When Olof Stenhammar launched Sweden’s Options Market (OM) in 1984, it was the platypus of the derivatives industry: a privately-owned, for-profit options exchange with no trading floor and no liquidity pool. A few years later, OM opened the first subsidiary exchange, OM London (today’s EDX), and floated shares in itself on the Stockholm Stock Exchange (SSE). Later, OM bought and spruced up the venerable SSE, and today OM is the core of Nordic-Scandinavian powerhouse OMX, which has exchanges in Copenhagen, Stockholm, Helsinki, Riga, Tallinn and Vilnius.
What’s more, lacking a home market the size of, say, Germany, and being obligated to its shareholders to deliver a profit, OMX has sold its technology almost from day one — and today it supports exchanges from Hong Kong’s HKX to New York’s International Securities Exchange (ISE).
The ISE, of course, was seen as breaking new ground when it launched in May 2000 as a privately-owned, for-profit options exchange with no trading floor and an already fragmented liquidity pool dominated by long-established exchanges. Today, ISE is battling the Chicago Board Options Exchange for options dominance, and OMX is the template for start-up exchanges from Mumbai to Tanzania, and for technology providers from London to Bangalore.
CLUB TO CORPORATION
Until the late 1990s, most futures exchanges, and all American exchanges, were member-owned “mutual” enterprises; and OM was the odd man out. Germany’s Deutsche Terminbörse (DTB, one-half of Eurex), however, operated for-profit and without a trading floor from day one. In 1997, it became the first exchange to wrestle an existing liquidity pool away from a competitor when it took the bund away from the London International Financial Futures and Options Exchange’s (Euronext.Liffe) member-owned trading floor and sparked that exchange’s lightning-fast migration to computers and eventual demutualization.
Demutualization is the process of shifting from a mutual ownership structure to a shareholder-owned structure and most exchanges have either made the shift or are in the process of doing so, in part because demutualization gives members a chance to cash in their chips, but also because a shareholder ownership structure offers distinct advantages versus the mutual model.
“As membership organizations, the exchanges were political beasts,” says James J. Angel, finance professor at Georgetown University. “That made decision making very slow and hard to implement. And in a rapidly-changing environment, the company needs the option value of having to move fast when an issue comes up.”
But in what direction are the exchanges moving? “When exchanges go public, the real master is the shareholder, who may not be in the trading business,” says Steven J. Sanders, managing director of marketing and business development for Interactive Brokers LLC. “Before, it was the traders who had an interest in promoting things that were good for their business. When you move to this model, the only thing that keeps that in check is competition and lots of it.”
However, competition is a sticky issue in futures, where existing exchanges with deep liquidity pools and long-standing clearing and settlement arrangements are difficult to unseat, except through seismic shifts in the trading landscape, as happened when the electronic DTB took the Bund away from Liffe in 1997. A liquidity pool is especially important in futures because contracts are not fungible; a long bund position on Eurex, for example, cannot be offset on Euronext.Liffe.
And then there is the issue of an exchange that owns its own central counterparty (clearing house), such as Deutsche Börse or the Chicago Mercantile Exchange (CME), the two largest. Not only can the exchange deepen its monopoly by restricting access to its clearing and settlement apparatus, but it can cross-subsidize its execution business with its clearing and settlement income, says Ruben Lee, founder and managing director of the Oxford Finance Group and author of the book What is an Exchange?
“Basically, when you develop new products, it’s extremely important to have full cooperation from the clearing house,” says Benn Steil, director of international economics at the Council on Foreign Relations. “Liffe as well as ICE are dependent on an arms-length contractual agreement with LCH, and that’s not always pleasant.”
The CME demutualized November 2000 and went public December 2002. Its share price has soared, and in earnings per share, its valuation is well above that of the ISE. A key difference between the two entities: the ISE deals in options, which are fungible, while the CME deals in futures and futures options, which are not.
“I wonder how many members truly appreciate that now the exchanges are not there for their benefit,” says David Webber, CEO of independent software vendor (ISV) Patsystems. “Now they are there to benefit shareholders, and they’re only bringing their prices down for the same reasons I would bring my prices down: to win business and maximize profitability. That’s not the same as serving your members.”
KEEPING THEM HONEST
No one denies that exchange fees have downright imploded throughout the past five years, and competition is certainly the primary reason with technology serving as the enabler.
“The driver bringing down costs is technology,” says Arman Falsafi, the CME’s managing director for Europe, Middle East and Africa. “Running an electronic exchange is characterized by high fixed costs and low marginal costs. To build Globex costs a ton of money, but the marginal cost of processing that next trade is fairly small.”
In a nutshell, she says low fees are here to stay, regardless of whether existing exchanges face bona fide competition. “The kind of growth we’re achieving is a natural effect of the fact that our rates keep coming down, because we’ve revamped our entire pricing apparatus so that the more you trade, the lower your rates go,” she says. “That means each incremental contract a customer trades brings his fees down by design. It’s a virtuous cycle, where lower fees lead to growth, which leads to better pricing for the customers.”
