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Skip Navigation LinksHome :: Back Issues :: A question of ownership

September 1998

A question of ownership


World stock and futures exchanges are in a turmoil of change and uncertainty. Fusion and cross-border linkages are in the air. Regulation to take account of this rapid change lags far behind, and stateless, borderless trading facilities may soon make it impossible. Remember, the only reason for an exchange to exist is to reduce transaction costs, argues Ruben Lee. Any new step that doesn't will end in tears.




Will Merrill Lynch buy up all the world's exchanges? It could certainly afford to do so, but it won't. The returns are just not there, and there are good reasons why they won't ever be.

An exchange is essentially a machine for reducing transaction costs. Exchanges are only used when it is cheaper to do so than to employ alternative dealing systems or search individually for a counterparty to a trade. Given that the major source of profits to exchanges are transaction related, any increase in an exchange's profits necessarily comes from an increase in transaction volume or transaction costs. It is for this very reason that when exchanges operated historically in a monopolistic environment, they normally did so with a non-profit or cooperative governance structure.

The presence of increased competition is encouraging exchanges to adopt a for-profit structure. It also, however, has implications for market participants considering investing in those exchanges that are selling their shares, be it via demutualization, corporatization, or privatization.

Goldman exit route

The owners of such exchanges are essentially following the Goldman Sachs exit strategy: capitalizing on their firm's accumulated goodwill at a time of all-time market highs and of peak uncertainty about the future. Such shares are unlikely to perform well.

Worries by intermediaries that they will not be allowed access to an exchange's trading system without purchasing its shares are mostly unjustified. Any exchange that restricts such access simply reduces the potential liquidity on its market, ultimately to its own disadvantage.

Will a linkage between exchanges ever work? Statistically no, given that just about all of them have failed so far. The likely success of such ventures in the future is, however, greater than in the past. The prime aim of an exchange in entering a linkage is to reduce costs.

Savings can arise from many sources. A joint order-routing mechanism may allow exchanges to offer their products to members of other exchanges, without requiring these members either to buy a seat on the other markets, or to deal through a local intermediary.

Economies of scale may be available to linked exchanges, if their shared costs in any joint facilities are less than the sum of their separate costs would otherwise be. A linkage may also allow cooperating exchanges to combine their order flows and thus achieve a more liquid market than they would be able to realize separately.

Despite these perceived advantages, most exchange linkages have failed. The key reason is that such ventures are never neutral in their effects on the various constituencies at the participating exchanges. Typically, one or more of such groups at exchanges potentially cooperating fear that it, or they, may be worse off if a joint project were established. They therefore block the linkage.

Tension between potentially cooperating exchanges is much less when their ownership configurations are the same or identical. In such circumstances, the success of any linkage becomes solely dependent on whether the combined trading volume of the exchanges increases as a result of the link.

This is because member firms of the exchanges, typically the exchanges' owners, are relatively indifferent where they conduct their business, and are thus not concerned about movements in trading volumes between the exchanges.

Urge to merge

A successful linkage between exchanges is likely, however, to become more than simply a linkage. If the cooperating exchanges have similar or identical members, there is little to lose and much to gain if the linked exchanges merge rather than maintain their separate identities.

Given the ever increasing consolidation among financial intermediaries, the overlaps between the members of different exchanges are growing, and thus the possibility of exchange mergers is becoming increasingly likely.

Will an appropriate regulatory framework for exchanges be developed? It's possible, but only if the critical question "what is an exchange?" is resolved for regulatory purposes. This issue is being addressed in different forms by both the key American regulators, which, despite denials to the contrary, still provide the models for many other countries' regulators. The Securities and Exchange Commission (SEC) recently proposed a new policy for regulating exchanges and, what it terms, alternative trading systems.

There are, however, several aspects of these proposals that do not allow competition policy to determine market structure (the optimal regulatory policy), by applying different policies to trading systems called exchanges and those - such as internet trading facilities - not called exchanges.

The proposals have not been adopted by the SEC yet, and there is thus just time for interested parties to influence the rules before they are implemented.

Cross-border conundrum

The other key regulatory issue concerning exchanges and trading systems is how they should be regulated across borders. It is the Commodity Futures Trading Commission (CFTC) that is looking at this question.

To date no definitive policy has yet been formulated for how to regulate non-American futures exchanges wishing to place their terminals in the US.

The most important question in this context is not the inter-jurisdictional battle that always occurs between two countries' regulators, but rather the implicit question of what is the difference between an intermediary using an order-routing system to send orders to a foreign exchange, and the exchange itself placing terminals in the US. Once, again the regulatory distinction between what is an exchange and what is not is critical and is as yet unresolved.

Will the success of exchanges be independent of Realpolitik? No, it never has been. Two examples of this are particularly relevant in the present battles between the European exchanges.

The current high level of order flow attracted to Eurex is dependent in part on the merits of its trading system. As important, however, to the exchange's achievement was its original ability, or political strength, to persuade the German banks to trade through Frankfurt at the expense of London. Without this feat, the exchange would not have attracted enough orders to achieve the initial liquidity needed to sustain the market.

Political clout can also be a vital element in some countries' attempts to use law and regulation to impede their competitors. Despite the supposedly liberal intentions of the EU's Investment Services Directive, a legal instrument specifically designed to promote competition in European financial markets, it may still be implemented in particular countries in a manner that inhibits the success of foreign markets.
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