically, these come from internalisation and electronic networks.
Exchanges do not have a monopoly on providing trading facilities. Banks and brokers use exchanges for their convenience. They are also able to cross orders in their internal systems and only use exchanges to execute any uncrossed balance. Given the waves of consolidation that have hit the banking sector, order flow is becoming increasingly concentrated in fewer and fewer firms. Regulatory treatment of internalisation, however – and thus its impact – varies from country to country.
Electronic communication networks (ECNs) provide a similar challenge to existing exchanges, particularly in the US. In the US, the inefficiencies of the traditional quote-driven market have been addressed by the emergence of ECNs and the creation of an online order book. The recent takeover of the Pacific Exchange by ECN Archipelago shows that this is a real threat.
A second important challenge comes on the heels of demutualisation. Demutualisation brings the benefits of responsiveness to market need, fewer conflicts of interest with members and clear valuation of what an exchange is worth. Demutualisation also brings potential problems. What a shareholder wants and what a member wants are not the same thing. In the past, retail exchange users have felt some loyalty to their national exchange. Looking at the consolidated groups that are starting to emerge in Europe, will investors feel the same degree of loyalty to a pan-European utility? Are they equally likely to be more interested in rival alternatives? Jiway failed to gain traction, but perhaps the model could be worthy of attention again in the future.
A third area of potential challenge is – in the EU – that of possible legislation. The European Commission has received support for its plans to improve cross-border securities clearing and settlement in the EU, possibly including legislation. Apart from wartime and for investor protection, legislation in Europe has traditionally been more focused on forbidding than compelling. Many would argue that evolutionary changes like this should be driven by financial innovation rather than the hand of the state, even with the most careful provisos about impact and drafting.
Finally, there is always risk for exchanges from their basic staple – price risk. Industry commentators have noted the extensive involvement in the world’s markets of hedge funds and have expressed concern over their exposure to sharp moves in the market. The Long Term Capital Management debacle in 1998 showed what might happen. Recent research by US research company Greenwich Associates indicated that hedge funds were responsible for one third of the futures contracts traded in the US and 70% of US exchange-traded fund volumes. A US Commodity Futures Trading Commission (CFTC) round table this April, however, hit back at claims that hedge funds are an unregulated financial disaster waiting to happen.
Technology
Beneath every commercial initiative there is technology. We take technology for granted, but it is a key ingredient in success or failure. Exchanges of all types are heavy investors in technology. Partly this is because they have no choice – poor systems erode confidence in a marketplace faster than anything else, apart from fraud or a market crash. The competitive pressure that exchanges find themselves under from users, shareholders, electronic trading networks or internalised order flow is likely to continue unabated, and technology is likely to remain a key issue.
Vendors – either hardware or software or management consultants – supply the exchanges and their members. There is the opportunity for large ticket sales here. In the recent past, on the heels of the dot.com bloodbath, the climate for vendors has been extremely difficult. It has now improved as companies realise that they can no longer delay vital investment, or require solutions for new business problems.
As a market-leading software vendor focusing on listed derivative markets, Rolfe & Nolan is – along with its industry peers – continually striving to supply products addressed at the current and future business needs of exchanges, banks and brokers. One of the top needs that we observe at the moment is the need for modular, platform-independent solutions to particular trade life cycle issues, functionality that is being addressed by Merlin, a ‘next generation’ modular processing solution. Available modules are a margin calculation engine and a fee/commission calculation module. As well as its modular flexibility and the wide range of platforms that it is available on, Merlin has been designed to be cross-asset capable, and not structured to address solely F&O processing. F&O trades are among the most complicated to process: with the exception of corporate events for equities, systems that are capable of addressing each small component of an F&O trade should also be capable of addressing the processing needs of other asset classes. Merlin’s asset neutral approach echoes the trend towards asset class convergence, which is evident at exchanges and clearing houses, as well as at banks with large trading operations who are under pressure to make their capital work harder.
A trading-related product developed by Rolfe & Nolan in response to frequent fee changes by demutualised and competitive exchanges is Fees Direct, which enables front office broking teams to accurately track fee changes and respond quickly and efficiently to client brokerage proposals and negotiations. Still with trading in mind, the calculation of risk, specifically margin calculation, is of great interest. Rolfe & Nolan has also recently developed Alerts Direct, a real-time risk assessment tool that addresses the three core areas of margin requirement against collateral held, the impact of price changes, and the breaching of lot limits. An on-demand margin calculation tool has also been developed.
Products like these – which Rolfe & Nolan has made significant investment in – also echo another trend in the increasingly complex financial marketplace: the trend to ASP solutions, whereby market participants outsource part or all of their processing or information gathering needs to vendors. This generates cost savings and efficiency gains. The ASP model also gives users a lower cost means of entering a market.
Lastly, and on a darker note, financial markets are now having to live with the possibility of terrorist acts of previously unimagined scale. 9/11 was a climacteric in the provision of disaster recovery (DR) services. What in the past was an unfashionable but necessary service – rather like sanitation – has become of key importance to the commercial future of financial services companies. Again, vendors can offer DR services that obviate the need for customers to reinvent the wheel, while harnessing market-leading practices.
Conclusion
After a long period of stability during the nineteenth and twentieth centuries, exchanges are experiencing rapid change, partly driven by changes in the markets themselves, and partly by demutualisation. The trends that have been discussed in this article include increased competition, the convergence of asset classes and the extension of listed derivative methodology to different asset classes. Possible challenges have been identified by alternative execution methods such as internalisation and ECNs, changes in user loyalty post-demutualisation, and legislation. Technology trends emerging in the market include the need for modular flexibility, the interest in asset neutrality, the interest in ASP services stemming from the challenge of keeping up to date with changes in, for example, exchange fees, and finally the renewed importance of DR. There is much going on at exchanges, which are in the process of becoming more dynamic organisations. There are obviously challenges to existing exchanges, but there are also many opportunities, which should in the long run benefit both the market and its participants.
