Despite the volume of high-profile mergers and acquisitions between exchanges, the number of trading venues in the US is an astonishing 55 and rising. According to industry consultant Larry Tabb: "The US financial markets are not just in flux; they are in full-out, no holds-barred, free-for-all radical change." Moreover, it is a trend that he believes is likely to be exported.
Nasdaq’s recent acquisitions of the Philadelphia and Boston exchanges and NYSE Euronext’s acquisition of the American Stock Exchange are prime examples of consolidation at the ownership level that have not led to a decrease in fragmentation. Although both groups have announced that they will attempt to consolidate operations and technologies, neither plans to eliminate markets or to consolidate liquidity pools, despite the benefits of increased scale that would result, which were often cited in the past as the main rationale for exchange mergers.
The reason is that what exchanges and other trading venues have discovered is that a consolidation of platforms tends to significantly reduce volumes because it eliminates arbitrage trades, which account for a significant proportion of total trading volumes. In the US, many statistical arbitrage funds and electronic market makers make their living from exploiting tiny price discrepancies in shares being quoted on different trading venues.
Because different market structures cater to and facilitate different styles of trading, exchanges are realizing that although they need to consolidate, they cannot eliminate trading venues altogether.
Exchanges are therefore shifting their attention to the creation of new matching venues with different market models aimed at different trading needs running on the same core platform. The launch of exchange-based crossing platforms, dark pools and algorithms is a case in point. By segmenting liquidity, exchanges hope not only to lock in greater volumes but also to charge premium prices to customers willing to pay for market structures tailored to their needs.
With similar trends spurring the growth of alternative trading venues in Europe and Asia and the spread of algorithmic trading to these markets, Tabb believes that Europe will follow the US’s lead in fragmenting further.
"What started as a way to disintermediate recalcitrant US market centres has effectively spurred the development of new trading tools to better support a wide-ranging selection of execution needs," says Tabb. "While this trend started in the US, Tabb Group believes it won’t end there. Once the genie’s out of the bottle, it’s impossible to recork."
Although the proliferation of trading venues looks messy and inefficient compared with a neat central limit order book national exchange, it has led to substantial efficiencies by enabling investors and traders to trade in the most advantageous way to them with no less than the best displayed price on any market – or at least it has to those that can afford the technology to make sense of it all.
"The proliferation of execution venues, in conjunction with significant investment in scheduling and routing logic, not to mention the market data infrastructure needed to read and analyse trading opportunities, have made the old school method of calling an exchange floor broker for an execution as anachronistic as a horse and buggy in the Daytona 500," says Tabb. "Not only can’t they win but they have a greater chance of harming everyone else around them."
According to Tabb Group estimates, developing the necessary technology to make sense and take advantage of the increasingly complex trading environment can cost more than $50 million a year. Although cheaper solutions are available from technology companies, there are few that mid and smaller-tier brokers can easily implement to put them on an equal footing with the bulge bracket, especially as speed, now measured in fractions of milliseconds, and sometimes microseconds, becomes more of an issue.
As a result, brokers outside the bulge bracket are losing market share. The 10 largest brokers in the US generate more than 73.5% of industry revenue, a situation that does not look set to change soon.
The concentration of ever more volumes in the hands of the largest broker dealers has consequences for the market that go beyond the sufferings of smaller competitors. There are fears that trading in mid-cap and smaller-cap stocks could deteriorate as large firms will not be able to profit from covering smaller companies. This could lead to fewer companies being covered by analysts, a trend that is already in evidence.