RTS Supervisory Board Chairman and University of Karlsruhe Professor Jörg Franke knows a thing or two about global exchanges. He’s the man who built up the screen-based Deutsche Terminbörse (German Derivatives Exchange, DTB) throughout the 1990s and took the Bund volume away from the floor-based London International Financial Futures and Options Exchange (Liffe), signaling the beginning of the end of open-outcry trading.
In the ensuing race between Liffe and DTB’s successor, Eurex, to build the planet’s fastest trade-matching engine, it’s often forgotten that what won the Bund wasn’t technology per se, but rather the distribution that technology delivered: DTB not only had screens, but it had them located on the desks of traders in Chicago and elsewhere. “Technology enables distribution,” says Franke. “Our distribution was, well, not exactly global by today’s standards, but broad, certainly when compared to the trading floor.”
Jane Wheeler points out that distribution and the race to achieve it is one of the key drivers behind the current wave of cross-border mergers. As senior managing director of Evercore Partners, she’s advised the Intercontinetal Exchange’s (ICE) acquisition of the New York Board of Trade (Nybot), the sale of Instinet to Nomura, and the FX Marketspace joint venture between the Chicago Mercantile Exchange (CME) and Reuters. “In the long run, exchanges are expected to add value in clearing and distribution and less so in trade-matching technology,” she says.
“That’s because trade-matching technology is now something where you either meet the standard or you don’t, so competitive exchanges are at the same level, which you can’t say about clearing and distribution.”
She adds a third competitive driver: product development, most clearly illustrated by the exchange assault on the over-the-counter (OTC) world. The rise of the ICE was nothing less than the commoditization of OTC energy markets, and the $30 trillion market for credit-default swaps is in the crosshairs of every major derivatives exchange, some of which have already managed to tease a bit of that business onto clearing systems.
The challenge now is to convert that success to exchange-traded products — not easy, since the dozen or so major banks that control order flow don’t want to lose that fat-margin volume. “This all means exchanges compete in part by getting big,” Wheeler says.
And that size extends in three dimensions: global reach, which enables the capture of volume from around the world; integrated clearing and settlement, which makes it easier to hold onto that volume by enabling cross-margining; and of course successful products, without which nothing matters.
SHAPE OF THINGS
But how to achieve size and global reach? In Europe, two approaches have emerged to capturing volume from across regulatory regimes. Deutsche Börse by and large bloated into one massive blob of liquidity attracting volume from around the world via a global distribution network, while Euronext assimilated diverse existing exchanges operating in various asset classes and regulatory regimes into a modular, borg-like entity with a central liquidity pool surrounded by the remnants of once-independent entities.
The cross-border mega-merger between the New York Stock Exchange (NYSE) and Euronext, as well as pending deals between New York-based Nasdaq and Scandinavia’s OMX and between Germany’s Eurex and the International Securities Exchange Inc. (ISE), all clearly follow the Euronext model. In fact, when announcing the merger between his exchange and Euronext, NYSE boss John Thain even cited Euronext’s expertise in amalgamating diverse entities into a functioning whole as being one of the intangibles his exchange was acquiring.
The CME and the Chicago Board of Trade (CBOT), however, represent a different approach. Although massive in scale, that pending deal would be a merger of two similar entities operating in one regulatory environment — a structure easier to take global when the products are all derivatives. The CME, in fact, was the first major exchange to really think globally — initiating the world’s first-ever mutual offset agreement, with Singapore, in 1984 and launching the Globex electronic platform in 1992.
NYSE-Euronext is predominantly a securities operation, and must therefore contend with more complex regulatory hurdles and a more fractured clearing and settlement network than does a pure derivatives platform.
Franke says that means it will be years before NYSE-Euronext exists as an exchange in any real sense, although it became a legal entity in April. “Don’t underestimate the complexity of combining exchanges,” he says. “This will take a long time and require a lot of change to become a success — and even provides a chance for Deutsche Börse to move ahead.”
