World of Exchanges: Adapting to a New Environment

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World of Exchanges Adapting to a New Environment

Edited by Shahin Shojai

E U R O M O N E Y

B O O K S

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World of Exchanges

Published by Euromoney Institutional Investor Plc Nestor House, Playhouse Yard London EC4V 5EX United Kingdom Tel: ⫹44 (0) 20 7779 8999 or USA ⫹1 800 437 9997 Fax: ⫹44 (0) 20 7779 8300 www.euromoneybooks.com E-mail: [email protected] Copyright © 2007 Euromoney Institutional Investor Plc and the individual contributors ISBN: 978 1 84374 343 9 This publication is not included in the CLA Licence and must not be copied without the permission of the publisher. All rights reserved. No part of this publication may be reproduced or used in any form (graphic, electronic or mechanical, including photocopying, recording, taping or information storage and retrieval systems) without permission by the publisher. This publication is designed to provide accurate and authoritative information with regard to the subject matter covered. In the preparation of this book, every effort has been made to offer the most current, correct and clearly expressed information possible. The materials presented in this publication are for informational purposes only. They reflect the subjective views of authors and contributors and do not necessarily represent current or past practices or beliefs of any organisation. In this publication, none of the contributors, their past or present employers, the editor or the publisher is engaged in rendering accounting, business, financial, investment, legal, tax or other professional advice or services whatsoever and is not liable for any losses, financial or otherwise, associated with adopting any ideas, approaches or frameworks contained in this book. If investment advice or other expert assistance is required, the individual services of a competent professional should be sought.

Typeset by Florence Production Ltd, Stoodleigh, Devon Printed by TJ International, Padstow, Cornwall

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Dedicated to the most important man in my life, Ardeshir Shojai, who personifies everything that I wish I could be and without whom life would never have meant much, and Doctors Michael Powell, Nicholas Hirsch and Ramesh Chelvarajah, from the National Hospital for Neurology and Neurosurgery, who gave him a new lease of life.

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Contents

Foreword by Andrew Hilton Author biographies 1

Exchanges: current challenges and future implications Shahin Shojai, Capco Introduction Contributions of this book Conclusion

Part I – Transformation of the industry 2

3

Cross-border mergers and alliances between exchanges: a global perspective Iftekhar Hasan, Rensselaer Polytechnic Institute, Tina Hasenpusch, European Business School and Heiko Schmiedel, European Central Bank Introduction Networks, cross-border mergers and partnerships among exchanges Data and variables Evidence on cross-border mergers and alliances Future trends, options and implications for securities market infrastructures Conclusions References Annex Electronic trading: rival or replacement for traditional floor-based exchanges? Wayne H. Wagner, ITG Solutions Network and OM/NI Introduction Competition on commissions, then on spreads The exchange as a process Balancing varied interests

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27

27 28 30 32 36 38 39 41

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42 44 46 47

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Contents

4

5

What can electronics bring? ‘Colour’ Governance Proliferation of alternatives Information-central

48 52 54 55 56

The outlook for global derivatives market competition Jens Nystedt, Deutsche Bank Introduction Recent trends in exchange-traded derivatives markets Academic literature on derivatives market competition Competition between exchange-traded derivatives exchanges The relationship between ODE and OTC derivatives markets Recent trends in the OTC market The regulatory environment for OTC derivatives Competition and cooperation between ODE and OTC markets Conclusions and outlook References

59

Electronic markets heat up; micro-exchanges arrive Eric Benhamou, Pricing Partners, Michel Everaert, GFI Group and Thomas Serval, Baracoda Introduction The internet bubble The future of trading technology A new player in electronic markets: micro-exchanges Conclusion References

Part II – Challenges confronting exchanges 6

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Market integration in the post-trade industry: lessons from Europe Daniela Russo and Simonetta Rosati, European Central Bank Introduction Functions and players in the securities market infrastructure Addressing risks in the securities post-trade industry The European landscape and its challenges Conclusions References

59 62 66 68 74 74 75 77 78 81 83

83 84 85 89 92 93 95

97 97 99 103 107 119 121

Current challenges and future implications

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7

8

US securities regulation in a world of global exchanges Reena Aggarwal, Georgetown University, Allen Ferrell, Harvard Law School and Jonathan Katz, formerly of US Securities and Exchange Commission Introduction The competitive environment Governance of exchanges Regulation of global exchanges: the pending NYSE-Euronext merger Conclusions MiFID and its effect on exchanges Simon Bennett, Capco Introduction: genesis and background What is MiFID? MiFID impacts Responses – the exchange perspective Conclusions

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123 126 128 132 136 140 140 142 148 155 157

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Foreword This is an astonishing piece of work. Unless you are an epic masochist, it is not a book to read in one go. And it is certainly not light reading for a Caribbean beach holiday. But it is an extraordinarily successful attempt to bring together in one place authoritative articles on all the key issues that plague the exchange space today. This is no mean feat. The exchange landscape is changing so fast today that there is a serious danger that what one writes this week will be out of date next week – and that is an obvious risk. But it is a risk worth taking since exchanges are, essentially, the plumbing of capitalism – the unglamorous back end that makes possible those Wall Street/City mega-bonuses and the romanticisation of investment banking and fund management. I do not know of any comparable effort to take stock of what is going on – certainly not one that brings together a genuinely stellar mix of regulators, practitioners and academics as authors. Of course, there is a price. Although the quality of the contributions is uniformly high, the styles that writers have adopted vary wildly – from a breezy journalism to pretty heavy, footnote-laden academic analysis. But that is a price well worth paying. The structure of the book reflects a broad consensus as to the challenges that exchanges face. Paraphrasing slightly, I see six big challenges: • First is a trend, both within individual markets and on a cross-border basis, for exchanges to consolidate. For most observers, this is the dominant trend de nos jours. The emergence of Euronext in Continental Europe set the trend: now we have the New York Stock Exchange’s bid for Euronext, and Nasdaq’s (more contentious) attempt to buy the London Stock Exchange. But it is not just Europe: there is also consolidation in the US itself. The issues are what is driving this trend? And what are its implications likely to be? • The second challenge, an important sub-theme of this book, is that there is really no agreement yet on whether consolidation of liquidity into bigger and bigger pools is an unequivocally good thing – or whether a better answer may not lie in using technology to link separate liquidity pools. Consolidation may be inevitable, in that demutualisation of ownership puts shareholders in the driving seat – and what they want is to boost their share price. But the technological imperative offers what is essentially a network alternative. Advances in technology can make what the book calls micro-exchanges a viable alternative to megaexchanges as we know them. • Technology is really the third point covered in this book. Until astonishingly recently, exchanges were open outcry, often pits, and were based on person-to-person contact. Some still are – and this kind of trading still has its advocates, who believe that a degree of subjective judgement is still necessary if deeper, darker layers of hidden liquidity are to be tapped. That said, the tide is really running in the other direction. The relentless fall in the cost of technology and the (equally relentless) increase in what software can offer in the way of artificial

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intelligence means that the days of brightly coloured jackets, loud-mouthed floor trading and the buzz of open outcry are numbered. It is boring but true that an Indian software engineer can now build you an exchange-in-a-box that can do everything a conventional exchange can do at a tiny fraction of the price. • The fourth theme that runs through the book is again one that stems from technology – particularly the falling cost of technology, which makes it easy and inexpensive to develop new markets, often in the derivatives area. Given that the cost of building an exchange is no longer a limiting factor, the constraint on what can be traded is simply a function of the market. From futures to options, to options on futures, to gas, to oil, to weather derivatives, to credit default swaps – the possibilities are endless. Many of these will obviously be developed and traded under the umbrella of existing exchanges (not least because of their marketing skills and the value they add through information collection and dissemination), but the lowering of the cost barrier means new players can come – and go. • The fifth big issue is the clearing and settlement space – the plumbing behind the plumbing, if you like. The post-trade infrastructure – particularly in Europe – is inefficient, expensive and largely non-contestable. As we move away from vertical silos, contestability should increase, but common sense suggests that those who have been making super-normal profits out of the opacity of the system will not give up quietly. Still, there are many initiatives in this space – including the banks’ own Project Boat, which holds open the prospect of building an alternative channel for trading information, thereby breaking the hold that exchanges and C&S systems have over data flows. • The sixth challenge – and, unfortunately, far from the last – is the issue of regulation, and its ugly twin, compliance. There is no doubt that the regulatory burden has increased exponentially in recent years – not least because industry players are forced to respond to any regulatory initiative with a battery of lawyers. Obviously, the issue in the exchange area is not as bad as at the retail end of the market, but the cost of this regulation is far from negligible – which makes any effort at cross-border harmonisation so important. But, as this book demonstrates, do not assume that rationality will always prevail. From the US side, SarbanesOxley demonstrates just how easy it is to drive business away; from Europe, the dreaded MiFID illustrates just how little Continental European regulators understand about the finer points of capitalism. And, in both cases, we are going to have to face a raft of unintended consequences – some fairly benign, but some not. From SarbOx, for instance, comes the strong probability of an attempt by the US authorities to extend their extra-territorial jurisdiction. From MiFID comes Project Turquoise and a quite plausible threat to the entire structure of national stock exchanges as we know them. This canter through a complex subject is inevitably a caricature, and the value of this book is that it is not a caricature. It is a collection of considered contributions to one of the most complex issues of contemporary capitalism, and, if it defies an easy summary, that is much to its credit. Exchanges make the capitalist whirligig go round, and the more we understand about them, the better. Andrew Hilton Director CSFI

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Author biographies

About the Editor Shahin Shojai Shahin Shojai is the Director of Strategic Research at Capco, Director of the Capco Institute and the Editor of the Journal of Financial Transformation. In addition, Shahin is also a senior subject matter expert and a member of Capco’s Private Client/Asset Management practice. Prior to joining the company, Shahin was President and CEO of WRA Group, a syndicated research company providing research and advisory services to the treasurers and CFOs of Fortune 500 companies. Before that, Shahin was Director of the European Institute, a think-tank for CEOs of the 92 largest institutional asset management firms in Europe and North America. In addition, Shahin has held visiting or full professorial appointments at a number of academic institutions in Europe and North America, including London University, Boston University, Paris Graduate School of Management, Université Paris-Dauphine, Syracuse University, and the American University in London, where he was the Chairman of the finance faculty. Shahin holds a PhD in Finance and Economics from the University of Nottingham and an MBA in Finance from City University Business School.

