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WFE Focus April 2011
A free option on the future: regulated securities exchanges beyond 2010
Stephan Malherbe
Chairman and Founder,
Genesis Analytics
Siobhan Cleary
Senior Manager,
Johannesburg Stock Exchange
Nicky Newton-King
Deputy CEO and Member of the Executive Committee and Board of Directors,
Johannesburg Stock Exchange


The business of financial intermediation – bringing capital to new endeavors, securing a well-regulated set of investment choices for savers, and enabling risks to be laid off or assumed – has been one of the world’s great growth industries. Regulated securities and futures’ exchanges have stood at the apex of the burgeoning business of financial intermediation.1 Were we not so used to it, we would be startled that a single type of business could be so prominent that its street address would serve as short-hand for the entire economy, and an index of its prices a key barometer of economic outlook. Wall Street, Threadneedle Street, Hang Sen, Sensex, CAC40: these and other such names have become accepted barometers for economic wellbeing or otherwise.

There is no guarantee that this pre-eminence will last. Few other businesses have had such a sustained institutional prominence in the lives of nations, but there have been some. Metropolitan newspapers, national airlines, large broadcasters, major automobile companies, oil companies, and major high street and investment banks come to mind. When pondering the future of regulated exchanges, it is a sobering list. Major newspapers, and to a large extent traditional broadcasters, are being superseded by other forms of information delivery. Flag-carrier airlines have been undercut by wrenching competition following deregulation. And the recent global financial crisis has resulted in famed banks and automobile firms going under, being absorbed by competitors, or taken over by the state. Pre-eminence today is not a guarantee of even viability tomorrow.

The crisp question is: will regulated exchanges turn out to be another artefact of the 20th century, reduced to a peripheral status by nimble new competitors or emerging global giants? Or will exchanges continue to evolve, successfully playing a critical role in financial intermediation and risk management around the world?

These questions assume that exchanges tend to have a similar structure and environment. This homogeneity, to the extent that it is still present, will disappear. The exchanges of tomorrow will face varying competitive pressures, regulatory regimes and degrees of protection from global rivals. To find a way through this increasingly complex picture, we first identify a handful of major trends that have transformed the operating realities for most exchanges.

Six trends that have transformed the world of exchanges

Six large trends over the last quarter century have tested the adaptability of exchanges. In our view the full impacts of these changes, momentous as they have been, still lie in the future.

The first trend: from club to company – and its corollary, increased regulatory oversight

Most national stock exchanges were for many decades owned by the brokers who were the direct users of their services. Those brokers did not consider themselves to be co-owners of a business, but rather members of a club operating a common asset. Exchanges have in recent years moved away from this mutual structure. In retrospect, the demutualization of the Stockholm Stock Exchange in 1993 and the demutualization and listing of the Australian Stock Exchange on its own market in 1998 forged a path subsequently followed, fully or in part, by many other exchanges. By the end of 2008, listed exchanges represented more than 40% of the membership of the World Federation of Exchanges, with an additional 18% having gone through the process of demutualization.2 With ownership, exchange profit (as opposed to member profit) became the main driver. In the decade to 2008, the number of for-profit WFE members more than doubled – to over 80% of members.3

Together with a clear profit motive came increased oversight by regulatory authorities, and a strong policy preference for encouraging competition as a means to discipline powerful, prominent businesses generally considered (at the time) to be natural monopolies.

The relationship between the exchange and brokers changed: the latter, hitherto proprietors, were now customers, and treated as such. This was never going to be an easy transition, and the scars may still bedevil exchange/customer interaction. But the tension between a business and its customers is a universal one: interests are sometimes aligned, and sometimes conflicting. How exchanges have struck a balance, and how they will do so in the future, will help determine the future shape of the industry.

The second trend: rapidly intensifying competition

Following the move from ‘club to company’, regulators and customers alike began to view the exchange less as a public entity, and more as a service provider that ought to be exposed to the same competitive forces as other firms.

Competition in trading services. The United States was the first to pass rules enabling privately owned alternative execution venues to compete with exchanges.4 By 2008, the US had more than 40 equity execution venues, comprising registered stock exchanges, electronic communication networks (ECNs), alternative trading systems (ATSs) and new entrants.5 The impact of the increase in competition has been swift and profound: the New York Stock Exchange’s (NYSE) trading market share in NYSE-listed stocks declined from over 70% in October 2005 to about 25% by March 2009.

On the other side of the Atlantic, European regulators followed the lead of their American counterparts. A milestone was the introduction of the Markets in Financial Instruments Directive (MiFID) in 2007.6 MiFID was expressly designed, amongst other objectives, to enhance competition between market operators.

