The resurgence of regional stock markets

In the UK, many rural market towns boast a substantial building in the centre known as the Corn Exchange. Now they tend to house building societies, discothèques and public amenities. In the past, however, they were where producers and consumers came together to negotiate contracts and transactions in grain and set local prices.

Modern investors may be surprised to know that active stock exchanges were located in a range of towns and cities such as Aberdeen, Cork, Florence, Venice, St Louis and many other regional cities which are no longer recognized as financial centres. The SFA, the UK securities regulator, in its current list of "Recognised Exchanges" includes stock exchanges in Bologna, Bilbao and Bordeaux, Florence, Lille and Nancy with Trieste and Turin.

In fact, during the industrial revolution in most major cities where businesses were starting up, requiring investment capital to grow and thrive, local stock exchanges acted as the interface between suppliers and consumers of capital. Now on a more global scale, part of establishing a credible international identity for a sovereign state has been the establishment of a domestic infrastructure that includes an airline, a central bank, and a stock exchange. Go to the capital city of virtually any country in the world and find a stock or commodity exchange. If there is not one now, there will be in the near future. Because building new exchanges is big business and growing.

In a curious way the interaction of technology and markets has led to a long-term cycle with stock exchanges during the 20th century initially becoming more centralized and now, in the dawn of the 21st century, the pendulum may be swinging towards the development of regional and even local stock markets.

In 1910 there were 19 stock exchanges located the length and breadth of the British Isles. Many listed and offered trading in the same companies. Consequently differentials in pricing emerged. Specialised dealers working between the smaller exchanges and the larger markets in Birmingham, Manchester and London, arbitraged the disparities. But technology, initially in the form of the telegraph, then the telephone and, more recently, networks, removed the differentials and promoted centralization of order flow and market information into larger and more efficient markets.

So the regional exchanges were shutdown.

Now the arrival of broadband communication, Internet technology, digital signatures and supra-regulators means that investors have as much information as the broker and, just as quickly, can access the market directly and securely. There is greater choice. Instead of single one-stop full-service exchanges, technology has enabled individual investment houses to become exchanges and software houses to offer execution engines to new market organizations. As a consequence the number of exchanges (taking into account ECN's, platforms, crossing markets etc) is actually rising.

Whereas, industry users are calling for consolidation of exchanges.

Understanding the reasons for this apparent contradiction will help predict the nature of the next wave of this long-term cycle.

Like other identified trends, "moves toward consolidation" may not agree with reality or necessarily be beneficial. Instead, the rise of capable, high-capacity, and rapid technology may actually counteract the global trend toward exchange consolidation. Maybe the future holds many more exchanges than in the past csome specialized, some single-product exchanges, or even Web-site exchanges - yet operating under a broader, global regime of regulation.

First signs of conundrum

In Europe, the consolidation of the 36 or so stock exchanges and 22 derivative exchanges has been widely discussed and tacitly welcomed at market and political levels. Many in these circles believe that a manifestation of the single EU market is a move toward a single stock exchange, affording pan-European coverage. This should combine with single European listings for issuers, a unified law of property governing the holding of securities and a single networked European market price in the same manner as the US Consolidated Tape. The single European currency is eliminating barriers to the movement of capital and assets across country borders and removes both interest differential and currency variance. This trend should focus liquidity into one market space to the exclusion of local interests. It is argued that as national stock exchanges compete with each other within the EU, the weaker ones will disappear through merger or take-over or by simply vanishing quietly as the regional exchanges have before them.

Meanwhile, the major European investment banks and broker dealers are talking openly about a single "virtual order book". The top 300-500 EU equities are increasingly able to trade in one place, drawing the highest volume blue-chip European securities and their liquidity from their domestic markets. Stock indices should therefore represent the EU stock market as a whole, much as the FTSE does in the United Kingdom and geographic investment policies yield to a cross-border industry sectors focus.

The clearing and settlement systems are consolidating or forming new alliances. They are being encouraged to move towards a European version of the single US market utility, the Depository Trust Clearing Corporation (DTCC). Driven by market users' demands for efficient low-cost performance, the next step could be a single organization to handle the settlement of all European securities - equities, debt, and derivatives.

For years, there has been a trend in the United States toward consolidating the exchanges. The merger between Nasdaq and the American Stock Exchange was a recent major-scale move in this direction, although significantly this has now been effectively reversed. Of further significance is the fact that the stock exchanges in Cincinnati, Boston, Chicago and Philadelphia are thriving despite the increased competition for exchanges from ECNs.

Outside the US, consolidation has been evident for some time, such as the unification of the UK stock exchanges in 1973 and, more recently, the three major Swiss exchanges in Basle, Geneva, and Zurich (although the Basle Stock Exchange continues to function). However, once again in contradiction, the seven regional stock exchanges in Germany are reporting buoyant trading volumes and appear to be vibrant and active organisations outside the reach of Frankfurt.