About the contributors Reena Aggarwal Reena Aggarwal is the Stallkamp Fellow and Professor of Finance at the McDonough School of Business, Georgetown University. She has authored numerous articles on Sarbanes-Oxley regulations; valuation and international corporate governance; IPOs in the US, Switzerland, Brazil, Mexico and Chile; regulation of emerging markets in Asia and Latin America; and functioning of stock exchanges. She was a Visiting Research Scholar at the IMF and an Academic Fellow at the US SEC. Dr Aggarwal received her PhD in Finance from the University of Maryland and MMS from BITS, India. Eric Benhamou Eric Benhamou is one of the founders and head of all the quantitative developments at Pricing Partners. His team develops models and pricers for all derivatives including fixed income, credit, equity, foreign exchange, inflation and hybrid products. He has a senior experience of developing pricing and risk management tools and worked previously at Goldman Sachs and lately Ixis CIB. A former alumnus of the École Polytechnique and the French National School of Economics and Statistics (ENSAE), he holds a PhD from the London School of Economics and a DEA in Financial Mathematics. He is a regular speaker at professional conferences and has already published in numerous reviews. In addition to his extensive research on financial mathematics,

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Author biographies

he has always been keen to follow (and research on) the developments and trends in the electronic market and publish one of the early papers on electronic communication networks (ECNs). Simon Bennett Simon Bennett is a Partner at Capco, focused on delivering transformational change to top-tier clients, via both process re-engineering and strategic sourcing. At Capco he has a role that combines business development with client delivery – with an exclusive focus on the Institutional and Investment Banking segment. Prior to joining Capco he spent over 20 years in a variety of management roles in the City with experience on both the buy side and the sell side. Simon holds a prize-winning MBA from Henley. Michel Everaert Michel Everaert is Chief Information Officer-E-commerce at GFI. He joined the company in May 2000. Prior to joining GFI, he was Senior Sales Manager for Investment Banking Services at Logica PLC between November 1998 and April 2000. Prior to this, he held marketing and sales positions at Dow Jones Telerate and Reuters. Allen Ferrell Allen Ferrell is the Greenfield Professor of Securities Law at Harvard Law School. He is also a Research Associate at the European Corporate Governance Institute, on the Board of Economic Advisors to the NASD and a member of the Committee on Capital Markets, which is advising the Treasury Department on reform of US securities law. He received his PhD in Economics from MIT, JD from Harvard Law School and BA and MA from Brown University. He clerked for Judge Silberman on the DC Circuit Court of Appeals and Justice Kennedy on the Supreme Court. His research focuses on corporate governance, exchange regulation and disclosure requirements. Iftekhar Hasan Iftekhar Hasan is currently the Cary L. Wellington Professor of Finance at the Lally School of Management and Technology of the Rensselaer Polytechnic Institute and the Director of the Center for Financial Technology. Professor Hasan’s expertise is in the area of corporate finance, financial institutions and capital markets. He has held visiting faculty positions in several reputed European and American universities such as the University of Rome at Tor Vergata, Robert Schuman University at Strasbourg, Cheng Chi University at Taipei and Stern School of Business in New York. Professor Hasan is also a Research Fellow at the Berkley Center of the Stern School of Business; a Scientific Advisor at the Central Bank of Finland; and a visiting scholar at the Federal Reserve Bank of Atlanta. He has been a consultant of the World Bank, United Nations, Italian Deposit Insurance Corporation and several US corporations. He has over 150 publications in print, including nine books and edited volumes, and 80 peer-reviewed journal articles in reputed finance and economics journals. He also serves as an associate editor for a number of reputed journals. He has presented his research work at many professional meetings and institutions in 52 different countries. Tina Hasenpusch Tina Hasenpusch is currently completing her PhD at the European Business School in Germany. Her research focus and expertise are in the fields of capital markets and securities market

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infrastructure. Her dissertation analyses the future development of the clearing industry. Before commencing her doctoral studies, Ms Hasenpusch worked for the CEO of Eurex derivatives exchange and clearing house. Her responsibilities included, among others, the preparation of presentations, speeches and research material, as well as acting as interface between the Executive Board, operational departments and subsidiaries. Prior to her career at Eurex, Ms Hasenpusch graduated with distinction from the European Business School in Finance and Management Information Systems. In addition, she studied business administration in Argentina and in the US. Alongside her studies, Ms Hasenpusch gained substantial international work experience in the area of finance, marketing and consultancy. Jonathan Katz Jonathan Katz was an attorney for the Securities and Exchange Commission for 23 years, and served as the Commission’s Secretary for nearly 20 years. In that position he participated in virtually all aspects of the Commission’s regulatory and enforcement programmes. Prior to joining the SEC, he worked for seven years in the US Department of Justice. Mr Katz received a BA in Economics from Colgate University and a JD from the University of Pittsburgh. Jens Nystedt Jens Nystedt joined Deutsche Bank in 2004. Since February 2006, Jens has been the Chief US FX Strategist focusing in particular on G10, links with EM and the commodity currencies (especially the CAD). He initially joined as DB’s Chief Economist for EMEA and Head of Local Markets Strategy. Prior to DB, Jens worked for almost six years as an Economist at the International Monetary Fund (IMF) where he worked for the Research, Policy Development and International Capital Markets Departments. Jens also participated in the IMF’s efforts to resolve several sovereign debt restructurings and currency crises across emerging markets. Jens holds an MSc in International Finance from the Stockholm School of Economics and a PhD in International Economics and Finance from the same business school. His thesis topic focused on competition issues in international financial markets. Simonetta Rosati Simonetta Rosati has been Senior Market Infrastructure Expert in the Directorate General Payment Systems and Market Infrastructure at the European Central Bank (ECB) in Frankfurt (Oversight Division) since May 2001. Ms Rosati graduated in Economics at the University of Rome LUISS ‘Guido Carli’. She started her career at the Banca d’Italia, in the (former) Foreign Department (current Monetary Policy and Foreign Exchange Department) where she was involved in the preparatory work relating to payment systems in view of the European Economic and Monetary Union (Target Interlinking project). In February 1998 Ms Rosati joined the European Monetary Institute (precursor of the European Central Bank) and contributed to the launch of Target, the euro large-value payment system, in 1999. Between 1999 and 2001 she was Secretary of the Payment and Settlement Systems Committee (PSSC), an advisory committee to the ECB Governing Council in the field of payment and securities settlement systems. Since 2001 Ms Rosati has been working on policy and oversight issues concerning securities settlement systems. Ms Rosati has contributed to the analysis of the determinants of large-value crossborder payments, to the comparative analysis of prudential and oversight requirements for

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securities settlement and to the analysis of the securities custody industry, and currently participates in the Working Group of the CPSS on Systems Interdependencies. Daniela Russo Daniela Russo has been Deputy Director General of the Directorate General Payment Systems and Market Infrastructure at the European Central Bank, based in Frankfurt-am-Main, since June 2005. Ms Russo graduated in Political Sciences from the University of Catania (Italy), and has Masters qualifications in Economic Development and in Foreign Exchange Trade. She started her career at the Banca d’Italia where her responsibilities included payment systems, EMU and coordination with the G-10 central banks’ payment systems activities. In 1994, she worked at the European Monetary Institute (EMI) as Head of the Securities Settlement Systems Unit. She also held the post of rapporteur of the Working Group on EU Payment Systems (WGPS). In 1998 Ms Russo joined the ECB as Head of the former Securities and Settlement Systems Division (currently Market and Infrastructure Division) and was promoted in April 2005 to her current position as Deputy Director General Payment Systems and Market Infrastructure. She is also chairperson of some internal working groups of the Eurosystem. She is the ECB representative in the ESCB-CESR Working Group and has chaired one of its Task Forces. She has represented the ECB at the meetings of the ‘Giovannini groups’ and is currently member of the Clearing and Settlement Advisory and Monitoring Expert (CESAME) Group. She has contributed to the working group of the CPSS on Securities Lending and to the two working groups of CPSS and Iosco (Committee on Payments and Settlement Systems and the International Organization of Securities Commissions) on central counterparties (CCPs) and central securities depositories (CSDs). She has chaired the CPSS Working Group on cross-border collateral arrangements. Heiko Schmiedel Heiko Schmiedel is a policy expert in the Directorate General Payment Systems and Market Infrastructure at the European Central Bank. He conducts economic research and policy analysis in the field of securities trading, clearing and settlement systems, as well as payment systems. Before he joined the ECB in 2003, he served as an economist at the Hamburg Institute of International Economics. He was visiting research scholar at the Research Department at Central Bank of Finland, the Dutch Central Bank and Stern School of Business at the New York University. Dr Schmiedel received a PhD in International Finance from the University of Hamburg. He has published articles in applied econometrics and finance including monographs, book chapters, academic journals and reviews, such as the Journal of Banking and Finance, International Review of Financial Analysis and Journal of Financial Regulation and Compliance. Thomas Serval Thomas Serval is President and CEO of Baracoda, a technology company located in Paris. He is a graduate from École Normale Supérieure and holds a Masters in Business Law and a degree in Engineering from the French National School of Economics and Statistics (ENSAE). He focuses his PhD work on internet economics and its impacts on stock exchanges. He was awarded an Arthur Sachs scholarship. He has published many articles on electronics communication networks (ECNs) and the future of exchanges, and is Vice President of the French Chapter of