With the changes, in addition to the platforms envisaged by MIFID, a further significant source of competition in trade execution has emerged. This is trading on brokers’ internal crossing networks. These networks are not currently registered under any of the existing MiFID classifications and are hence largely unregulated. MiFID is currently being reviewed, and it remains to be seen whether the discrepancies in regulatory oversight are addressed.

The third trend: acquisitions as a strategic tool

Enabled by demutualization and encouraged by the globalization of their clients, exchanges have periodically joined in the more general merger and acquisition frenzy. These exchanges can be broadly grouped into ‘globalizers’ wishing to diversify into new geographical markets, and ‘consolidators’ expanding their business within a chosen geographic area.

A variant of the ‘globalizing’ game has been the rush by exchanges and other market participants to stake their claim in fast-growing regions such as Asia and the Middle East, usually through minority stakes.7

The fourth trend: riding the technology tiger

Managing the exponential rate of technological change remains a critical challenge for exchanges. Technology brought about the move from physical trading floors to electronic central order books, which then enabled and required ever greater transaction processing speeds, and expanded the reach and audience for exchange market data. And technology has resulted sharply lower operating costs per trade executed, particularly for new entrants. Many exchanges have had to migrate from legacy systems and structures – a slow and often costly process – whereas more recent market entrants have escaped these migration costs by exploiting low-cost technology from the start.

The acceleration of technological change had some surprising effects. For all but a few exchanges, technology is now largely acquired rather than developed internally. Looking to the future, the rise of third-party technology providers has in some ways leveled the competitive playing field, allowing smaller exchanges to stay abreast of technological change. In many markets, the competitive battle will shift to business models and market positioning, rather than technological differentiation.

But it would be mistake to dismiss the future role of technologically-based differentiation altogether: we may be entering a new era of product differentiation, a possibility that is discussed in more detail below.

The fifth trend: ‘emerging’ markets move from the periphery to the centre

There is by now general recognition that the role of Asia in the global exchange business – as a customer, a destination and a marketplace – is on the cusp of even greater expansion. Already the shape and, to some extent, nature of the global flows of capital and savings have changed radically. Asia (excluding Japan) has become the principal source of new global savings. And those savings are in many instances intermediated by the state – abroad through central bank reserves and other forms of sovereign wealth funds, and domestically (in both China and India) through state-owned banking sectors. Thirdly, enterprises and production facilities in the region are important recipients of capital.

The first half century of the WFE’s existence saw the emergence of an ‘Atlantic’ consensus on exchange activities, in which the US and the EU assumed broadly similar views on regulating capital markets, including embracing a large degree of trading freedom, profit, free transfer of ownership and competition. It is too early to say whether during the next half century, exchanges will see a different, ‘South South’, consensus emerge, including the Indian Ocean giants and countries like Brazil and South Africa. It is already apparent that countries such as India and China are taking a non-Atlantic view on such key matters as exchange ownership and control.

The sixth trend: the return of risk – and a declining belief in market self-discipline

There is nothing like a financial crisis to remind one and all that risk is not a notional concept, and that optimal risk management is a critical objective. Following the American-European financial crisis of 2008, risk management has returned to centre stage.

A silver lining for central counter-party systems. The bilateral risk management characteristic of over-the-counter (OTC) transactions has been particularly criticized. Market participants, policy-makers and the public have woken up to the fact that essentially unregulated OTC markets are sufficiently massive in size (for example, including the large majority of international derivatives markets) that defaults in these markets can imperil global institutions. In oft-remarked contrast, central counter-party (CCP) risk management structures, often operated by exchanges, have been lauded for the manner in which they handled various defaults stemming from the crisis.

US Treasury Secretary Timothy Geithner endorsed the CCP model in written testimony, saying:

“Central clearing of standardized OTC derivatives will reduce risks to those on both sides of a derivative contract and make the market more stable. With careful supervision and regulation of the margin and other risk management practices of central counterparties, central clearing of a substantial proportion of OTC derivatives should help to reduce risks arising from the web of bilateral interconnections among our major financial institutions. This should help to constrain threats to financial stability.”8

Hence the emergence of a widely-held view that many OTC derivatives should be at least centrally cleared through a CCP-type structure, if not also standardized to the degree where they can be exchange-traded. As the memory of the crisis fades, bank and other users of OTC derivatives have pushed back against such regulations with increasing vigor. On balance, it is likely that CCPs – and possibly even exchanges with derivative offerings – will see a greater percentage of this activity. Some market participants, however, are apparently still not reconciled with the entities that they used to own, the exchanges, and they are arguing that if they are going to be required by regulation to utilize exchanges or clearing houses, then these should be run as utilities rather than as for-profit entities.9

Transparency. Another major factor blamed for the crisis was the lack of transparency that prevented regulators from identifying the systemic risk posed by certain institutions and their activities. Once again, OTC markets – opaque by nature – received a share of the blame, and greater transparency was held up as a means of preventing future crises of this nature. Exchanges, CCPs and other central reporting venues were identified may be used to enhance market transparency. According to a recent report prepared for the Bank for International Settlements:

“Introducing CCPs would improve transparency by allowing for easy collection of high-frequency market-wide information on market activity, transaction prices and counterparty exposures for market participants who rely on them. The centralization of information in a CCP makes it possible to provide market participants, policymakers and researchers with the information to better gauge developments in various markets on the position of individual market participants.”10

The 2008 crisis has largely been an Atlantic one. But in one respect its consequences will be global: the renewed emphasis on risk and the reduced confidence in capital markets as self-regulating, self-policing entities will for many years cause a societal bias in favor of increased scrutiny and regulation.

