Exchange consolidations: Help or hospice?

Nationalism. This is less a problem in the realm of financial markets but it played a factor in stopping mergers between the London Stock Exchange and Canada’s TMX Group as well as between the Singapore Exchange and the Australian Stock Exchange. And it can emerge years later when national interests diverge.

Investor Sentiment. While exchanges are enjoying record volumes and fees due to recent price volatility, their shareholders seem to see a different future. Shares of the New York Stock Exchange have fallen nearly 15% this year, and the CME Group stock is off more than 21%. Might they be equally worried about the encroachment of private systems that current exchange strategies seem to ignore?

Intuition. While this is in the realm of a “sixth-sense,” seasoned veterans of financial markets would have considered it unthinkable 10 years ago that the storied New York Stock Exchange would put itself on the auction block and cede control to others. When something this improbable occurs, powerful new forces have emerged that did not previously exist.

Unintended Consequences. The financial press reported that the Deutsche Boerse/NYSE-Euronext merger would have reduced the need for margin requirements by about $4 billion dollars through a merger of their derivatives clearing houses. This outcome may have been good news for market users but perhaps not for shareholders. If (as occurs in the U.S.) the clearinghouses make money from investing cash margins and from service fees charged clearing members by investing on an overnight basis as well, consolidation could produce reduced revenues for the combined exchanges.

What to Do. I take no fault in exchange mergers. The question is whether, for whatever benefits will accrue, they may simply postpone the day when alternative trading systems and over-the-counter derivatives make them obsolete. The $9.3 billion price tag that was attached to the DB/NYSE merger suggests that the answer, right or wrong, will bear a heavy cost. Better minds than mine have grappled with this question and yet the trend toward exchange combinations remains alive and well.

My question is whether the same funds might be more fruitfully used by building or acquiring a direct challenge to the exchanges’ major competitors. Why not go gung-ho into the alternative trading systems world or full-bore into the over-the-counter swaps business? Why not improve on my opening scenario with the following:

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 they emerged, they announced that they were combining to buy an auto dealership.

Reprinted with permission from “Penn State Law Review,” Vol. 116:3 (2012) beginning on page 977.

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