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the Internet Society and a Director of Comité Richelieu Board (French Association of High Tech Companies). Wayne H. Wagner Wayne H. Wagner consults on issues relating to securities trading and exchanges. He co-founded Plexus Group, a Los Angeles-based firm that provided trading evaluation and advisory services to money managers, brokerage firms and pension plan sponsors. In 2006, Plexus Group became a part of ITG Solutions, Inc, for which Mr Wagner consults as Senior Advisor. He is a frequent writer and speaker on many trading and investment subjects and author, co-author and editor of different titles. Mr Wagner is a founding partner of Wilshire Associates and served as Chief Investment Officer of Wilshire Asset Management. Prior to that he participated in the design of the first index funds at Wells Fargo Bank. He holds an MS in Statistics/Management Science from Stanford University and BBA in Management Science/Finance from the University of Wisconsin.

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Chapter 1

Exchanges Current challenges and future implications Shahin Shojai Capco

Introduction The world of exchanges has gone through a number of transformations over the past 30 years or so. Our aim with this book, which coincides with the twentieth anniversary of the Big Bang in London, is to review some of these changes, assess what their implications have been and try to look into the future to see what lies ahead for the world’s major exchanges. When we first started considering publishing this book with our partners at Euromoney Books, we knew that we were embarking on a journey at a time of great change in the world of exchanges. The announcements of potential combinations and acquisitions were filling the front pages of major financial publications on a daily basis, and prognosticators were assessing their potential implications for the future. Since then, many of these combinations have been consummated and more are on the way. In addition, we knew that we would be writing about the industry at a time when it was facing a barrage of new regulations from both sides of the Atlantic, if not globally. It was, therefore, quite clear to us that many of the predictions that would be made within this book might be deemed old news or even inaccurate because of the events taking place subsequent to its publication. However, we believed that our objective was to partner with some of the leading minds in this subject to ensure that we published a book that provided a thorough assessment of the issues that are currently facing the world of exchanges, and an analysis of why the different events are taking place and how they could impact the future of the industry, as well as establishing the factor causalities. Despite the enormity of this challenge, we knew that, once we had the commitment of the remarkable list of authors in this book, we would be publishing a uniquely informative and practical source for those interested in this industry. Consequently, before we provide our review of the world of exchanges we would like to first and foremost thank each and every one of the authors for taking the time to help us create the most in-depth and comprehensive source of information about the world of exchanges to date.

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Current challenges and future implications

How did we end up here? Exchanges have a long history, with many agreeing that the first exchanges were established in the twelfth century in Bruges, Belgium, though forward contracts are believed to have existed as far back as 1700 BC. Over the years, and especially more recently, exchanges have become an integral part of our lives, helping us plan for our future and retirement. The establishment of the major exchanges in the world’s leading financial centres, such as Frankfurt, London, New York, Paris and Tokyo, further helped their integration within our societies. Looking back over the history of these institutions, it is not surprising to find that most of us are more familiar with the events, mostly crises, that have transpired on these exchanges, and have thus shaped our industry and to some extent our societies, than necessarily the actual dates when they were first established. The most famous of these events are perhaps the two wellknown market crashes, namely the Dutch Tulip crisis of 1637 – which resulted in a 3,000 per cent appreciation of the price of tulips between 1 December 1634 and 5 February 1637 – and the great Crash of 1929 in New York City, which led to the Great Depression. Perhaps 20 October 1987 and 20 March 2000 can be also added to this list. These events demonstrated how greed and lack of knowledge can create speculative bubbles that cannot be explained with any economic rationale. Yet, interestingly, many of those investors who were caught up in the midst of these bubbles were fully capable of finding patterns in data that could be used to explain why the markets had risen so much and why they would continue to do so. The problem, of course, is that, once these bubbles burst, their repercussions are not limited to only those who thought they understood the markets and their functioning. The damage is not limited to the professional investors. Sadly, it is not even limited to those who played their part in helping create the speculative bubble. When bubbles burst, most of the economy suffers, as was demonstrated by the Crash of 1929. That is why from my perspective the most important year in the history of exchanges, and perhaps finance in general, is 1973, when the Chicago Board Options Exchange was founded and the world came to learn about the works of Fischer Black, Myron Scholes and Robert Merton. This date marks the beginning of the use of complex asset pricing models to create and trade instruments with option-like behaviours. In my opinion, this is the first time that truly scientific methodologies were used to determine the value of different assets, which until then were based predominantly on a combination of gut feeling and mediocre valuation models. In many markets, current prices of assets are based on how their derivatives markets are behaving. The revolution that was the options pricing model made it possible for all of us to get a better understanding of how shares, bonds and the many assets that are derived from them should be valued and helped to create the most exciting period in the history of finance. The complexity and variety of the new products that were, and continue to be, introduced are truly magnificent. The world of finance owes a lot to these great thinkers of our time, whose work has ensured that many of the inefficiencies that had existed for centuries have been arbitraged away. Today’s hedge fund managers are the main benefactors of this remarkable development, and they are the people who are instituting the corrective measures required to create tomorrow’s even more informationally and analytically efficient markets.1

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Current challenges and future implications

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The Big Bang Perhaps the next major milestone in the history of exchanges is the Big Bang in London in 1986, which resulted in the removal of the trading pits and the introduction of electronic trading, elimination of minimum commissions and restrictions on the size and functions of member firms, and the establishment of the exchange as a private company. The implications of this transformation of the industry can still be felt today; the most important being the disappearance of some of the world’s most famous brokerage firms and the growing influence of the major US bulge bracket investment banking firms in London, one of the most important financial centres in the world. The Big Bang broke up the cosy world of broker partnerships and stock jobbers, where fees of around 2 per cent of trades were charged, and replaced it with one where overseas banking giants could take them over, trading hours were extended, electronic trading became the norm, trading costs were cut by 90 per cent (to 0.2 per cent), and where knowledge rather than relationships dictated the likelihood of success or failure. In addition, the market structure was changed from open outcry to electronic, screen-based trading. Within a year of the Big Bang, both the number of market-makers and the daily trading volume had tripled and London’s importance as a major financial centre was even more evident. The Big Bang not only brought down the cost of trading local equities, but SEAQ International, the quote-driven electronic market for international equities, attracted trades from other Continental European markets due to the lower costs of trade. Of course, some of these gains would be reversed over time, but the result of the Big Bang for London was to make it a dominant force in the world of equities. By the late 1980s, in addition to the growing power of the London Stock Exchange (LSE), London was also benefiting from the growing power of its derivatives exchanges as well. The London International Financial Futures and Options Exchange (Liffe) was able to attract some of the biggest futures and options contracts to London and for some years retain control over the most important contract, the German Bund Futures, despite it being a German contract and trading on the Deutsche Termin Börse as well. However, Liffe’s inability to see the benefits of electronic trading, unlike its cash market peer, the LSE, meant that by 1997 the Bund market had returned to Germany, where the Deutsche Termin Börse had been using electronic trading for some years. By the end of 1997 Liffe’s share of the Bund futures contract had fallen to around 10 per cent. Liffe did later change its policy and introduce electronic trading, but it was too late to reverse the trend. Had someone been looking at the future of the world of exchanges in 1986 they would have certainly felt that the brightest star was shining in London. It was the most powerful equities and derivatives market in Europe, along with the world’s largest currency market. Of course, that was also the time when Japan was the envy of the world and its stock market was reaching melting point. By the 1990s, London was still a dominant force in the world of high finance, with many of the world’s leading investments banks establishing their international hubs in the City. Most, if not all, of the world’s leading global investment banks used London as the centre for their operations in Europe. And, despite Frankfurt’s huge efforts to replace London as the major financial centre in Europe, it simply did not succeed. The decision by Deutsche Bank to move

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Current challenges and future implications

most of its investment banking operations to London was the final proof that London had won the battle.