Succeeding in the new reality

The new value reality

When we consider the twentieth century corporate titans mentioned at the start of this chapter, it becomes apparent that quite a few have come undone (national airlines, metropolitan newspapers, broadcasters) or been strengthened (oil majors) by large changes in the core value of their products – i.e., the prices people were prepared to pay for products such as airline tickets, media advertising slots and crude oil changed, and did so permanently. The causes are generally complex, involving profound technological changes, global shifts in markets, and entrants with brand new business models. Yet the impact boils down to something quite simple: a large permanent change in price, usually a fall. So it is, we believe, for the exchange business: The rich tapestry of exchange trends described above boil down to three short, simple statements on value:

Trading services are being devalued. As communication and processing costs continue to fall, and competition intensifies, the long-term trend in the unit prices of standard trading services points inexorably downwards.

Risk management services are being re-valued. Following the financial crisis, the immense social value of the risk reduction offered by exchanges and central counterparties is evident. If this currently widely-shared realization changes the behavior of capital market actors, then the value of offering risk management services will increase – not necessarily in unit price increases, but as volumes in increase, in revenues generated over the same fixed costs.

Regulatory services are being un-valued. Traditional exchanges’ regulatory and listings services are of great value to capital market participants and the economy as a whole. Yet these services are not appropriately valued as a public good by market users or regulators. The result is that exchanges continue to struggle to monetize this value.

Not all exchanges will face the same combination of these value impacts, and not all will respond in the same way. In these shadings lies the difference between relative failure and success.

Strategic responses to the devaluation of trading services

Trading revenues remains the largest component of total exchange revenues, and in many cases, the reliance of exchanges on trading services revenues is growing. According to the WFE’s survey of members, by 2008 trading contributed no less than 53% of overall revenues. This proportion has been rising steadily, up from 43% in 2003, and 39% in 1998. However, the underlying trends of that period, during which falls in the unit prices of trading were compensated for by volume growth, may well not last.

Falling prices need not be a cause for alarm. Trading is a digitized activity that works off a fixed-cost base: It is to be expected that prices will fall as the processing and communicating of digital information become ever cheaper. Broadly speaking, the exchanges in markets with pricing pressures are responding with three strategies:

Leading the charge to win the low-cost game – by exploiting scale, and in certain cases by creating or buying MTFs.

Adding value to trading – for example, by providing trading ‘privacy’ in so-called dark pools, or by catering for the needs of high-frequency traders. An important variation on the value-adding theme is to assume the role of a liquidity aggregator offering smart order routing amongst the various trade execution venues.

Diversifying – to new products and revenue streams. One example is achieving product diversity by providing access to securities traded on exchanges in other geographical areas.

Will the regulated exchanges win the battle for trading?

Only time will tell. Exchanges with the will and discipline to change timeously in the face of gathering competition are likely to prevail. Alternative trading systems may wax and wane as an investment priority for their backers. And many of these new businesses still have to find the equilibrium prices at which they will be viable.

What about exchanges that are operating in jurisdictions where they are the sole provider? In the short run, it may well be a feasible strategy for the incumbent to protect its domain against insurgents, for example by regulatory means. In this way, exchanges in developing markets might usefully buy time to build scale and adjust business models so as to fend off future competitors. But the protection strategy will not work forever: Investors and traders, both domestic and foreign, will seek more trading alternatives, and regulators are likely to become sympathetic to that view. The protection strategy is best understood not as a means to eliminate future competition, but to prepare for it.

Strategic responses to the revaluation of risk management services

The key post-crisis opportunity for exchanges is in risk management. As mentioned earlier, regulators now clearly believe central counter-party clearing to be more prudent than the naked reliance on the deal counter-party that one finds in OTC market. Hence the global talk about the advantages of bringing OTC trades “on-market”.

Work is needed on two fronts. The first is in the regulation and policy debate. In the midst of a financial crisis, multi-billion dollar bail-outs of banks and insurers, and fiscal costs that may be paid by an entire generation made tangible the social costs of poor risk management, both unilateral and bilateral. When systemic risk becomes visible in this way, it is vital to undertake systemic reforms. Therefore, this is a time for exchanges and other suppliers of centralized risk management to provide a strong voice for reform – and to do so for reasons that go beyond self-interest, that go to the long-term health, and hence political viability, of the sophisticated financial markets on which global economic activity depends.

