Exchanges jostle to escape the middle

According to the Austrian economist Joseph Schumpeter, the “process of creative destruction is the essential fact about capitalism”. It is therefore apt that the investment exchanges, the places where investors and issuers meet at the crossroads of capitalism, should be exemplifying this so fully.

It is unusual to see the competitive market operating at full throttle in financial services. Ironically for an industry that is capitalism’s battering ram, parts of it appear to be oligopolistic, protected from competitive forces by high barriers to entry and a cozy deal between customers and suppliers. Exchanges, by contrast, have met technological change and globalisation head on. The result has been a state of constant reinvention culminating, in the past five years, in a series of transformational mergers.

Perpetual thrust and parry amongst exchanges has occurred in every major financial jurisdiction. In the US, Nasdaq, a market that was only formed in 1971, often out-traded the long-established New York Stock Exchange in the early years of this century. Determined to be part of the global story, the NYSE bought an electronic trading platform in the US and in 2006 merged with Euronext in Paris.

The UK, a historic home of joint stock trading, has seen more change than most. Before “Big Bang” financial reforms a quarter of a century ago, the London Stock Exchange operated on a market floor in Threadneedle Street. The LSE was a member-owned mutual society with a near-monopoly of secondary trading and new issues. Its principles had not changed for decades and its customs and practices could be traced back to their origins in London’s 18th-century coffee shops.

The deregulation that was completed in 1986, a decade or so after a similar change in New York, changed the relationships of the exchange’s members and opened it up to outside competition. The LSE demutualised, revamped its technology and professionalised its management. After a series of near-misses, it merged with its Italian counterpart and is now hoping to do the same with TMX Group, owner of the Toronto and Montreal exchanges. It is unrecognisable from the institution that existed 10 years ago, let alone 25.

This is some story for an organisation that had a clubby history and a reputation for sloppy management, but it may not be enough. While the market will continue to grow as a result of technology-enabled rapid-fire trading and new regulations forcing more derivatives on to recognised exchanges, competitive pressures on margins and market share will not go away. Pressure will come from start-ups, financial institutions seeking to keep as much order flow as possible in-house, and from an emerging group of exchange behemoths of which LSE-TMX would be a fringe member at best.

For while the LSE has been through exhilarating change, others have moved even faster. As a result of financialisation in China, Hong Kong Exchanges & Clearing has a market capitalisation about three times that of the projected LSE-TMX Group, as does the Chicago Mercantile Exchange following its acquisition of its rival the Chicago Board of Trade in 2006. The NYSE-Euronext group is in merger discussions with Deutsche Börse, and if this were to occur the new entity would form the world’s largest exchange measured by revenues and profit.

Mergers on this scale have the potential to redefine what exchanges do. As investment banks and hedge funds converge into the exchanges’ space, will the exchanges start to fight back and migrate into their customers’ territory, initiating deals and forming closer relationships with investors and issuers?

Mega-mergers can also reshape the competitive landscape. There is a risk of a classic “squeezed middle” getting caught between the emerging top three and smaller “dark pool” exchanges operating in niches. Exchanges such as LSE-TMX or the proposed Singaporean-Australian SGX could fall into this category. This would be a challenge but should hold no fears for, as we learnt from Schumpeter, creative destruction is a process, not a result.

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