A Free Option on the Future: Regulated Securities Exchanges beyond 2010

Author Name: 
Stephan Malherbe, Siobhan Cleary, Nicky Newton-King


The business of financial intermediation – bringing capital to new endeavours, 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.[i] 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 Major newspapers, and to a large extent traditional broadcasters, are being superseded by other forms of information delivery.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 demutualisation of the Stockholm Stock Exchange in 1993 and the demutualisation 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 demutualisation.[ii] 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.[iii]

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.[iv] 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.[v] 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.[vi] 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 demutualisation and encouraged by the globalisation of their clients, exchanges have periodically joined in the more general merger and acquisition frenzy. These exchanges can be broadly grouped into ‘globalisers’ wishing to diversify into new geographical markets, and ‘consolidators’ expanding their business within a chosen geographic area.

A variant of the ‘globalising’ 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.[vii]

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 levelled 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 criticised. 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.”[viii]

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 standardised 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 vigour. 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 utilise exchanges or clearing houses, then these should be run as utilities rather than as for-profit entities.[ix]

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 centralisation 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.”[x]

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 favour of increased scrutiny and regulation.

[i] 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).

[ii] Based on a review of 45 of the 51 member exchanges - “2008 Cost and Revenue Survey”, Devai, R., World Federation of Exchanges, October 2008.

[iii] Ibid, pg 9.

[iv] The most recent US regulation, Regulation National Market Systems (also known as Reg NMS) was fully enacted in October 2007.

[v] “Is market fragmentation harming market quality?” O’Hara, M. and Ye, M., 10 March 2009, Available at SSRN: http://ssrn.com/abstract=1356839.

[vi] MiFID was adopted in 2004, and finally implemented on 1 November 2007.

[vii] 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.

[viii] Tim Geithner, Written Testimony to the House Financial Services and Agriculture Committees, Joint Hearing on Regulation of OTC Derivatives, 10 July 2009.

[ix] 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”.

[x] “Central counterparties for over the counter derivatives”, Cecchetti, S., Gyntelberg, J., and Hollanders, M., BIS Quarterly Review, September 2009.


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