Thus we identify the first signs of a conundrum. If exchanges and exchange capacity are consolidating, why are there new ones being built? If global liquidity is converging on increasingly few exchanges, what is the purpose of adding to the number? Or, are new exchanges being built solely in the emerging and developing world? Not at all. In the last five years, for example, the U.S. Securities and Exchange Commission and CFTC have approved over 50 new exchanges or proprietary trading systems (PTS), and this trend continues. In 2000 82% of US fund managers paying over USD5m in commission used PTS's and it is estimated that these platforms now account for 25-30% of all US securities trading.

Are these new exchange organizations real stock exchanges? Do they actually add to the reserve of exchange capacity and create liquidity? In brief, exchanges provide their target community with a forum (physical, electronic, or cyber) for facilitating transactions for:

Raising capital - initial sale of securities for capital subscriptions
Trading - buying and selling as part of routine commerce;
Dealing - transacting business on behalf of others;
Investment - taking a market position with the intent of generating a profit (in commodities this includes using the exchange as a surrogate for storage);
Risk management - the reduction or increase of price risk; and
Arbitrage - comparing related prices and profiting from fluctuations in their correlation.

The mechanisms employed to perform these transactions include price discovery, information distribution, and raising finance. Exchanges overlay these with sound operation and the application of regulation to achieve these aims. And all these functions were well established before the recent major technology shift to the Internet.

The impact of technology on exchanges

Technology is playing an increasingly important role in exchanges. A recent survey from the Fédération Internationale des Bourses de Valeur (FIBV) shows that 75 percent of exchange markets are fully electronic and decentralized and 86 percent of exchanges use the Internet.

Internet-based technology brings a range of important attributes to the exchange. Orders can be routed from investor to market either through or without an intermediary. Geographically remote counter-parties can deal directly with one another with no disadvantage to either side of the transaction. A participant can access different markets simultaneously and retrieve and use prices and other market information remotely. Online prices and transactions can be monitored, providing the type of audit trail vital to market supervision.

Web crawlers and specific search engines, such as CyBercorp and ECN Sweep can find quotes and prices for securities on different markets and platforms and combine them to look as though they were from a single marketplace.

The application of this technology for finding the global supply and demand balance for a company listed on several exchanges worldwide is significant. It also ensures prices from smaller markets or exchanges, that may offer some new insight into the price discovery function, will not be ignored.

As an example, FpMLä (a financial products markup language derived from XML developed by J.P. Morgan and PricewaterhouseCoopers) is a new protocol for Internet-based electronic dealing and information sharing of financial derivatives. Initially, it is being used to trade interest rate and foreign exchange products. Going forward, more and more financial instruments will be negotiated using FpML and other, similar languages.

Web-based technology enables a trader, intermediary, or investor with a suitable search engine to access a number of different exchanges remotely, withdrawing specific price quotations, comparing these independently, and triggering executions against displayed orders on the exchange that offers the most attractive terms for the trade. In effect, the investor puts together his/her own market quote from different national stock exchanges.

A scenario for future markets and exchanges

Consider this scenario of how markets might work and feel in the new technology-driven environment of the future:

The geographic location of an exchange will be of secondary importance: location alone will not guarantee success; by the same token, it will not inhibit it. Traders will need only to be as near to the action as the nearest Internet access point, which, with wireless technology, will be anywhere.
Stock exchanges will coalesce around individual industry sectors and specific regional expertise - for example Silicon Valley for high-tech stocks, Edinburgh for closed-end funds, and Hamburg for shipping companies. The location of an exchange could be driven more by its relevance to the issuer sectors and the investor pools it serves.
Liquidity will be an issue of access to 1) the databases supporting various exchanges and 2) the secondary trading of their listed assets.
Listing will be a choice for issuers as to where the connections to investor search engines are most active. (This would produce new fields of work for the investor relations industry.)
For tax and regulation purposes, exchanges and markets will be free to locate in the environment most conducive to frictionless trade in the assets they list.
Regulators and taxation authorities will focus on the end product rather than the process of capital raising, trading, and investment - ensuring that the end product will be compliant with the governing rules.
The quality control function delivered by exchanges will be increasingly focused on the production of real-time, on-line catalogues of listed securities and assets. This will preserve and support the continuing importance of the listing role and function.
Multinational companies, such as General Electric, Nestle, and BP, could be able to operate their own "stock markets", offering direct issuance and trading in the different classes of their equity, fixed income, and derivative securities. Global "specialists" or market makers could then contract with these companies to oversee a fair and orderly market in the trading of their listed securities. This may naturally raise regulatory hackles and places the spotlight on clearing and settlement efficiency.
Exchange organizations and clearing systems would have the added responsibility of sponsoring the access of their members into other markets.

How likely is this scenario?