The second front requiring action is customers, particularly the new and possibly reluctant ones migrating from the OTC environment. Exchanges will have to work hard to understand and be responsive to these customers and their particular requirements, a point to which we return below. And all participants, not least customers, need to understand that competing on cost by lowering levels of risk management would not be responsible.

Some exchanges now provide clearing and risk management for OTC derivatives, with Intercontinental Exchange (ICE) gaining a first-mover lead in this realm.11 Derivatives exchanges tend to own their central counterparty clearing infrastructure, though in Europe LCH.Clearnet is a notable independent clearing service provider in that context.

Not all exchanges provide risk management. In the UK and US, most equity exchanges have tended to focus until recently on listing and trade execution services, with post-trade clearing and settlement performed by an independent third party (in the case of the US, a quasi-utility). Exchanges that are not already providing CCP clearing services may seek to partner with or acquire existing clearing providers. NYSE Euronext recently received permission for its derivatives business, NYSE Liffe, to become a self-clearing recognized investment exchange: This means that in future it will be able to act as the CCP for its trades.

Competition will also come from outside exchanges. The US-based Depositary Trust and Clearing Corporation (DTCC) has registered a wholly-owned subsidiary, EuroCCP, in the UK to provide “low-cost” pan-European central counterparty clearing services, predominantly for equities. Similarly, Fortis Bank established the European Multilateral Clearing Facility (EMCF) in 2007 before needing to be saved itself during the financial crisis.12

Strategic responses to the non-valuation of regulatory and listing services

The aftermath of the financial crisis of 2008-09 is not the first period where exchanges have been touted as the solution to a core weakness revealed by the crisis. The Asian crisis of 1997-98 led to a renewed focus on corporate disclosure and governance. Equities exchanges, wielding the power of listings requirements were widely seen as a key part of the solution.

If they are, they have not been paid for it. According to the WFE’s survey of its members, in 2008 listings fees accounted for only 6% of revenues – down from 18% ten years earlier, at the height of the crisis, and before the corporate governance movement had reached its apogee. Why is this?

There is little doubt of the immense social value of the listings function. It is in the realm of the listings rules that new approaches have been set, shareholder rights and managerial practicalities balanced, and entrenched interests overcome. Why, then, have exchanges not been able to monetize the extraordinary value they have created for shareholders and companies alike? The public nature of listings is one part of the answer. A shareholder does not need to trade on an established exchange to have the benefit of the disciplines imposed by its listings function. Thus trading revenue has become disjoint from listings virtue.

It should be of concern to all market users and stakeholders that exchanges may decide to give up their costly regulatory function if faced with competitors that free-ride on this public good.

Further, it is by no means clear that national regulators ought to take over this function or would be able to perform it effectively. Some exchanges in jurisdictions where national legislation lags international norms now require adherence to higher corporate governance standards. BOVESPA’s Novo Mercado is a justly celebrated example of such initiative. In other jurisdictions, the exchange is potentially a more trusted and more sophisticated source and arbiter of these rules of corporate conduct.

This may also apply to other supervisory functions performed by exchanges. In many jurisdictions, the market regulators are reliant on exchanges to provide them with information they require in order to investigate and prosecute insider trading or other instances of market abuse. It is not clear how this is catered for in a more fragmented environment with potentially less regulation. The overall impression is that not only users but regulators undervalue the public good nature of the regulatory services of exchanges.

How the battle between exchange models will be decided

We foresee a mix of models into the future, including hybrids that combine the profit incentive with some customer participation. Generally, though, we believe that the ‘company’ offers a better chance of success than the ‘club’. Exchanges organized as companies have a particularly strong incentive to adapt and prosper, as do their managers. The company form also allows for speedy responses to opportunities, including mergers and acquisitions. Perhaps most importantly, for-profit corporations can more readily access capital – capital that will be needed to fund the strategic responses to the new value reality.

There is some evidence that the ‘companies’ do diversify more quickly. According to the WFE’s 2008 member survey, for non-mutual exchanges, trading accounted for roughly 40-50% of all revenues with “services” contributing a further 25% plus. Listed exchanges were particularly well diversified, deriving nearly 40% of their revenue from other services. By contrast, the four responding exchanges that were associations of members derived over 80% of their revenue from trading. It is worth noting that exchanges that had pursued integration across asset classes relied less on trading revenue (57%) than did their single asset class peers (over 90% for derivative exchanges and 75% for cash only exchanges).

Finally, a word of warning to the ‘companies’. The corporatized exchanges often still have work to do to win back the trust of their customers who might have found the transition from belonging to a club to being serviced by a company to be a jarring experience.