The internet bubble and its implications London also benefited from its long history of expertise in fund and asset management. When the internet bubble started to expand and most people wanted an avenue into the market, they chose the major global asset management companies based in London. In fact, many US asset management companies followed their investment banking brethren and took over some of the major London asset management companies in order to gain access to the market and the expertise that existed in the City.2 Consequently, the internet bubble helped London become the route of choice to the assets of the major European economies and maintain its leading global position. However, the same bubble was not as beneficial to the LSE as it was to the City of London. As Exhibit 1.1 illustrates, between 1986 and 2000, while the LSE experienced a dramatic increase in market capitalisation, by almost 400 per cent, its growth was dwarfed by its US and European counterparts, some of which increased the capitalisations of the stocks trading on them by magnitudes of around ten. Of course, despite being the slowest market in Europe, London still performed significantly better than Tokyo.3 The two major US markets were understandably the main benefactors of the bubble, with Nasdaq going from being almost half the size of the LSE in 1986 to being almost 40 per cent larger by 2000.4 These growth figures become more descriptive when one considers the change in the share of the global equity market capitalisations held by each market (see Exhibit 1.2). In those terms, both London and Tokyo experienced a reduction in the proportion of the global market capitalisations they held, with the latter experiencing a huge loss. On the other hand, we see that London’s two major regional competitors increased their contributions to the global equity market capitalisation, despite still remaining smaller than London. The two major US stock markets increased their dominance of the global equity markets by increasing their share from 32 per cent in 1986 to almost 50 per cent of the global market capitalisation by 2000.

Exhibit 1.1 Stock market capitalisations 1986 (US$bn)

2000 (US$bn)

% change

France

172

1,447

841

Germany

213

1,270

596

UK

681

2,577

378

Japan

2,803

3,157

113

NYSE

2,199

12,372

563

341

3,597

1,055

Nasdaq

Source: The Securities Industry Fact Book, Securities Industry Association

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Current challenges and future implications

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Exhibit 1.2 Share of global equity market capitalisations 1986

2000

% change

France

2.20%

4.49%

204

Germany

2.72%

3.94%

145

UK

8.70%

7.99%

92

Japan

35.79%

9.79%

27

NYSE

28.08%

38.35%

137

4.35%

11.15%

256

Nasdaq

Source: The Securities Industry Fact Book, Securities Industry Association, Capco analysis

The tremendous appreciation in the values of stocks and trading volumes, combined with the advent of new technologies that were inexpensive and easily accessible, and the chance to circumvent limitations imposed on traditional financial institutions by the regulators, meant that a number of alternative trading venues were established to provide investors with cheaper access to the markets and greater liquidity.5 The most successful of these alternative trading systems (ATSs), Instinet, had at one stage controlled over 40 per cent of trading in Nasdaq-quoted stocks. As with all speculative bubbles, the stock market bubble of the 1990s also came to an end – quite abruptly. Most of us remember what happened in March 2000, when the global equity market bubble burst and certain stocks lost close to 99 per cent of their market capitalisations. Many of the world’s leading economies slowed down, with some entering recessions. New regulations were introduced to make sure that some of the excesses of the 1990s are not repeated and to ensure that the confidence of the investor community could be restored.

Demutualisations While discussions were being held at the highest levels of US government concerning the potential backlash caused by the likes of Enron and WorldCom and to introduce new legislation to ensure that such manipulations would not happen again, the world of national exchanges faced its next major milestone – the creation of Euronext. On 22 September 2000, the exchanges of Amsterdam, Brussels and Paris were merged to create a new powerhouse in the world of exchanges. The founders of this new group of exchanges knew that tomorrow’s world belongs to those who could offer the most technologically advanced and efficient exchanges. Through the combination of these three exchanges, Euronext hoped to introduce greater efficiencies and trading methodologies/technologies to the market. The idea was a great success; by 2002 the Portuguese stock exchange Bolsa de Valores de Lisboa e Porto had also joined the partnership. The year 2000 was also when all three of the major European exchanges – Deutsche Börse, Euronext and the LSE – demutualised6 in preparation for their public quotations and being traded on their respective exchanges in 2001. Nasdaq followed the example set by its European

5

Current challenges and future implications

counterparts and also demutualised in 2000. By the middle of 20027 its shares were being traded on the over-the-counter Bulletin Board and it was quoted on the Nasdaq Stock Market itself in February 2005. The New York Stock Exchange (NYSE) also became a public company in 2006, subsequent to its acquisition of Archipelago Holdings, Inc (see Exhibit 1.3). Transformations in the ownership structures of the major exchanges, from being non-profit mutually/member-owned (typically by the major brokerage firms) organisations to having private individuals and institutional investors as the ultimate owners, were made possible by the advent of new technologies, which allowed the exchanges to provide access to a much wider group of users scattered across the globe. Steil8 suggests that as ‘the marginal cost of adding a new member to a trading network declines to zero, it becomes infeasible for an exchange to impose a fixed access cost, or “membership fee.” Rather, only transaction-based (ie variable cost) charging is sustainable.’ Subsequent to going public, the exchanges had to take into account the needs of another group of stakeholders, namely the shareholders, in addition to those they had historically dealt with – their users and the national regulators. What the users want is a low-cost and efficient exchange to trade on, with minimal friction, although Domowitz and Steil9 suggest that, due to the monopolistic nature of most traditional exchanges, the members could in extreme cases oppose enhancements to the quality of services provided if they are deemed to diminish their welfare, which basically means that demutualised stock exchanges should provide better-quality markets. On the other hand, what shareholders want is increased profitability for the firms they hold shares in. These two objectives cannot easily be reconciled within the world of listed exchanges; and the situation has become even worse ever since hedge funds, which in some cases look for quick returns, have become active investors in major stock exchanges. For example, in 2005, Fidelity Investments in combination with two hedge funds (TCI Fund Management and Atticus Capital LLC) prevented the planned takeover of the LSE by Deutsche Börse because they were worried that the bidder might overpay. Consequently, despite the fact that the transaction would have allowed Deutsche Börse to take over the jewel in the crown of the European equity markets, these active shareholders prevented it.

Exhibit 1.3 Market capitalisations, in billion euros, of the major Western exchanges (1 November 2006) LSE

4.18

Euronext

9.99

Deutsche Börse Nasdaq NYSE Source: Authors’ own

6

13.10 3.16 10.70

Current challenges and future implications

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What the regulators want, however, is to ensure that the change in the ownership structure does not in any way create a conflict of interest between the exchange’s role as a self-regulator and the objectives of its shareholders. Steil, who looked at the four major tasks undertaken by exchanges – listed company governance and disclosure, surveillance of traders, financial and operational compliance of member firms, and fair and equitable treatment of customers – believes that the national regulators do not need to worry about the self-regulatory obligations of the exchanges. He believes that ‘mutual exchanges appear no less prone to malpractice or commercial risk-taking, nor is there any logical reason why they should be’.10 Whatever one’s views are on the pros and cons of public ownership of national exchanges, one thing is clear, by going public exchanges are able to raise the necessary capital to be able to take over their peers. Of course, it also means that they could become takeover targets themselves. Between 2001 and 2006, the LSE was involved in a number of discussions to establish partnerships with other exchanges in Europe. Of course, as many are aware, it was also the target of a number of takeover attempts from its European peers during this period – despite being the largest exchange in Europe in terms of the market capitalisation of the stocks quoted on it – as well as receiving offers from Nasdaq and Macquarie Bank. What is surprising is that the LSE has not as yet made a hostile bid for any of its peers. Perhaps the LSE’s lack of ambition can explain why the largest European stock exchange has a market capitalisation that is less than 50 per cent of Euronext and around 30 per cent of Deutsche Börse. The LSE’s European counterparts used their new sources of capital well. Euronext aggressively competed with the LSE to take over Liffe, one of Europe’s major derivatives exchanges, and certainly London’s most important, to create Euronext-Liffe in 2001. Euronext had the belief that, with the growing demand for derivative instruments from hedge funds, it made perfect sense to take over one of the best in Europe. This was quite painful for the LSE, given its local proximity to Liffe. Deutsche Börse also took advantage of its new source of capital to take over Clearstream in 2002, to establish a more vertical operation. Through the acquisition of Clearstream, Deutsche Börse was now able to provide not only the venue for conducting the trades, but also the location for settling and clearing them, similar to the model operating at Bolsa y Mercado Españole (BME) and Borsa Italiana. It must be said that, during the takeover discussions between the exchanges, it became clear that should Deutsche Börse merge with another European exchange it would be hard for it to retain control of Clearstream, as this would mean that it would have dominance in terms of both the volume of trades and where they are cleared and settled. The combination of Deutsche Börse and Clearstream also raised another problem for regulators, concerning the governance issues associated with the combinations of exchanges with central securities depositories (CSDs) and central counterparties (CCPs). According to Russo and Papathanassiou,11 many are worried about ‘the extent to which vertical integration of stock exchanges with depositories and clearing houses that all belong to a vertical silo may impede horizontal integration of those service providers across national borders’. The national regulators are also concerned by ‘the extent to which governance is a tool for ensuring appropriate management of service providers that provide a wide range of services underpinned by very divergent risk profiles under the same legal entity’. These include international CSDs (ICSDs) ‘that offer security depository services as well as banking services assuming credit risk, CSDs

