01 July 2005 Features

 

New deal for exchanges

Anyone who ascribes to the philosophy that competition is healthy and market forces rule has to admit that exchange consolidation in the US is unavoidable. The market is mature and the existing traditional exchanges and ECNs are having trouble making significant profits. Put into context, eBay earned more revenue in 2004 than Nasdaq, the NYSE, Archipelago and Instinet combined.

According to TowerGroup, in 2003 Nasdaq made about 45-50 per cent of its revenue from commissions, 30 per cent from listing fees, and 25-30 per cent from market data fees. In contrast, about 35-40 per cent of the NYSE’s revenue came from market data fees, 25-26 per cent from listing fees and 15 per cent from commission revenue. The remainder fell into the “other” category. The NYSE was pretty happy as long as its seat prices were going up, market data fees were staying flat or declining only marginally, and it was covering its costs.

But over the last few years, competitive and economic forces, changes in the industry structure and technology have dramatically changed the exchange landscape. The NYSE and Nasdaq of today are very different entities than they were during the nineties. They cannot go back to the old ways of being lethargic entities unwilling to do what is best for buyers and sellers operating in the securities and capital markets.

That reality is driving the two big mergers on the table now: NYSE and Archipelago as well as Nasdaq and Instinet. By merging, these major players can get better economies of scale and regain margins in the business. Moreover, investors will benefit from improved liquidity.

But merging is not enough. They also decided to change their corporate structure from privately held to publicly held organisations. In doing so, both the NYSE and Nasdaq will be in a better position to respond to market forces, but they are substantially changing their business model. “You’ve got to understand who pays the bills for these guys,” says TowerGroup analyst Dushyant Shahrawat. “Traditionally, your members paid a lot of your fees. Now that it’s publicly owned, the strategic drivers for these organisations are going to change.”

As public companies, the exchanges will have to look for other sources of revenue to boost profits and satisfy their shareholders. Similarly, decision-making is going to be done in the interests of the shareholders, not necessarily the capital markets.

Exchanges in Europe and Asia Pacific that have already gone down this road and have improved efficiency in their markets. “Benchmark tests show that there are opportunities that can be leveraged,” says Magnus Bocker, president and chief executive of OMX.

He should know. OMX has acquired exchanges, integrated markets and managed the technological and operational transformation in the process. No one else in the industry has been through as many technology transfers and consolidation initiatives globally. But Bocker also points out that the extent of the opportunity depends on the type of technology they deploy, how it is operated and maintained and whether development is continuous.

How fast the two merger groups integrate their platforms — or if they do it at all — is anyone’s guess. During the last few weeks, the organisations have sent mixed signals to the market about their plans.

It is relatively straightforward for an ECN like Instinet, which runs a fully automated order book with no delays on fills, to link to an electronic exchange like Nasdaq. The exchange already accomplished that when it acquired Brut. But linking an ECN to the NYSE system is a different story. “It is definitely a more difficult integration because you have to take into account the specialists who actually are not really wired into an ECN-like mode of execution,” says Peter Kearns, president of NeoNet Securities in New York.

Specialists can hold orders for up to 30 seconds to try to improve a fill. Of course, whether it is a worthwhile endeavour to wait for a better fill if the order is held up is debatable.

A much more interesting issue, however, is what the NYSE’s business model will be in the future. Currently, the Intermarket Trading System — an antiquated system used to connect to the regional exchanges, Nasdaq, NYSE and the ECNs — protects the NYSE. Meanwhile, ECNs like Instinet, Archipelago and Brut battle for market share on names listed on Nasdaq as well as on the ECNs. But it is more difficult to take liquidity from the listed names that trade on the NYSE simply because it is always harder to start a new pool of liquidity in a name if a pool already exists. If there are impediments to get to that liquidity pool, it makes it even more difficult to gain market share.

If the NYSE puts all its listed stocks on the Archipelago platform, all the other ECNs could access them as efficiently as they can access the Nasdaq listed stocks or over the counter stocks. “That could mean that you see a big drop in the percentage of volume done on listed names on the NYSE,” says Kearns. “It could drop below 80 per cent quite quickly.”

Whether consolidation will increase or decrease competition is arguable. For vendors like NeoNet Securities, consolidation is a mixed blessing. On one hand it is a little less technology infrastructure to deal with, but its clients also have less choice for execution.

Others maintain that a reduction in the number of players will allow the remaining exchanges to achieve critical mass, increase liquidity and efficiency, decrease costs and reduce risk — that is, assuming regulation does not hinder competition. Nowadays, a diversified range of companies are duel listing on both exchanges, unlike five years ago when essentially only technology stocks were listed on Nasdaq. That indicates that competition will be intense.

What remains to be seen is whether the new regime will be a barrier to new entrants to the marketplace. “It’s the type of marketplace where liquidity begets liquidity,” says Kearns. “Once you have established pools of liquidity where stocks trade, it’s very hard for a smaller company to come up and try and compete.”

With such radical changes in the dynamics and strategic drivers of the industry, there can be no doubt that there will be ramifications and repercussions across the board.

What is rapidly becoming clear is that these effects will be felt internationally as the current wave of realignments is played out again on the global stage.