In every industry, the best for-profit companies succeed at winning over customers, and the same will be true of exchanges. More unusually, exchanges will have to deal with a blurring of the lines between customers, competitors and partners, a phenomenon to which we now turn.

Press Release from European Union - Brussels, 29 April 2011

Antitrust: Commission probes Credit Default Swaps market

The European Commission has opened two antitrust investigations concerning the Credit Default Swaps market. CDS are financial instruments meant to protect investors in the event a company or State they have invested in default on their payments. They are also used as speculative tools. In the first case, the Commission will examine whether 16 investment banks and Markit, the leading provider of financial information in the CDS market, have colluded and/or may hold and abuse a dominant position in order to control the financial information on CDS. If proven such behaviour would be a violation of EU antitrust rules. In the second case, the Commission opened proceedings against 9 of the banks and ICE Clear Europe, the leading clearing house for CDS. Here, the Commission will investigate in particular whether the preferential tariffs granted by ICE to the 9 banks have the effect of locking them in the ICE system to the detriment of competitors.

“CDS play a useful role for financial markets and for the economy. Recent developments have shown, however, that the trading of this asset class suffers a number of inefficiencies that cannot be solved through regulation alone. We are therefore opening two new cases to improve market transparency and fairness in the CDS market. The first case will investigate privileged access to CDS transaction data by Markit, an information service provider. The second will examine the existence of preferential treatment by ICE Clear, a CDS clearing platform, of some well established banks who themselves promote this platform at the expense of others. Lack of transparency in markets can lead to abusive behaviour and facilitate violations of competition rules and the Commission should react accordingly. I hope our investigation will contribute to a better functioning of financial markets and, therefore, to a more sustainable recovery,” said Joaquín Almunia Commission Vice President in charge of Competition Policy

CDS information market

The first investigation focuses on the financial information necessary for trading CDS. The Commission has indications that the 16 banks that act as dealers in the CDS market give most of the pricing, indices and other essential daily data only to Markit, the leading financial information company in the market concerned. This could be the consequence of collusion between them or an abuse of a possible collective dominance and may have the effect of foreclosing the access to the valuable raw data by other information service providers. If proven, such behaviour would be in violation of EU antitrust rules (Articles 101 and 102 of the Treaty on the Functioning of the European Union – TFEU). The 16 CDS bank dealers are: JP Morgan, Bank of America Merrill Lynch, Barclays, BNP Paribas, Citigroup, Commerzbank, Crédit Suisse First Boston, Deutsche Bank, Goldman Sachs, HSBC, Morgan Stanley, Royal Bank of Scotland, UBS, Wells Fargo Bank/Wachovia, Crédit Agricole and Société Générale.

The probe will also examine the behaviour of Markit, a UK-based company created originally to enhance transparency in the CDS market. The Commission is now concerned certain clauses in Markit’s licence and distribution agreements could be abusive and impede the development of competition in the market for the provision of CDS information.

CDS clearing

In the second case, the Commission is investigating a number of agreements between nine of the above 16 CDS dealers (Bank of America Corporation, Barclays Bank plc, Citigroup Inc, Crédit Suisse Group AG, Deutsche Bank AG, Goldman Sachs Group, Inc., JP Morgan Chase & Co, Morgan Stanley and UBS AG) and ICE Clear Europe. These agreements were concluded at the time of the sale, by the dealers, of a company called The Clearing Corporation to ICE. They contain a number of clauses (preferential fees and profit sharing arrangements) which might create an incentive for the banks to use only ICE as a clearing house. The effects of these agreements could be that other clearing houses have difficulties successfully entering the market and that other CDS players have no real choice where to clear their transactions. If proven, the practice would violate Art 101.

The Commission will also investigate whether the fee structures used by ICE give an unfair advantage to the nine banks, by discriminating against other CDS dealers. This could potentially constitute an abuse of a dominant position by ICE in breach of Article 102.

The CDS market

CDS are financial products traded between financial institutions or investors. They are derivatives originally created to provide protection against the risk of default. Today, CDS are also used for speculation. Information about CDS is needed to allow market participants to determine the value of their investment portfolios and develop investment strategies. In order to create and sell aggregated CDS information products and services, information service providers need access to a certain amount of CDS transaction and valuation data.

The lack of transparency about the trading of derivatives and financial instruments traded Over the Counter (OTC) became apparent during the recent financial crisis. Given the importance of financial markets for the real economy, the Commission has been working to improve the regulation of CDS and other derivatives (see IP/10/1125 and IP/10/1126). The Commission’s antitrust tools are complementary to these regulatory measures, which together seek to ensure safe, sound and efficient financial markets.