7

Current challenges and future implications

that also perform central counterparty services, and stock exchanges that also act as central securities depositories’. In order to alleviate such concerns, a code of conduct agreement was reached on 7 November 2006 between the European exchanges and clearing organisations and EU Commissioner Charlie McCreevy for improving transparency and reducing the costs of cross-border trading. The code establishes a phased timetable for implementation: by 31 December 2006, price transparency will be in place; by 30 June 2007, access and interoperability conditions will be established; and by 1 January 2008, service unbundling and accounting separation will be implemented. Over the years, the US market has also witnessed a number of domestic acquisitions, as mentioned above; the most newsworthy of which was the recent combination of two giants of the world of derivatives – the Chicago Mercantile Exchange and the Chicago Board of Trade – which has created the world’s most extensive and diverse global derivatives exchange, with average daily trading volumes of around 9 million contracts per day. It would be interesting to see how the other derivatives exchanges around the world react to this news. It is quite plausible that this transaction has set in motion a series of other combinations in this space. Although these transactions make the headlines, what many fail to consider is whether these combinations, especially those involving two or more national exchanges, are undertaken for the benefit of the management of these institutions (this is to improve their own personal status),12 their shareholders or the market participants. There is no doubt that, when the exchange combinations were initially announced, all three stakeholders were deemed to benefit from the transaction. The win-win scenario would arise from the increasingly efficient operations of the combined group, generated through economies of scale and even perhaps scope, as a result of which trading costs would fall and the profitability of the exchange would increase. According to Malkamäki,13 merging two national exchanges would result in operational cost savings of around 40 per cent. Translating these savings into reductions in costs of trade has, however, been more difficult to achieve. Shojai and Wang14 compared the cost of trading on the major exchanges from 1999, the year prior to the establishment of Euronext, to the end of 2001 and found that the cost of trading French stocks in Paris has gone up by around 50 per cent,15 three times the average of the other major exchanges. In fact, the increase has been so pronounced that the cost of trading shares in Paris has gone from being around 30 per cent less than Frankfurt in 1998 to being 20 per cent more in 2001. This goes against the logic used to justify consolidation among exchanges. Unlike Paris, however, the Tokyo Stock Exchange seems to have become very efficient for investors. It has reduced costs of trading by over 20 per cent during this period.16 Some might argue that limiting the study to 2001 might be unfair as it would be too short a time period for the anticipated benefits of the merger to be crystallised, which is a fair comment. However, even after we extend the study to the end of 2005 (see Exhibit 1.4), we find that the Paris exchange is still the only exchange, in addition to UK-buys (not sells, which has fallen by 6 per cent) where the cost of trade has actually increased. Consequently, based on the data available, we can see that exchange combinations have not benefited market participants. If anything, they increase the explicit cost of trade.

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Exhibit 1.4 Overall cost of executing trades (basis points) % change (1999–2001)

2005

% change (1999–2005)

1999

2000

2001

Japan

25.17

22.06

19.92

79

19.55

Germany

28.73

29.28

30.67

107

22.38

78

US – NYSE

24.55

28.39

32.18

131

23.26

95

UK – sells

30.50

38.81

35.93

118

28.80

94

UK – buys

71.74

72.74

69.01

96

76.14

106

Switzerland

36.51

33.58

36.65

100

31.85

87 110

78

France

24.87

33.83

36.95

149

27.37

Italy

34.16

38.97

37.24

109

32.36

95

US – Nasdaq

33.28

36.34

38.60

116

30.32

91

Source: Elkins/McSherry

However, if our aim is to ascertain the potential benefits of exchange combinations, we should focus solely on the explicit costs, which are the costs that increased efficiency can reduce. Based purely on explicit costs, Tokyo was the cheapest market, where trades cost around 80 per cent of those of Paris. With regard to the impact of exchange combinations on liquidity, history tells us that, as the number of exchanges fall, the worse the liquidity becomes for the shares of the not-so-giant companies,17 especially if pan-European indices become the rule. Shares of companies that fall out of these indices will certainly have less trading activity than those that are included. For example, just imagine that there is one exchange in Europe, and the chosen index, which typically accompanies an exchange, is the Dow Jones Eurostoxx50, which has an active futures contract. It would not be hard to imagine how many household names actively traded today will sooner or later become nothing more than orphan stocks.18 The best examples are certain shares in Germany, such as Porsche AG, where liquidity is greater within some of the regional exchanges than in Frankfurt itself, because that is where the activity is greatest for these stocks. Creating a single European market will certainly lead to what many had anticipated back in 1999, when the euro became a currency, which was the creation of one or two dominant pan-European indices. Well, we all know that is not the case yet, and we should certainly be grateful for that. But having a single exchange will certainly speed up the process and kill the liquidity in those shares that are today part of the FTSE 100 or CAC 40 but fall off the radar in a pan-European index. The reality is that, even if exchanges are able to save 40 per cent on their operational costs, which Malkamäki19 finds to be the case, one would not expect that to have much of an impact on the overall costs of trade, as that does not amount to much, especially when one considers the number of trades that go through these institutions every day. However, were the organisations that provide regulatory oversight, clearing and settlement to merge, the savings could be huge.

9

Current challenges and future implications

It is the after-trade costs that really need to be reduced, especially for pan-European trades, not the execution costs per se. However, it seems quite interesting that, while the exchanges are merging quite aggressively across borders, consolidation among settlement and clearing organisations has been quite rare in Europe, with LCH-Clearnet’s merger in 2003 being an important exception, although the benefits of this specific combination seem to be more elusive than initially anticipated. It is through greater cross-border efficiencies among these institutions that costs of trade, especially across Europe, which Hobson20 finds to be seven to ten times higher than costs for domestic trades in the US and which the European Union internal market commissioner Charlie McCreevy finds to be six times domestic European settlements, can be reduced. Even greater collaboration, by allowing users of a trading platform to choose their clearing and settlement providers, and interoperability would help. In the US, however, there seems to be a growing recognition of this fact. The announcement by the National Association of Dealers (NASD) and the NYSE in November of 2006 that they plan to merge their respective self-regulatory operations into a single watchdog, which ‘will be the private sector regulator for all securities brokers and dealers doing business with the public in the United States’ is a step in the right direction. The two partners stated that they ‘expected to reduce regulatory costs to the industry by millions per year once the operations are fully integrated’.

Repercussions of the bursting of the internet bubble Of course, with the crash of the stock market many started looking for people to blame for the fact that they had lost money. This was an unprecedented crash, even more severe than the Crash of 1929. The Crash of 1929 resulted in a loss of value equal to 50 per cent of the US GDP of the time and it took ten years for the markets to recover the losses. The markets still have a long way to go to fully recoup the losses incurred on the two major US exchanges subsequent to the crash of March 2000.21 The overall loss of value of the recent crash was equal to 70 per cent of the US GDP in 2000. The severity of the crash meant that people wanted an explanation about why it was not foreseen, even though Alan Greenspan, the world’s most respected market commentator, had in December 199622 accused the markets of irrational exuberance. Shojai and Wang suggest that [the] reason that few, if any, investors took his advice was because the people around them kept on telling them that it was still possible to make very easy money from the markets and that they would lose out on a great opportunity if they left the markets. Of course, our own personal greed also played an important part. And, to some extent we were all correct in our assertions. The markets continued to appreciate for a further four years. But, of course, reality set in and we all know what happened next.23 Nevertheless, soon after the hunt began, the discovery of a very interesting series of e-mails from Henry Blodget of Merrill Lynch gave those who had lost money the ammunition they needed to actively pursue those same investment bankers, whose advice they very much valued prior to the crash and whose relationships were treasured for getting access to highly profitable initial public offerings, to be compensated for their losses. The result was a number of record penalty payments by the biggest and the best of Wall Street and agreements with the New York

10

Current challenges and future implications

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State Attorney General, Eliot Spitzer, to separate research from investment banking. Four years have passed since that agreement was reached and as yet it has not been fully enforced. The Securities and Exchange Commission (SEC) decision in July 2006 has made it less likely that separation of research and investment banking will be enforced, since it has left it to the banks and the asset managers to decide whether they wish to separate the two functions. As of January 2006, however, the UK’s Financial Services Authority requires that payments for research be separated from trading and other services and that investment managers disclose how much they have spent on various services to their investors.24 Another repercussion of the bursting of the internet bubble was the passing of the SarbanesOxley Act of 2002 (Pub. L. No. 107–204, 116 Stat. 745; also known as the Public Company Accounting Reform and Investor Protection Act of 2002) by the US Congress on 30 July 2002, with the principal intention of making directors of corporations more accountable to their shareholders, although the Act also covers the issue of separation of research from investment banking. Formaini and Siems25 suggest that, while the intention of increasing transparency and accountability is a noble one, the actual execution of the overreaching Act is less than desirable, making it quite costly for companies to implement.26 The significantly increased cost of compliance with the Act has induced many firms to take their shares off the public markets and go private. Of course, this trend has coincided with the huge increase in the levels of liquidity available to private equity firms who wish to take over major public corporations. Nevertheless, despite the growing influence of private equity firms, the Sarbanes-Oxley Act is believed by many to be responsible for the decision by many companies to take their shares off the US public markets. Aggarwal and Dahiya27 find that voluntary deregistrations by US firms increased from 14 in 2000 to 183 in 2003, the year after the Act was signed into legislation. The case for delisting is even stronger for foreign firms that also have cross-listings on US exchanges, where Section 302 of the Act is particularly onerous for their CEOs and CFOs. According to Pozen,28 the ‘uncertain civil and criminal liabilities implicated by these certifications are truly daunting to the top executives of foreign companies’. Grant and Moher29 estimate that the additional costs of compliance are approximately US$2m and that as a result audit fees have increased by between 30 and 40 per cent. As a result, many believe that not only will the number of new and cross-listings by foreign firms fall in the US, but that many companies that are already listed will consider delisting; the result of which is a decrease in revenues for the major US exchanges, which are more reliant on listings than their European peers, such as Euronext and Deutsche Börse (see Exhibit 1.5). According to Marosi and Massoud,30 the number of foreign firms with cross-listings in the US that have announced their intentions to delist went from fewer than ten throughout the 1990s to 31 in 2005. Aggarwal and Dahiya31 find that the number of new listings by foreign firms had also fallen dramatically, from 95 in 2000 to 29 in 2005, hitting a low of 13 in 2003. While the US exchanges are suffering from the new Act, their competitors in London and Luxembourg have become more attractive to those companies that wish to have foreign listings. According to Aggarwal and Dahiya, of the US$32.5bn raised in 2005, over half was raised in London and Luxembourg, as compared to 31 per cent over the preceding five years. There were 51 Global Depository Receipts issued in London and Luxembourg in 2005, more than twice the 2004 figure.