The exchange’s goal, then, is to set fees high enough that it can make a profit, but not so high that it discourages active trading. The premise is that such a strategy will ensure low fees regardless of the competition — because the exchange wants people trading as actively as possible.
Such strategies have sparked competition among software vendors who serve the new for-profit exchange sector. London-based Rolfe & Nolan is in the midst of an extremely successful roll-out of a product called Fees Direct after it became clear that several larger futures commission merchants (FCMs) had missed out on hundreds of thousands of dollars in fee rebates.
But users are not universally convinced the low-price-equals-high-volume equation is enough to keep driving down fees. A case in point: fees on the Chicago Board of Trade (CBOT) plunged noticeably when Eurex opened its Chicago-based Eurex US platform in February 2004, but rebounded slightly once the threat was gone. The same scenario played out with the CME when faced with competition for its Eurodollar contract from Euronext.Liffe. Neither exchange’s fees have come anywhere near their pre-Eurex U.S. levels.It is clear that supporters of Eurex US including some Deutsche Börse shareholders faced a win-win situation.
On the European securities front, continental banks set up x-clear in 2003 to provide clearing and settlement on Switzerland’s virt-x exchange. And more recently Citgroup, Credit Suisse, Fidelity Brokerage Company, Lehman Brothers and Merrill Lynch created a trading platform called LeveL, which lets them match with their own order flow as well as contra-party trading — clearly with an eye on the implementation of the Markets in Financial Instruments Directive (MiFID), a complete overhaul of the European financial services regulatory framework.
A cornerstone of MiFID is the best-execution provision, which larger banks and brokers are lobbying to bring into effect, and no wonder: It would force brokers to deliver best execution to their customers, and would put more pressure on exchanges to make competition among platforms as easy as possible.
Ironically, the mature stage of the trend towards demutualization appears to be new, user-built platforms, which run on a business model that looks a lot like the mutual platforms of old.
COMPETITION DEFINED
Competition, of course, doesn’t have to be direct to be effective. “Just look at JADE, the new joint venture between the CBOT and the Singapore Exchange (SGX),” says Webber. “They have launched a rubber contract that doesn’t compete exactly with the Malaysian exchange’s rubber contract, but you can see how it moves into same territory.”
Ditto the battle between the CBOT and the Brazil Mercantile and Futures Exchange on Brazilian soybeans destined for China: such products compete not just on price, but on delivery points and expiry procedures. “We’re seeing more and more innovative products,” Webber says. “Euronext.Liffe is launching a series of bond indexes based on the MTS cash platforms — that’s a product that competes with Eurex’s bund, but not by offering the same product cheaper.”
Even murkier still are the incestuous waters inhabited by exchange subsidiaries such as Euronext subsidiary GL Trade, an ISV that provides connectivity to exchanges around the world. GL Trade recently co-sponsored a road show promoting both Liffe.Connect’s new Linux-based trading platform and Fortis Banque’s new incentive program for traders on rival Eurex.
Virtually every conceivable competitive relationship has been comprised of such strange bedfellows. “If you have a member who is trading the exchange-traded derivative and the OTC derivative at the same time, then their biggest customers are also their biggest competitors,” says Angel, citing New York Stock Exchange market-maker Brute LLC, which is also Nasdaq’s broker-dealer subsidiary. “Here, one of their biggest customers is one their biggest competitors.”
“The CME looks at players in the market, like Citigroup, and says, ‘they are not just a customer, they are a competitor,’” says Stein. “You’re going to see a heck of a lot more innovation in the derivatives industry.”
And innovation means change. “I’ll be surprised if in five years time we have the same independent names as we have now still in place,” Webber says. “As exchanges consolidate and compete, they’ll become even more efficient, but they may not be achieving the same returns on capital.”
“I do think there is a case for exchanges to consolidate and have more global scale and product diversity against using some well-respected technology underneath that,” says Jeff Sprecher, CEO of the Intercontinental Exchange (ICE). “Not withstanding that roll up, there will be more exchanges. The barriers to entry are even lower now than when I tried to do it. You will see more competition, but also consolidation that will lead to larger exchanges. That will be good, it will be a very healthy market.”
And let’s not forget that when ICE first launched, it wasn’t serving a centralized futures market, but rather providing an OTC energy platform. It’s this kind of point-to-point model that is taking off around the world, and only gradually evolving into a centralized, hub-and-spokes model.
AGE OF THE MICRO EXCHANGE?
Colin Howard, chairman of Comdaq, a software company and consultancy that builds trading systems for smaller exchanges is banking on an explosion of micro exchanges. “The time has come for what Patrick Young calls ‘micro-exchanges’ — small, niche platforms that can be set up for less than $200,000 and meet the needs of an illiquid but existent trading community.”
The reference is to Young’s 1999 book Capital Market Revolution, which described a future dominated by tiny niche markets that meet a regional hedging need and bring it to a global market. “We’re seeing micro-exchanges in emerging markets, new instruments, the securitization of assets in new ways and exchanges built on a hypothesis, not fact — particularly sports exchanges.”