Background on antitrust investigations

Articles 101 and 102 of the TFEU prohibit anticompetitive agreements and the abuse of dominant positions. The implementation of these provisions is defined in the EU’s Antitrust Regulation (Council Regulation No 1/2003), which can also be applied by national competition authorities. The fact that the Commission has opened proceedings does not mean it has conclusive proof of antitrust violations. By initiating proceedings, the Commission relieves national competition authorities of their authority to apply the rules. National courts must also refrain from making decisions, which could conflict with a Commission own decision.

The Commission has informed the parties and the national competition authorities it has opened proceedings in this case.

There is no legal deadline to complete antitrust investigations. The duration depends on a number of substantial and procedural factors.

Co-opetition: thinking afresh about customers and competitors

The demutualization revolution meant that for the first time exchanges had to think about customers, and, with the coming of competition, competitors in a traditional, generic business way. Customers were customers, not members or owners. And competitors became a reality.

The demutualization revolution is now in a second, new phase, and again exchanges need to think about their customers and competitors afresh. This is because, in ways that are quite specific to the securities industry, the lines between customers, competitors, suppliers and business partners are blurring. Customers are competing with exchanges, competing exchanges are cooperating, and both customers and competitors are becoming business partners of exchanges. In a fast-moving industry, this may become the most creative and dynamic area of strategy. At the same time, the lingering discomfort between exchanges and their customers needs to be addressed.

Customers rediscovered

Demutualization gave exchanges the ability to respond to market demands as opposed to simply member demands. But the pendulum may have swung too far, with exchanges being insufficiently attentive to direct user needs. The result has been some appetite for “remutualization”, for example of execution services. Exchanges need to ensure that they understand the requirements of not just the end-users of their services, the issuers and the investors but also the intermediaries. These are, after all, their direct customers.

An important test for the customer skills of the exchanges will come in the form of efforts to attract current users of OTC instruments on-exchange, or into centralized risk management mechanisms. Absent regulatory fiat, customers will need to be persuaded that a move to centralized clearing is in their own interest as well as that of society.

Ironically, demutualised exchanges will face competition from firms that have decided that the best way to listen to customers is in fact to make them co-owners – a trend apparent in various MTFs that have sought in this way to secure trading volume.

Competitors redefined

An exchange and an MTF compete aggressively in one market but agree to cooperate in offering a new service. Or an MTF entering a new jurisdiction may decide to do so in partnership with the incumbent exchange. The common thread is combining competitors with complementary strengths to make a new business feasible. And there is a word for it: ‘co-opetition’, a combination of the two seemingly opposite notions of ‘co-operation’ and ‘competition’. Its proper definition is “the arrangement between competing firms to cooperate on specific projects or in certain areas of business for mutual benefit, even while remaining competitors in general”13 – a venerable notion in technology, and a fairly novel, and potentially potent, one for exchanges.

In a recent example of co-opetition, the Singapore Exchange (SGX) has partnered with Chi-X global to create Chi-East, a pan-Asian, non-displayed trading platform on which Australian, Hong Kong and Japanese listed securities will be available for trading.14 In response to customer demands, and perhaps making a pre-emptive strike against possible competition, both Bursa Malaysia and BM&FBOVESPA have entered into arrangements with the CME Group under the terms of which members of the Brazilian and Malaysian markets are able to access the CME (and vice versa) via the CME’s Globex network. In terms of the Bursa Malaysia/CME agreement, the new Malaysian derivatives trading technology will be provided by the CME and hosted in Chicago. BM&FBOVESPA is contemplating a similar network-type relationship for equities with NASDAQ OMX.15

Four policy paradoxes that will shape the future playing field

Exchanges are not the only players with complex and important choices to make. Policymakers, too, face a particularly acute set of challenges right now. These challenges are best presented as four paradoxes. Why a paradox? It suggests that there is fork in the road where choices will have to be made. How these paradoxes are resolved, both by rule-makers and businesses, will shape the contours of the field of action for exchanges and their competitors.

The regulatory paradox

The regulatory paradox is hard to solve, but easy to state. Despite the post-crisis emphasis on enhanced regulatory supervision, the drive for increased competition has allowed for execution venues subject to different and lower regulatory standards to compete with the regulated exchanges. One important regulatory discrepancy is the ability of these competitors to free-ride on the listings function provided by the exchanges. This listings free-riding problem was noted by the OECD in their report on “The Role of Stock Exchanges in Corporate Governance.” 16

Above, we posed the question of whether the costs of providing regulation, particularly listings, could be fully and appropriately compensated for in the form of fees paid by listed entities such as companies. This poses a severe long-term threat to capital markets if, as we believe, exchanges are uniquely well positioned to perform these critical functions.

The liquidity paradox

The second paradox goes to the heart of efficient capital markets. While direct execution costs may decline as a consequence of competition between execution venues, overall transaction costs (or price discovery costs) may increase as a result of this liquidity fragmentation. The additional costs could arise from required investments in new liquidity-seeking technologies and data aggregation requirements, as well as from increased spreads in certain stocks.