11

Current challenges and future implications

Exhibit 1.5 Annual fees for different exchanges, 2005 Market capitalisation of £100m LSE Main Market LSE AIM

4,029

£500m 8,235

£10bn 34,515

4,180

4,180

n/a

19,110

19,110

273,000

16,653

24,297

40,950

11,466

11,466

n/a

Euronext

2,752

8,256

13,760

Deutsche Börse

5,160

5,160

5,160

NYSE Nasdaq National* Nasdaq Small Cap*

* The annual fee on NYSE, Nasdaq and Euronext is calculated with reference to the number of shares outstanding; for the purpose of this illustration, a median level of share prices observed on the NYSE (c. £14), Nasdaq (c. £7) and Euronext (c. £27) is assumed in order to allow estimation of annual fees. Source: Oxera calculations based on information available from the exchanges

One way that the US exchanges can overcome the hurdles created by the Sarbanes-Oxley Act and regain their market share of global listings would be to acquire exchanges based overseas, such as the recently announced combination of the NYSE and Euronext. According to the 15 June 2006 CIBC World Markets’ research report, CIBC expects ‘the transfer of the NYSE brand to Euronext to be one of the strongest revenue synergies of the deal. International companies would be able to list on the NYSE-Euronext exchange, trade in Europe, have the cachet of an NYSE listing and need not concern themselves with Sarbanes-Oxley regulations.’ Nasdaq is also trying to follow the NYSE by attempting to take over the LSE, in which it holds 25.1 per cent (as at November 2006). There is no doubt that the companies that list on the merged exchange can benefit from the cachet of being listed on NYSE-Euronext. However, it is highly unlikely that while Sarbanes-Oxley is in force there would be much of an economic benefit to the merger, as the two exchanges will not be able to operate on a single platform. Putting the two exchanges on a single platform might mean that the companies listed on the new exchange might fall under the auspices of the Act, something both exchanges vehemently wish to avoid. The major US exchanges were not the only major losers in the aftermath of the stock market crash. The ATSs, which were created by and as a result of the advent of those same new disruptive technologies that the speculative bubble was founded on, discovered that, when the tide was turned, their attraction to the investors had also waned. As demand for trading fell, due to increased competition and lower trading volumes overall, so did the power of these alternative trading venues.32 Finally, as a consequence of the tough market conditions for ATSs and the growing power of the two major exchanges, Nasdaq and the NYSE took over the last three major electronic communication networks (ECNs) – Brass utility, Archipelago and Instinet/Island.33

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Current challenges and future implications

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There are, of course, other ECNs – such as Tradebook (owned by Bloomberg), Attain (owned by Domestic Securities), Track ECN (owned by Track Data Corporation) and Nextrade – as well as a number of successful micro-exchanges, such as GFI and ICAP, which are still operating in the markets. However, they have found it hard to replicate the dominance experienced by their predecessors, who in combination used to control over 70 per cent of Nasdaq’s trading volume. The problems facing ECNs are not, however, limited to the falling trading volumes. Even though trading volumes have picked up quite dramatically in the last few years, the fortunes of ECNs have not been able to match that. The main issue facing ECNs is that the increasing trading volumes coincided with the adoption of the National Market System rules, Reg. NMS, in June 2005. Reg. NMS, which has four parts (trade-through rule, market data, market access and abolition of sub-penny quoting), has certainly introduced some advantages for ECNs, such as the ability to sell market data and to trade listed securities. This means that ECNs can now compete with the NYSE, which should help to increase revenues, although the NYSE’s hybrid market, which was created in combination with its new division, Archipelago, should make it harder for ECNs to take away liquidity from the Big Board. However, the disadvantages of Reg. NMS seem to be bigger than its advantages. First, access fees, the most important source of revenues for ECNs, will be cut, and quite dramatically; more than 60 per cent based on some estimates. Secondly, the abolition of sub-penny quotes will remove another advantage that ECNs have over established exchanges. Finally, the trade-through rule prohibits those who have access to the Intermarket Trading System (ITS) from executing an order at a price worse than that posted by another ITS participant. It would be interesting to see whether ECNs would be able to meet such best execution requirements. In addition to the changes introduced by Reg. NMS in the US, the European market is also undergoing a major transformation as a result of the introduction of the second pan-European financial services Directive, MiFID.

Implications of MiFID Coinciding with the changes introduced by Reg. NMS in the US was the introduction of MiFID in Europe. MiFID (Markets in Financial Instruments Directive), which is an essential part of the EU’s Financial Services Action Plan (FSAP), designed to provide a legislative framework for creating a single European market for financial services, is believed by some to be ‘the largest shakeup of the financial markets since the Big Bang’.34 From an exchange perspective, the main features of the new Directive deal with where trades can be conducted and how they can be reported. In markets where concentration rules (that is legal requirements that investment firms route orders to the national exchanges exclusively) were not applied, such as the UK and Germany, national exchanges have for some years faced competition from what MiFID terms systematic internalisers, which are typically investment banks that regularly try to match client orders with securities that they are holding on their own books, rather than trading them on a recognised exchange. Of course, given that the trade occurs off-exchange means that it would be hard to ascertain whether best execution was achieved. Furthermore, if the trades go unreported, or the reporting is not immediate, there would be price discrepancy in the market, as information about all trades is not incorporated into the price provided by the exchange.

13

Current challenges and future implications

However, under MiFID’s transparency regime, these systemic internalisers are required to publish information about trades in over-the-counter (OTC) stocks to end-investors within three minutes of the transaction, to report trades in all instruments to the national regulator by close of business of the following day, and to provide information about all off-book activity to the primary exchange and a number of multilateral trading facilities (MTFs) and third parties. Despite these requirements, the Directive is now making it legal for these investment banks to compete directly with the national exchanges in markets where concentration rules were still in effect prior to MiFID – such as Euronext, Borsa Italiana and BME; the result is further dispersion of pools of liquidity. In response to these changes, a number of investment banks are considering establishing their own trading platforms and becoming MTFs or ATSs in their own right in order to benefit from different rules under the Directive. The announcement by a group of seven global investment banks – Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS – that they are establishing a new pan-European trading platform to compete with the regional exchanges (Project Turquoise) was of such concern that it was mentioned as one of the main reasons why Deutsche Börse had abandoned its plans to merge with Euronext. Reto Francioni, Deutsche Börse’s CEO, announced that he views the threat from the new ATSs as being very serious and that he would be focusing his attention on seeing how these changes impact the dynamics of the European exchange markets. The reason that the threat from the group of seven, which will certainly increase in the number of members soon, has to be taken very seriously is because, according to the Financial Times, they control over 50 per cent of existing order flows in Europe. However, Europe is not the only region where exchanges are facing serious threats from the establishment of internal crossing networks by investment banks. The aforementioned Reg. NMS also increased the level of competition facing exchanges and the established ECNs in the US. In 2006, an industry-wide initiative was established in the US to access dark liquidity pools, which are not available on major exchanges. Called BIDS (Block Interest Discovery Service), it was founded by UBS, Citigroup, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley. The main aim of these industry-wide initiatives is to reduce costs of trades by eliminating exchange transaction fees. Additionally, electronification of the system helps reduce costs for the brokers. A number of investment banks have also established their own independent internal crossing networks in the US, such as Goldman Sachs’ Sigma, Credit Suisse’s CrossFinder and Citigroup’s ACE, to ensure that they retain control over their order flows and prevent them from being lost to other ATSs. One of the attractions of these internal crossing networks, or any crossing network, for the buy-side community is the ability to conduct large trades without having much market impact. However, the buy-side firms are concerned that the proprietary desks of the brokerage firms that establish the ATS might also have access to this pool of liquidity and get access to information about their interests. That is why many still prefer to participate in independent crossing networks, such as ITG’s Posit (though it is now partnering with Merrill Lynch), Liquidnet, Pipeline Trading Systems and Nyfix Millennium. In order to alleviate the concerns of its clients, Goldman Sachs is not only providing access to internal and customer-to-customer crossings, it is also providing users of its Sigma X network access to a number of dark liquidity pools, including internal

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liquidity from Goldman Sachs & Co, external crossing networks, electronic market-makers such as Automated Trading Desk, and Sigma ATS.35 More importantly, users can opt out of matching against all Goldman liquidity within Sigma X. In the future, Goldman Sachs is planning to allow its clients to place resting orders on its Sigma ATS, which means that they can provide, as well as extract, block liquidity from the system. Under the current system, passive orders are required to be held on the client’s blotter or placed on the public markets. In addition to taking away transaction fee revenues from the exchanges, some of these new MTFs or ATSs are also considering becoming financial data publishers, in direct competition with established exchanges. In early 2006, a group of nine investment banks – ABN Amro, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, Merrill Lynch, Morgan Stanley and UBS – announced that they had plans to establish a pan-European platform for the collection and sale of trading data, in direct competition with European exchanges. They might even follow the example of Bats, an ECN, and offer real-time market data free in return for trading volumes. In that case, it would be much harder for the exchanges to continue charging for market data. As a result, the major exchanges are facing falling revenues from two of their most important sources – exchange transaction fees and market data provision.36 The major European exchanges are reacting to these developments and establishing their own in-house capabilities to allow banks and brokers to execute orders against their own books. Their aim is to entice the brokerage community to use the exchanges’ systems rather than create their own. For example, Deutsche Börse is introducing new reporting services to help clients comply with the pre- and post-trade reporting and transparency requirements of MiFID. Similarly, Euronext, despite being against the implications of the Directive on exchanges, is planning to develop a new transaction platform that will enable banks and brokers to internalise trades. Consequently, a combination of MiFID in Europe and Reg. NMS in the US will significantly change the landscape of the European exchanges and significantly increase the sources of competition they face.

