Exchange consolidations: Help or hospice?

Reprinted with permission from “Penn State Law Review,” Vol. 116:3 (2012)

Two blacksmiths who had competed to shoe the horses of the townspeople for 30 years watched as the first automobile drove down the main street. Recognizing that something big was occurring, they set aside their rivalry and met to discuss a response. When the blacksmiths emerged, they announced that they were merging their blacksmith business.

Might this be the future for the growing number of central financial markets that have announced interest in combining forces, often across national lines? In both the securities and derivatives worlds, new rivals have emerged to offer comparable services for similar transactions. This article raises the question whether exchange mergers can stem or reverse the gains made by those alternative execution methodologies. The article is based in part on my own experience working with markets for over 50 years, and incorporates a generous dose of conjecture. Unfortunately, if there are empirical data that resolve this matter definitively, I have been unable to locate them.

Markets for financial instruments and commodities have evolved over the centuries from the occasional get-together of nearby producers and buyers to nanosecond electronic execution facilities that operate from anywhere with lightning speed (“flash trades”), and often operate beyond the berm (read “dark pools”). The preeminence of even the mature central exchanges has been challenged by these new systems. Like the blacksmiths, one might wonder why, instead of merging with each other, they do not either acquire or create competitive mechanisms to confront these rivals head-on.

 A Few Words About Markets. Markets are commonly comprised of three participants:

  • Speculators, who from time to time commit funds in the hope that their results will be profitable;
  • Hedgers, who take positions that will generate profit from events that hurt their commercial bottom line; and
  • Professional traders, who make a career of trading with speculators and hedgers.

In the securities world, there has long been a contest between exchange-executed transactions and those brokered privately (the “over-the-counter” or “OTC” market). Federal law legitimizes both routes. And while, well into my career, doing business on an exchange was heavily preferred (a listing on the New York Stock Exchange was cause for jubilation), the OTC dealer slogged along with what remained outside that privileged circle. Today many, if not most, securities transactions bypass the exchanges.

The history of futures, options, and other “derivatives” is more complex. In the United States, the futures markets operated largely free from federal oversight for nearly 70 years, focusing mainly on grain and other farm products. As reliance on central exchange prices became more prevalent at the beginning of the 20th century, and apprehension grew among producers, processors, and exporters about whether the prices disseminated by the exchanges were bona fide, pressure was placed on Congress to impose some kind of oversight. After all, in major cities (Chicago, in particular), wheat and corn prices were set as much by “floor traders” as by merchants. Who were these urbanites to decide what my crop is worth? Would they even recognize a soybean in the unlikely event they ever saw one?

By 1922, the agricultural community had amassed sufficient political power to induce Congress to pass legislation creating a regulatory framework for the futures (and related options) markets, and the task was assigned to the U.S. Department of Agriculture. Oddly, this development was met by the markets with mixed emotions. On one hand, the markets would lose their absolute control over their own operations. On the other hand, it became an opportunity to try to eliminate a class of pesky competitors who often set up shop next door and induced people to trade look-alike products offered directly by those dealers. Some of the vendors were crooks; most were not. The exchanges had tried to exterminate these competitors through the enactment of state “bucket shop” laws, but the results were hit-and-miss. Now, maybe Congress would agree to a ban against off-exchange futures and options if the central markets would accede to federal regulation.

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