The transparency paradox

The third paradox deals with the key issue of price discovery. In Europe, the primary regulatory focus has been on the extent to which so-called pre-transparency waivers permitted in terms of MiFID have been applied consistently across member jurisdictions, ensuring the existence of level-playing fields. In the United States, the focus has been on the issue of transparency itself. In calling for a response to new proposals to enhance the transparency of dark pools, Mary Schapiro, Chairman of the US Securities and Exchange Commission stated, “We should never underestimate or take for granted the wide spectrum of benefits that come from transparency, which plays a vital role in promoting public confidence in the honesty and integrity of financial markets.”17

In October 2009, the US Securities and Exchange Commission released for public comment measures aimed at increasing the transparency of dark pools to ensure that the trade and related activity occurring on these platforms form part of the broader price discovery process.

The paradox of national interests in a world of global capital

While this financial crisis has seen renewed talk of global regulation, national leaders naturally remain focused on what is necessary for the recovery and protection of their economy. This inward focus may result in the introduction of regulation that seeks to limit the free flow of capital, as well as the ability of local firms and exchanges to forge relationships with foreign enterprises. It is possible, though not yet certain, that the ability of foreigners to access local capital markets or to cooperate with local entities and vice versa may become more constrained in a post-crisis world.

Another example, from our discussion of global trends: the fast-growing Asian nations’ divergence from the ‘Atlantic’ consensus with respect to nationality ownership restrictions on exchanges.

One can expect these regulations to evolve, but it is not clear at this point in which direction that will be, and whether exchange services markets will become more national or global as a result.

A free option on the future

The near-term future of exchanges depends on the ability of these organizations to navigate large shifts in the value of exchange services. To survive and prosper, exchanges will have to be better than their competitors in managing the long-run devaluation of trading services and the re-valuation of risk management services – and also in turning to account the business and social value generated by their regulatory functions, particularly listings.

In the longer run, value too will be determining for the destiny of exchanges: in this case, we mean value in a broader sense than pricing trends – in the sense of creating new and lasting value for customers and society.

A high return to innovation. It is worth recognizing that exchanges sit astride three key processes of modern economies:
the allocation of resources through capital markets,
the custodianship and governance of long-term investments, particularly in companies, and
the management of financial risks.

These are important and complex areas in which new insights, service delivery models and products that add value will yield enormous returns. There ought to be no limit to the ability of exchanges to devise new means of adding value to their customers.

Markets are on a strong growth trajectory. The financial crisis that forms the backdrop of the last few years ought not to obscure the momentous changes that are taking place in the world economy, and very much so in leading developing countries. The resulting massive long-run increase in global economic activity augurs well for exchanges.

Geared growth. In our view, the business of securities exchanges will grow even more quickly than the underlying economy. This is because within that economy, another momentous shift will be taking place. In future, as macro-economic balances shift and long-term savings institutions throughout the developing world mature, a larger part of these massive savings flows should logically shift to investment in traded securities such as equities.

The business of exchanges is not simply trading, clearing and settlement; it is to be a core part of the ever-innovating process of financial intermediation. Regulated exchanges all over the world have a free option to add extraordinary value to this process as the future unfolds.

About Stephan Malherbe

Stephan is the founder and chairman of Genesis Analytics, the largest economics consultancy in Africa. He is also the chairman of sister Genesis companies in India and Dubai providing advice in the areas of regulatory and competition economics and financial services policy and strategy respectively. He was educated in law at the University of Stellenbosch in South Africa and in economics and policy at the Kennedy School of Government, Harvard University. Stephan's work on capital markets combines macro, market development and competition perspectives. He was a principal co-author of the benchmark report of the International Organisation of Securities Commission on the emerging markets financial crisis of 1997-1998. The report focused on the role sound capital market institutions can play to reduce the incidence of financial crises precipitated by private cross-border capital flows. He also authored capital markets development strategies for the South African government and has advised on nascent capital markets in low-income countries. This work links sound design of capital markets to ensuring sound allocation of capital and risk management in virtually all types of economies. Corporate governance work for, amongst others, the Development Centre of the OECD has focused on the potential role for long-term institutional investors and exchanges in improving the quality of decision-making in large publicly traded businesses. As a competition economist practicing in a number of jurisdictions, he has worked on both merger and conduct cases dealing with equity and bond markets, derivatives markets and central securities depositories. Stephan has provided economic policy advice to a number of African countries at a presidential level, including Mozambique, Rwanda and Liberia. He played an influential role in the drafting of South Africa's democratic constitution with respect to the economic aspects of the Bill of Rights and the constitutionally guaranteed independence of the country's central bank. He was also a member of the team that designed the country's competition policy. Currently, Stephan splits his time between practicing in India and South Africa.