Contributions of this book Reading through the previous sections of this chapter, it becomes quite clear that the world of exchanges has faced a number of challenges in its history, especially during the past decade. Our objective with this book is to delve deeper into the causes of these challenges and assess their implications for the future of this industry. Of course, as was mentioned earlier, the fact that new announcements are made about the transformation of the industry almost on a daily basis might mean that many of the assessments made in this book could prove to be old news and many of the predictions challenged by events taking place subsequent to publication. However, while the speed of change makes our task a daunting one, it is quite comforting to know that the team that has been put together to ascertain the implications of the challenges currently facing the industry is among the best in the business. So, what do our experts say about this fascinating industry?

Transformation of the industry We begin our journey in Chapter 2, the first chapter to tackle the issue of the transformation that the world of exchanges has been undergoing, in which Iftekhar Hasan, Tina Hasenpusch and

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Heiko Schmiedel undertake an empirical investigation into the types of non-organic expansion strategies pursued by exchanges across the globe. Using the largest sample of exchanges to date and analysing a number of initiatives available, they find that in most developed markets opportunities for organic growth have been exhausted. As corporations aim to broaden their shareholder base and raise capital beyond local markets and as investors wish to invest more globally, at ever lower costs, exchanges will be forced to consider some form of partnership or combination in order to meet the needs of their most important stakeholders. The analysis conducted in Chapter 2 demonstrates that exchanges based within the less developed economies are likely to over time follow in the footsteps of their US and European peers. Albeit not being a prerequisite, the implementation of sophisticated technologies seemed to prove to be a viable vehicle for exchanges to leverage their production and to become more efficient marketplaces. In addition to organically growing their core services, exchanges discovered other options and mechanisms available for growth in the form of network strategies, such as different forms of alliances, mergers and acquisitions. Whereas weak forms of cooperation are used to interlink exchanges across the globe, strong forms of cooperation, that is mergers, seem to follow a certain pattern. Once the domestic market has been consolidated, exchanges start considering combinations with peers across borders, but still within their own regions. Such combinations include partnerships with counterparts that offer similar assets – Euronext is a good example of that – or between partners offering alternative assets, such as derivatives (Euronext-Liffe), and/or providers of clearing and settlement services, such as Deutsche Börse’s combination with Cleastream. The final step seems to be cross-regional deals, such as NYSE-Euronext, where exchanges merge with peers based in other regions of the world. The authors believe that, once less developed exchanges reach the levels of excellence achieved by their US and European peers, they too can be suitable partners for strong forms of cross-regional cooperation. Of course, the findings of Chapter 2 are not so black and white, as they find that there are alternative steps available to exchanges that do not wish to take part in full-blown combination. In fact, they find that a large majority of transactions between exchanges involve contractual agreements whereby the systems are still operating separate technical platforms. No matter what form of alliance exchanges choose, what the authors find is that, in order to survive in tomorrow’s world, exchanges will have to partner with their peers in order to provide the kinds of services that tomorrow’s companies and investors will demand. No matter what method of growth is selected by a given exchange, one has to bear in mind that, unlike most other industries, in the world of exchanges growth is not pursued simply to increase revenues or profits, though that is certainly the most important objective for their shareholders. If executed correctly, size can also be accompanied with greater liquidity, something that all exchanges strive for and is the main determinant factor for long-term success. Consequently, exchanges try to grow in size in order to benefit from economies of scale in order to help reduce costs of trade, which hopefully leads to capturing a greater proportion of the liquidity present in the market. However, this relationship is not as clear-cut as it seems; hence the emphasis on the words ‘executed correctly’, because size, and the lower costs associated with it, and liquidity do not always go hand in hand. In Chapter 3, Wayne H. Wagner tackles this ageold issue of immediacy versus costs of trade from the perspective of the structure of the exchange. Wagner looks at the tools available to institutional traders who wish to trade blocks of stock. One common method applied now is the use of algorithms to chop large trades into retail-sized pieces

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that can be completed without human intervention and executed in a rapid-fire succession. However, this is not a complete solution to institutional trading needs. Wagner finds that, while there is not really a need for a physical central marketplace, such as the NYSE floor, matching large sell-orders of a stock with a large buy-order of the same stock would be difficult without human intervention. He finds that, while electronic exchanges are helpful for simple, liquid trades, even acting as price discovery mechanisms, executing large complex trades still requires human intervention. He suggests that, while the progress made by the electronic exchanges is very impressive, they have as yet not been able to tackle the issue of finding the other side for large complex trades, especially when there is a great need for immediacy. Consequently, he believes that, until electronic exchanges can satisfy the needs of both small and large investors, they will have a tough time completely replacing human intervention. Whether that human intervention is best provided on an exchange floor or over the telephone lines is a different matter. Wagner believes that ‘the sell-side is poised to capture this business by automating the handling of large institutional orders, internalising where possible, and intelligently routing to limit information leakage’. Wagner also believes that it would be hard to beat the prestige players, such as the NYSE, though they can certainly be challenged. Large chunks of their business can be routed elsewhere, but their reputations will help them survive in the long run. Their scale makes them natural monopolies, which helps attract liquidity, which in turn attracts more liquidity. Stock exchanges are not the only exchanges that are facing intense competition from incumbents and new technology-driven competitors. The world of derivatives exchanges is also extremely competitive and becoming even more so. However, studies of the competitive landscape of derivatives trading are quite rare and it seems this highly fascinating part of the world of finance is not receiving the necessary attention it deserves. That is why, in Chapter 4, Jens Nystedt provides an in-depth look at the world of derivatives exchanges and assesses what it takes to succeed. Chapter 4 begins with a look at the explosive growth experienced by traded derivatives, with total open interest of financial derivatives rising from US$87tn in 1998 to US$434tn by 2006, which Nystedt attributes to a number of factors, such as greater comfort level on the part of investors, harmonisation of regulations, increasing number of hedge funds, falling transactions costs as a result of a greater degree of competition and electronification, and proliferation of derivatives across the globe, with some emerging markets becoming the largest derivatives exchanges in the world in terms of volume. However, despite this tremendous growth, competition within this market is huge. The reasons are that there are significant economies of scale in operating a derivatives exchange and there is always the threat of commoditisation. Therefore, trying to corner liquidity is no easy task. Two very important contributions of this chapter are in the way it highlights how the relationship between the two competing markets, namely exchanges and OTC, might be misunderstood and also how competitors can actually take business away from each other. In terms of the relationship between exchanges and OTC, Nystedt suggests that the transparent nature of the instruments traded on the former does not bode well for innovation, hence the greater level of innovation is in the OTC market. However, despite this competitive disadvantage, in addition to the possible regulatory advantages in terms of oversight and compliance that the OTC market has (especially in offshore markets), exchanges can benefit from the existence of

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OTC competitors because they can in turn become clients of their clearing services, which are businesses that benefit from significant economies of scale. In addition, many of the contracts issued in the OTC market are hedged on the exchanges to reduce market risks, hence creating another source of revenue. With regard to taking business from competitors, Nystedt provides two fascinating examples of what it really takes to win. He finds that simply having an electronic advantage, which should help to reduce the costs of trading on that venue, is not enough and that you need to have a certain level of liquidity before you can challenge the incumbents, as Deutsche Termin Börse demonstrated with Liffe. However, you also need your established competitors to be asleep and for the regulators to not slow down the process of issuing regulatory approvals, as was the case in Eurex-US and the Chicago Board of Trade (CBOT). When Eurex-US tried to take on CBOT, by providing cheaper and perhaps more efficient services, the latter reduced its cost of trading in advance, which made it very hard for the former to get the kind of liquidity needed to start challenging CBOT. However, the case of the International Stock Exchange (ISE) proves that reducing costs and improving efficiency can be successful if you stick to your strategy over the long term and provide a cheaper and more efficient service. As a bottom line, Nystedt believes that we have seen only the start of a more intense derivatives market competition and that efforts towards consolidation, towards bigger is better, and concerning how OTC derivatives markets are incorporated in a typical derivatives exchange’s strategy will determine who is left standing five years from now. In Chapter 5, Eric Benhamou, Michel Everaert and Thomas Serval focus specifically on the implications that the introduction of new technologies have had on the competitive landscape of the world of exchanges. They assess how new technologies have helped to break down the traditional financial services supply pyramids, have lowered barriers to entry and consequently levelled the playing field, and have helped blur the lines between the contributions made by market participants. They find that the most extreme application of new technologies to the world of exchanges has been the establishment of micro-exchanges, which take advantage of the network capabilities of the internet and cheaper technology development costs of offshore locations to established markets, sometimes staffed by only a few people, that combine electronic trading and auctions for the use of professional participants. Of course, established exchanges have also benefited greatly from the advancements made in technology. New technologies have allowed the major exchanges to significantly improve how they service their users; an issue that Chapter 5 looks into in great detail. But it is the application of new technologies to micro-exchanges that is most fascinating. The authors discuss how these exchanges, for which the primary objective is to bring together buyers and sellers in new ways at the lowest possible cost, have made it possible to create efficient markets in assets that were still using processes that were centuries old. For example, the South African Futures Exchange enabled South African farmers to sell their produce at a higher price by squeezing the margins of intermediaries and in turn reducing the subsidies that the farmers were receiving, as well as improving the efficiency with which the entire product provision process was managed. These micro-exchanges, while focusing predominantly on markets with pricing anomalies too small for traditional exchanges and where electronification of the process has not yet happened, have also taken on the big boys. For example, the OMX market in Sweden started life

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as a micro-exchange and is now a major global player (and at one time even wanted to take over the LSE). As our knowledge of the areas where technology can improve efficiencies increases, so will our familiarity with the phenomenon that is the micro-exchanges.