Franke says it’s still possible to become big organically, even in equities, with a minimum of complex cross-border mergers. “It’s by far easier now than 10 years ago to combine market participants,” he says. “Asians can trade directly on U.S. and European exchanges, and Europeans can trade directly on U.S. or Asian exchanges, but the Securities and Exchange Commission (SEC) is not allowing U.S. participants to directly trade non-U.S. exchanges.”
Recent comments out of Washington indicate that may change. Weeler says whichever consolidation strategy wins in the short term will be little more than a transitional form until something more efficient comes along. “Long-term,” she says, “the financial capital of the world won’t be in New York and it won’t be in London and it won’t be in Paris and it won’t be in Tokyo and it won’t even be in Shanghai. It will be in cyberspace.”
Patrick Young, Executive Director of ODL Monaco and author of the new book The Exchange Manifesto, says that consolidation will continue — whether cross-border or domestic.
“There are still clearly three types of exchanges,” he says: “Predators, prey, road kill.”
While outright mergers have been the headline-grabbers the past year, there is also a massive proliferation of alliances and cross-holdings.
“South Korea, Taiwan, Thailand, Singapore, the Philippines and Australia have all signed comprehensive deals with the Tokyo Stock Exchange (TSE),” says Herbie Skeet, CEO of Mondo Visione. “And the Australian Stock Exchange itself has been entering into agreements with the Korean, Taiwanese, Philippine, Thai, Singapore, Tokyo and Hong Kong stock exchanges, while Singapore’s SGX has signed memoranda of understanding with the Shanghai Stock Exchange and the Shenzhen Stock Exchange.”
In India, Goldman Sachs has a nearly 10% stake in the National Commodities and Derivatives Exchange (NCDEX), and Fidelity has a similar stake in the Multi-Commodity Exchange (MCX). On the equities front, NYSE and Goldman have each bought into the National Stock Exchange (NSE), while SGX and Deutsche Börse have each bought into the Bombay Stock Exchange (BSE).
It’s not, however, clear what these stakes mean. All of the buyers insist they are simply diversifying their holdings and not looking for strategic endeavors, and the management of NSE has made it clear that SGX and Deutsche Börse bought their stakes from shareholders cashing in, rather than at the invitation of NSE management.
More interesting is Tokyo, where new TSE boss Atsushi Saito has been brought in explicitly to expand the exchange’s offering of products and boost its international standing via international alliances as the exchange prepares for its 2009 IPO.
In a plan that echoes similar attempts in Germany to create “Finazplatz Deutschland” in the 1990s, Japanese Financial Services Minister Yuji Yamamoto, with the backing of Prime Minister Shinzo Abe, wants to turn Tokyo into a hub that can compete with Hong Kong and Singapore. That means forced consolidation or at least cooperation among competing exchanges (see “Asia: Almost here,” June 2007).
Then there’s the Dubai International Financial Centre (DIFC) and its subsidiary, the Dubai International Financial Exchange (DIFX), which are attempting to outbid Nasdaq for OMX.
Interestingly, two of the top dogs at DIFX are high-ranking European exchange executives who were unexpectedly, and many would say unjustly, squeezed out of their jobs in the past few years. DIFX boss Per Larsson had run Sweden’s OM for six years, but was forced out when the exchange merged with the Helsinki Exchange to form OMX in 2003, while DIFX advisor George Möller ran the Amsterdam Exchanges and was promised the top job at Euronext, only to be shunted aside when Jean-Francois Theodore decided to stay on in 2004.
SIZE BEGETS PRODUCT
Another advantage of getting big is having the cash market connections to launch proper derivatives products.
One of Euronext’s jewels is euro-MTS, the secondary government bond platform that changed the way Europe handles its public-sector debt. MTS gives Euronext the ability to construct interest-bearing, tradable European bond index products, and as Euronext is folded into the NYSE, you can bet that expertise will be harvested for other regional products offered via the ever-expanding global distribution network.