A survey by the Swiss Stock Exchange found that there are no economies of scale for the listing and non-trading services of stock exchanges. The study showed that being bigger does not produce any material benefits. Naturally, the trading function generates significant benefits in scale as the market for an asset or security develops added liquidity and depth as counterparties present themselves in greater volume. Liquidity itself breeds some powerful benefits.

Perhaps the future of traded markets is one in which there is a profusion of specialist and single-product exchanges focusing on the advertising and description of specialized assets and securities to potential users. Could these exchanges operate as distinct Web sites? For example, securities could initially be bought on a primary market basis over the exchange. This would equally apply to the initial launch and subscription of an issue of bonds from an issuer under the rules and oversight of the exchange in question. Then these assets or securities would be open for trading on a single, globally networked, secondary market, consisting of multiple national and regional exchanges, in which investors and intermediaries would log-in on a remote basis to gain access to the price information and trade.

Regional stock markets - patterns for development

If regional stock markets are to play a greater role in future, how are they likely to work together?

There are some recognisable patterns from other market theatres which could enable regional markets to achieve their potential:

Each market operates independently
Bilateral links with other markets are supported
Issuer may have to choose whether to list on more than one market
Investors have to select the most appropriate market to transact on
All markets rely on central supporting infrastructure for regulation

Each regional market is connected to the others
The linkage enables prices to be exchanged between regions
Issuer listings are "passported" around all markets
Investors have a greater chance of finding a counterparty to an order
The "Ring Main" could be extended across borders
All transactions would be routed to the national CSD for settlement
Markets could opt for different methods of governance and delivery

Regional markets are linked to a central "Hub" market
The Hub may supply services such as technology and market supervision
Regional markets would be motivated to specialise i.e warrants, bond etc
Potential for Regional markets to adopt individual characters may be constrained
Bilateral links between the "spokes" would tend to be discouraged by the Hub

Issuers choose where to list
Investors select best regional view/mix
Uses central infrastructure for regulation
All transactions routed to CSD for settlement
Central technology and market supervision
Regional views give a regional "look and feel" with specific regional content

There are factors in favour of each model. However the common characteristic is the establishment of a regional focus for market participants whereby local issuers can be brought into closer contact with local sources of capital be they retail investors or regional municipal investors and local government funds.

The American Stock Exchange has found that bringing local populations of investors together via the "Amex Clubs" across the US has helped to develop natural investor interest in companies listed on the Amex. How much more powerful will be the effect if the companies in question are those that are both locally visible, tangible and with personal contacts and relationships through employees and tradesmen?

It is this recognition of the "regionalisation" of investment flows, from investor to issuer and from local buyer to local seller, that is driving the resurgence of interest in regional stock markets. The "touch and feel" of personal contact that has been lost for many investors in centralised markets can be regenerated through access to local markets.

Politically, it has been recognized that regional stock market have potentially powerful impacts on local economies by bringing the capital markets closer to the indigenous needs for investment - small and medium-sized enterprises (SMEs) who are often turned away from established capital markets that are set-up to handle capital raising of several hundred million dollar's worth at a time and who find an SME's requirement for a few million dollars commercially unattractive.

Enabling SMEs to raise capital cost-effectively on a regional market provides them with a choice over and above purely bank funding and the consequent high-gearing that results. It also enables initial investors in a company to recycle their investment and encourage them to continue supporting other SMEs. In time as they prosper, SMEs can transfer to the national main market and beyond.

And it is not only the small company that benefits.

There are opportunities for larger companies, even those multinationals for whom an additional listing on a regional exchange could provide useful local access and focus. For many of these companies are committed to support economic development efforts and public relations in regions around their key industrial plants. Similarly, listings on regional exchanges could support employee stockholder relations by providing the "local feel" which a number of companies have, in the past, attempted to provide through in-house "stock markets". The local quote could additionally provide opportunities for "friends and families" of employees to become actively engaged in their colleague's employer.

Summary

As the role of stock markets expands in supplying capital to companies across the globe in place of bank funding, coupled with the increasing number of retail investors whose investment activity is being stimulated by, for example, the ease of access to markets and the need to enhance retirement funding, and to take stakes in their employers, regional exchanges are likely to play a role in bringing the benefits of capital markets to areas of the economies that cannot by themselves participant actively in the major wholesale markets. If quality control is exercised effectively at a local level under the broad umbrella of global standards implemented by national regulators on intermediaries and issuers, the entire value chain can benefit, from the issuer to the primary investor and, in secondary trading, both sellers and buyers of all sizes and positions. These benefits include improved access to capital markets, more liquidity, greater choice, improved price transparency, lower cost, and improved trading opportunities.

By providing services to niche markets in an efficient and fair manner using the capabilities of modern technology, regional stock markets will develop a role that can be recognised alongside the traditional national stock exchanges.