It is difficult to get excited about regulation. Financial historians will probably recall November 2007 as the month when the credit crunch was turning nasty and the music stopped for Citigroup’s Chuck Prince. The passage of Mifid (the Market in Financial Instruments Directive) through the European Union will be recalled only by those unfortunate enough to work in bank compliance departments, and mostly for the vast amount of paperwork it created.
But it is this unheralded directive that explains the present spate of deals among the world’s stock exchanges. In January, the London Stock Exchange announced that it would acquire TMX Group, the parent of the Toronto Stock Exchange, for $3 billion. The following month, Deutsche Börse announced a merger with NYSE Euronext to create the world’s biggest exchange in a $10.2 billion deal.
Although a far smaller deal, the acquisition of Chi-X Europe by Kansas City-based Bats Global Markets, for a sum reported to be about $300 million, is of equal consequence. Bats Global Markets is also planning an initial public offering to raise $100 million, valuing a company founded in 2005 with $2 million in seed capital at $1.2 billion, about 60 times 2010 earnings.
Increased efficiency, reduced costs
Bats’ owners have a lot to thank Mifid and Regulation NMS (National Market System) in the US for. These regimes made their business model work by levelling the playing field between the big incumbents and technologically savvy upstarts. Price became the main determinant for assessing best execution.
The aim was to increase efficiency and cut costs. Whether or not these benefits have filtered down to end users is debateable. But it is clear that the trading landscape has changed dramatically. Low latency and high speed have become watchwords and driven the rise of algorithms. The proliferation of dark and lit liquidity pools has made smart order routing essential.
Incumbent stock exchanges’ share in cash equity trading has collapsed. In January 2005 the New York Stock Exchange executed 79% of the consolidated share volume of its listed stocks. This has fallen to about 26%. In just three years, Chi-X Europe has overtaken Deutsche Börse and NYSE Euronext in market share of European equity trading. Its volumes grew by 80% to more than $1.5 trillion in 2010.
In cash equity trading, the fight for relevance is the main driver of the mergers between the incumbent national bourses. A merged Deutsche Börse/NYSE Euronext would be the biggest European exchange operator, with about 28% of overall trading. But this pales by comparison to their combined market share in European listed derivatives, where the two bourses operate an effective duopoly.
Just as relevant is the market-leading position of Eurex Clearing. Assuming it is the central counterparty clearing house for the merged entity, some 95% of all Europe’s exchange-traded derivatives will be cleared in Frankfurt. Deutsche Börse’s spinmeisters have been at pains to point out to the competition authorities that only 20% of derivative transactions are on exchange. But that will change.
At the Pittsburgh G20 meeting in September 2009 it was agreed that all standardized OTC derivative contracts would be traded on exchange, "and cleared through central counterparties by the end of 2012 at the latest". Dodd-Frank in the US has already moved decisively in this direction and European Markets Infrastructure Regulation is on the same road. Mifid is also being reviewed.
The imperative to get derivative contracts on exchange with central clearing is a global phenomenon. In Asia, SGX, the Singapore Exchange, has already announced plans to clear NDFs (non-deliverable forwards) in Indian rupee, Indonesian rupiah, Korean won, Malaysian ringgit, Philippine peso and Taiwan dollar.
The move to CCPs also explains why there is such competition to buy LCH.Clearnet, the dominant clearer of interest rate swaps. NYSE Euronext, Nasdaq OMX and the LSE are all reportedly interested. The danger is that these new clearing entities will become so systemically important that they will be regulated minutely and the costs will be passed on to users. For the time being, however, European authorities seem content to have multiple for-profit companies rather than market utilities.
Trading revolution
Exchanges with strong derivatives franchises and clearing businesses are well positioned to benefit from this trading revolution. The authorities are right to look at Deutsche Börse’s vertical silo model, which combines execution and clearing, for possible competition issues. But from a business point of view it is an enviable position. The LSE failed to build a clearing and settlement infrastructure when the Taurus project imploded in 1993. The London derivatives market, Liffe, was grabbed from under its nose by Euronext a decade later.
In this new world order the LSE looks seriously challenged. It is a big listings authority with a small technology and data company attached. An Anglo-Canadian tie-up with TMX Group is hardly game changing. Acquiring LCH.Clearnet almost 20 years after the failure of Taurus would be too little, too late. The summit of the LSE’s ambition is seemingly to be to global trading what Greg Rusedski was to world tennis: a transatlantic also-ran.
Andrew Capon has won multiple awards for commentary and journalism on markets, investment and asset management. He welcomes comments from readers and can be reached at amcapon@btinternet.com