The new Joint Asian Derivatives Exchange (JADE) in Singapore draws on the global distribution of the CBOT’s e-cbot system and the clearing and settlement of the SGX to offer a dollar-denominated palm oil contract that can be traded on the same platform as corn and soybean oil, for example.
Despite all the talk about size, Young says there’s plenty of room for left-field competition. In his 1999 book Capital Market Revolution, he wrote that established exchanges would spend the ensuing decade scrambling to compete with upstarts, and that’s proved prescient, with ICE, ISE, MTS, and London-based broker-dealer ICAP stampeding from obscurity to prominence since then.
Many of today’s left-field competitors, however, manage to succeed because they have the backing of well-heeled established players. Two of the newest certainly fit that bill. Kansas City-based BATS Trading was set up a year ago by Lehman Brothers, Merrill Lynch, Morgan Stanley and Credit Suisse, and now has 10% of Nasdaq’s volume. Likewise, the pan-European Project Turquoise is being driven by Europe’s largest banks. If it gets off the ground, Turquoise will clear its trades through the Depository Trust & Clearing Corporation (DTCC), which handles trades for American exchanges.
The project could get a boost in November, when the European Union’s Markets in Financial Instruments Directive (Mifid) kicks in, making it easier for securities companies to bypass exchanges and “internalize” trades on their own execution systems.
Nasdaq CEO Bob Greifeld must have kicked himself as the implications of Mifid sunk in. When he took over in 2003, Nasdaq and Franke had just launched Nasdaq Deutschland together with the Berlin Stock Exchange, Commerzbank and Dresdner Bank. The new board simply purged projects that weren’t paying off, and Nasdaq Deutschland was one of the first to go.
In so doing, they threw away a platform that had been designed to provide internalization services to brokerages and could have positioned them for Mifid at a lower cost than buying OMX or the London Stock Exchange (LSE).
BATTLE FOR CLEARING
Judging by stock market valuations, derivatives markets are still the prize, and with good reason. Not only are derivatives volumes growing faster than equities, but derivatives exchanges tend to have stickier liquidity, especially when they own their own clearing firms. Rich Ripeto, a principle of Sandler O’Neill & Partners, points out that the higher valuations apply especially to futures exchanges, and not to equity option platforms. “ISE has a higher valuation than equity exchanges because it has higher secular growth,” he says, “but it’s still discounted from futures exchanges because you don’t have that roped-off, protected trading facility that clearing provides.”
Wheeler says that owning a clearing firm makes it easier for exchanges to integrate their matching engines with clearing and launch new product, and adds that buying an existing one is easier than starting one from scratch.
“Clearing firms are a little bit like taxi medallions,” she says. “There are a fixed number of them, and it’s very hard to start new ones. Owning one of those rare commodities is a valuable thing for an exchange and gives you a competitive advantage.”
Which explains why inter-dealer OTC brokers GFI Group and ICAP have bought into The Clearing Corporation. “GFI and ICAP intend to work with The Clearing Corporation to jointly develop clearing services for OTC derivatives products, including credit and interest rate derivatives,” the three jointly announced in December.
Bank of America analyst Chris Allen says you can read that two ways. “GFI tends to embrace the exchanges, and I think it’s just going to be additive in terms of the exchange listing credit derivatives,” he says. “But ICAP perceives the exchanges as monopolies; they don’t think the competitive playing field is very fair, and they think that once it is on a more level playing field, the profit margins and the pricings are going to change dramatically.”
“ICAP is a company that creates a vast amount of product that ultimately gets commoditized, and traditionally by exchanges,” says Young. “Therefore, ICAP must have its own interest in even the early stages of commoditization.”
Franke agrees, and says the battle for dominance in clearing and settlement will be a top story in years to come. “Things could get really interesting if these clearing houses start merging,” he says. “Of course, all the talk on that end has come from the users.” Users, like ICAP and GFI.