About Siobhan Cleary

Siobhan Cleary heads up the JSE's strategy team and forms part of the Strategy, Investor Relations and Legal Counsel Division headed by Nicky Newton-King, Deputy CEO. Prior to joining the JSE at the start of 2006, Siobhan worked as a Business Law lecturer at the University of Cape Town and was a Manager (Strategy) with global management consulting firm, Accenture. Her Accenture clients included several major South African financial services firms as well as one of the world's largest NGOs. As part of the consulting engagement for this last client she spent six months in Bangladesh. She has also published in the field of development economics. Since joining the JSE, Siobhan has worked on (amongst other projects) the JSE's listing, the JSE's acquisition of the Bond Exchange, the strategic review of the SRI Index and the establishment of the JSE's All Africa Indices. Siobhan's interests are varied but she is particularly fascinated by the interplay between the private and the public and not-for-profit sectors.

About Nicky Newton-King

At the JSE, Miss Newton-King leads the JSE's legal, strategy and investor relations teams. Over the years, she has been part of various teams which were responsible for drafting key legislation affecting the South African financial markets including the Insider Trading Act, 1998, the Securities Services Act, 2004 and the new Companies Act. She is also a member of the Financial Markets Advisory Board, the Standing Advisory Committee on Company Law and the Presidential Remuneration Commission which determines the remuneration of all South African Public Office Bearers. Nicky lead the development of the JSE's Socially Responsible Investment Index, the first such index in the world sponsored by an exchange and has lead most of the JSE's group level transactions including the acquisition by the JSE of the South African Futures Exchange and the Bond Exchange of South Africa. Nicky was one of the South African Global Leaders of Tomorrow appointed by the World Economic Forum in 2003 and is a WEF Young Global Leader. She was South Africa's 2003 Businesswoman of the year and in 2006 spent 5 months at Yale University as a Yale World Fellow.Nicky is married with 2 young sons and prefers to spend her private time with her family.

1 Because of problems in ensuring information comparability, the "regulated exchanges" referred to in this chapter are the exchanges that are members of the World Federation of Exchanges (WFE).
2 Based on a review of 45 of the 51 member exchanges - "2008 Cost and Revenue Survey", Devai, R., World Federation of Exchanges, October 2008.
3 Ibid, pg 9.
4 The most recent US regulation, Regulation National Market Systems (also known as Reg NMS) was fully enacted in October 2007.
5 "Is market fragmentation harming market quality?" O'Hara, M. and Ye, M., 10 March 2009, Available at SSRN:
6 MiFID was adopted in 2004, and finally implemented on 1 November 2007.
7 Examples are NYSE/Euronext taking a 5 percent stake in the National Stock Exchange of India and concluding a strategic partnership with Qatar's Doha Stock Exchange, while Deutsche Borse acquired its own 5 percent stake in the Bombay Stock Exchange. NASDAQ-OMX recently sold its 33% stake in Nasdaq Dubai to rival exchange Dubai Financial Markets (DFM) for a combination of cash and a 1% stake in DFM.
8 Tim Geithner, Written Testimony to the House Financial Services and Agriculture Committees, Joint Hearing on Regulation of OTC Derivatives, 10 July 2009.
9 In a joint response to the European Commission Working Group paper entitled "Ensuring efficient, safe and sound derivatives markets" published in July 2009, industry bodies ISDA, SIFMA and LIBA indicated that while they were not opposed to CCP clearing of suitable instruments, they believed that CCPs that are owned by for-profit clearing houses are "driven by revenue and commercial drivers, which are not obviously aligned with the core purpose of a CCP, namely risk reduction".
10 "Central counterparties for over the counter derivatives", Cecchetti, S., Gyntelberg, J., and Hollanders, M., BIS Quarterly Review, September 2009.
11 "Competition in OTC Clearing Comes with Its Own Risk - ICE CEO", Bunge, J., 22 October 2009, Dow Jones Newswire,
12 EuroCCP website, "About Us",
13 Free Encyclopaedia of eCommerce,, accessed on 29 November 2009.
14 "LCH.Clearnet to clear for SGX-Chi-X dark pool", The Trade News, 18 November 2009,
15 "Nasdaq OMX and BM&F Bovespa in partnership talks", Finextra, 27 August 2009.
16 OECD: Directorate for Financial and Enterprise Affairs, Steering Group on Corporate Governance, July 2009. In the report, the OECD notes the important historical role played by exchanges in the regulation of listed companies and the promotion of corporate governance. While the report points out that concerns have been raised regarding the ability of exchanges as for-profit entities to continue to perform this function in a meaningful fashion, it also concludes that there is no concrete evidence that exchanges do not continue to play an important role in this regard.
17 "SEC Issues Proposals to Shed Greater Light on Dark Pools", US SEC Press Release, 21 October 2009.
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