By Howard’s criteria, ISE is downright old-school compared to the new wave of ventures like Mumbai’s Multi-Commodity Exchange of India, a Windows-based project that in less than a decade has become the world’s second-largest natural gas exchange and lists multiple futures across 11 sectors.
“This has been entirely driven by entrepreneurial energy, which with demutualization became respectable,” Howard says. “When everything was mutual, a cooperative if you like, then there was something ‘not quite right’ about being commercial — and because the participants owned the operation, they did not look elsewhere for market opportunity. If they needed something, a new product, then they demanded that their market provided it.”
Although the major legacy exchanges are still flying high, Howard says the future belongs to microexchanges. “The big exchanges who thought they were becoming commercial retained significantly the same management,” he says. “That has been a huge restraint, because people brought up within a protected community cannot reinvent themselves and become entrepreneurs. They retain a natural resistance to ideas; they reject outside participation; they believe they need no advice.”
Falsafi would certainly find fault with his characterization of larger exchanges, but she agrees microexchanges have a future. “In this business, especially now that we’re all for-profit and publicly-owned, you have to be coming in saying, ‘I can do something that isn’t being done,’ or, ‘I can do it better.’ If a commodity exchange doesn’t exist in a country that can benefit from commodity risk management, some smart person is going to figure it out and start one and figure out how to build liquidity. It’s not easy, but it’s been done and it will be done — but it’s demand-driven, customer-driven — and in the electronic world the customers are more diverse.”
Falsafi is also skeptical of the tendency to view legacy exchanges as clunky old dinosaurs pointing out even the largest exchanges have fewer employees than most Fortune 500 companies.
“Our demutualization was a commitment to go down a different path than we had been on the previous 100 years,” she says. “In a mutual, the interest of the members was the driving force behind the institution, and we realized we had to change our path and our direction and do it in a committed way for the long haul. Demutualizing and going public were part of a conscious decision to not just respond to the challenges facing us today, but to the challenges that will face us down the road.”
Specifically, she says, the CME now has to deliver growth to shareholders — and it will do that by keeping painfully aware of the cutthroat nature of the business it’s in. “This business isn’t about maintaining products, but about maintaining a spirit of innovation and invention,” she says. “Twenty years ago, the Eurodollar didn’t exist, but we invented it, and we’re going to have to keep inventing things or we lose — we’re very aware of that.”
And Webber, from his perspective as a technology provider, says the CME is far from alone in trying to remain innovative. He points to Euronext.Liffe’s new index futures based on government bond indexes developed by MTS — a company that, less than a decade ago, was itself an innovative modular platform set up by the Italian treasury, and today is 50% owned by Euronext.
The indexes will offer pan-European coverage and country-specific coverage for France, Italy and Germany — and they’ll even pay interest. “They’re not just trying to offer a cheaper way of trading bund futures but are competing by coming into that territory with a whole new concept,” Webber says.
THE DREAM/NIGHTMARE
“If you list your shares, you live both the dream and the nightmare,” says Lee. “The nightmare is, theoretically, a takeover — although an exchange is somewhat protected both politically and otherwise.”
One exchange that wasn’t protected was the Deutsche Börse, which put all of its shares in free-float in an admirable show of support for the market itself. As a result the German bankers who long owned and controlled the exchange essentially lost control in 2002 (see “Meet the new boss,” below), setting the stage for last year’s hedge fund coup (see “Corporate governance: Who pulls the strings,” September 2005), in which London-based Children’s Investment Fund led a successful charge to depose Werner Siefert and sink his attempt to merge with the London Stock Exchange, which just a few years ago had fought off a hostile takeover attempt by none other than Stenhammar and his Swedes.
Lee says there’s something else to worry about: the unlikely but possible bankruptcy of a major exchange. Howard points out that scores of smaller exchanges have failed, and in some cases been put on their feet by savvy investors. Also, let’s not forget that Enron ran its own trading platform and the market simply abandoned it in favor of regulated exchanges once the writing appeared on the wall.
But Lee says if a major exchange with its own central counterparty (CCP) went under, governments would rush in — rightly or wrongly — to bail it out. “The operation of a CCP goes to the heart of a country’s payment system, and any government will therefore be extremely loath to allow such an institution to go under,” he says. “The notion that it might be possible for an exchange to be allowed to go under, while still ensuring the financial sustainability of a CCP that it owns, assumes that sufficiently tight financial firewalls can be created around the CCP for it to survive, even if its owner fails. Given the general difficulty of supervising financial conglomerates, this is a notion that few governments will be willing to put to the test.”
The problem, of course, is moral hazard. “The management of for-profit exchanges are paid, and will seek to take risks to maximize the exchanges’ profitability,” he says. “However, they will know that any serious mistakes they make are likely to be supported in the end via government subsidy. Exchange management may therefore take excessive risks.”
The issue could be especially pronounced in developing countries, or in Eastern Europe, where government interventionism is still considered a valid method of correcting private sector failings.
But even if that happens, the blessings of demutualization are here to stay. The general consensus is that, five years from now, we’ll have a few massive exchanges and perhaps hundreds of microexchanges — providing opportunities of their own, and reminding big boys like ICE and OMX where they came from just a few years ago.