Challenges confronting exchanges In Chapter 6, the first chapter to tackle the ‘issues confronting exchanges’, Daniela Russo and Simonetta Rosati describe the European experience in overcoming the barriers to market integration in the post-trade industry and find that it is no easy task. They review the steps taken since the adoption of the euro in promoting further integration in the industry and find that progress has been hampered by ‘a number of concurrent causes, such as vested interests, and the presence of technical, legal and fiscal barriers, and that appropriate positive actions need to be taken to support an adequate pace of adaptation of the infrastructure environment for the needs of integrated financial markets’. They find that the European post-trade landscape is still fragmented, and note that there is a slow uptake in the use of the links between securities settlement systems to settle cross-border trades. Eighty per cent of the total cross-border collateral was transferred in monetary policy and central bank credit operations using the Correspondent Central Banking Model (CCBM), a temporary solution developed by central banks (the CCBM can be used only to deliver collateral to the eurosystem, not for transfers among market participants, and data on cross-border transfers among market participants are not available). Russo and Rosati also discuss some of the more recent initiatives undertaken by public authorities at the regulatory level, such as the adaptation by central banks and securities regulators of the CPSS-Iosco (Committee on Payment and Settlement Systems and International Organization of Securities Commission) ‘Recommendations for securities clearing and settlement’ to the European Union context, in the form of a report adopted by the Governing Council of the European Central Bank and the Committee of European Securities Regulators in October 2004. The aim of this agreement was inter alia to design a coordination framework for the conduct of oversight by the different EU competent authorities, as well as at the operational level, such as the Target2-Securities project. While applauding these initiatives, the authors suggest that the solution to the integrated European post-trade landscape problem lies within a partnership between financial institutions and regulators, including coordination with initiatives supported by other authorities, and not a top-down regulatory approach in which solutions are imposed. Interestingly, they find that, while national governments are being slower than expected in removing legal and tax barriers, other public and private initiatives have been undertaken to accelerate progress on other fronts. For instance, the private sector agreement to abide by their own Code of Conduct for achieving the required transparency, interoperability and free access conditions in 2006 in response to the European Commission orientation to favour market solutions in a first instance, instead of proposing new legislation, receives special praise as an important step in the direction of resorting to modern forms of cooperation between public and private stakeholders in line with the principles of better regulation adopted by the European authorities, including the possibility of resorting to soft-law alternatives to regulation, as is also recognised in the 2003 Interinstitutional Agreement on better law-making. Regulators should certainly work hard to assist in removing the barriers that currently impede integration, while at the same time, of course, ensuring that there is an optimal balance between consolidation, which

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increases efficiency, and risk awareness and management, and protection of risk management practices from being sacrificed in the process of pursuing commercial objectives. Overall, from the perspective of technical infrastructure, Russo and Rosati find that, notwithstanding some consolidation progress, the current post-trade landscape is still highly fragmented with around 16 securities settlement systems in the 12 euro-area member states37 (so far, systems’ technical integration has not followed legal consolidation by the private sector). Currently, in the field of securities settlement there is still nothing comparable to the fully integrated infrastructure for payments. For this reason, the authors argue that an operational role by the central banks, as in the case of the Target2-Securities project, would support market efficiency and serve the post-trade industry by providing a single entry point for settlement of domestic and cross-border securities transactions in central bank money. Another challenge facing exchanges is the implication of demutualisation and the introduction of another set of stakeholders, namely shareholders. In Chapter 7, Reena Aggarwal, Allen Ferrell and Jonathan Katz look at the implications of exchange demutualisations for their dual role of being for-profit institutions and self-regulatory organisations (SROs) that oversee the activities of their members and the companies that list on them. The authors highlight the fact that the problem arises because exchanges, similarly to any other business, have to either reduce costs, which includes regulatory costs that their electronic peers, such as ATSs, do not face, or increase revenues, which can be achieved by increasing trading volume, through either adding new listings or by acquiring other exchanges or trading platforms, in order to keep growing their profits. Consequently, many are concerned that some exchanges may not be as inclined to enforce their market oversight tasks as they should be in order to attract investors and listings. In response to such concerns, the NYSE and Nasdaq have both established separate subsidiaries, with separate boards, to undertake the self-regulatory functions. The authors describe the exact functioning of these separate bodies and provide prescriptive advice on how to tackle the governance issues arising from exchange demutualisations. A very important contribution of Chapter 7, however, is its analysis of the implication of global exchanges for the governance of these institutions and how their corporate structures can influence how the companies listed on them are treated by regulations in effect within the different jurisdictions where the exchanges are located. For example, they highlight the concerns that some companies have raised about falling under the auspices of the Sarbanes-Oxley Act should the NYSE and Euronext merge. Aggarwal, Ferrell and Katz point to a number of situations where companies listed on Euronext need not worry about the merger and a situation that might be of concern. The options are as follows: firstly, if Euronext had to register as an exchange with the SEC, it would have to submit to the SEC its rules and rule changes for approval, ensure compliance by its members with the myriad provisions of the Exchange Act, comply with SRO governance requirements and Reg. NMS, which under the auspices of the trade-through rule prohibits trades that occur at prices inferior to quotations that are immediately accessible through automatic execution. Secondly, even if Euronext does not have to register, the companies quoted on it might have to register with the SEC ‘if there are more than 500 owners of record of the company’s equity securities worldwide, with 300 of those investors being in the United States, with the company having more than US$10m in assets’. Companies can use Rule 12g3–2(b) of the Exchange Act to be exempted if they had not listed on a registered exchange, had not made a

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public offering in the US and had fewer than 300 US resident investors at the time of application. More importantly, the authors suggest that the SEC has gone out of its way to assure companies listed on Euronext that they will not be forced to comply with Sarbanes-Oxley requirements should the two exchanges merge. However, while these exemption options are available, the important issue here is that, in order to be exempt, the two exchanges have to operate on separate trading platforms. Should they have merged the exchanges onto one platform, which is where the main economies of scale would have been derived from, then getting an exemption from Sarbanes-Oxley would be pretty much impossible. Another important motivation behind the merged group was to take advantage of economies of scope that could be derived from operating an equity market in conjunction with a derivatives market, such as the ability to offer investors the option of purchasing a covered call. The authors highlight that, should the Commodity Futures Trading Commission (CFTC) change its softtouch approach of no-action exemptions from US regulation to foreign derivatives exchanges operating in the US, Euronext-Liffe might find itself being regulated by CFTC rather than the Financial Services Authority. The book concludes with Chapter 8, in which Simon Bennett provides an overview of the implications of the Markets in Financial Instruments Directive (MiFID) for the European exchange landscape. The chapter starts off by looking at what MiFID is, what its aims are and how it impacts the major stakeholders, such as markets, products and investors. Subsequent to the introduction of the Directive, Bennett looks at how it might impact the world of exchanges. He finds that, given the large array of changes being introduced within the European landscape – such as the Single European Payments Area, the Market Abuse Directive, UCITS III, the EU Savings Directive, the Transparency Directive (Issuer Information) and Basel II, with the latter being very high on the executives’ agenda – MiFID is by no means the only game in town. Consequently, different markets within the European Union will choose to prioritise the issues they wish to implement, which could result in a situation where some markets implement MiFID earlier than others – what Bennett calls ‘asymmetric implementation’. As a result, larger multinational investment banks may try to take advantage of such differences and book business onto the balance sheet of those divisions that are based in the laggard economies, where they would be more lightly regulated. One of the most important implications of MiFID will be the abolishment of the concentration rules, which means that countries such as France and Spain will no longer be able to force client orders to be routed through a specific national exchange and that they will be forced to open their order flows to outside competition from other liquidity pools. Of course, while this means that there would be a more level playing field in the European exchange landscape, it might also result in a fragmentation of liquidity. With regard to the other potential implication of MiFID, namely consolidation among exchanges, Bennett believes that the influence of the Directive is somewhat exaggerated here, as most institutions were involved in some kind of merger talks long before MiFID was being introduced. Consequently, while MiFID might be of assistance here, it will not be the major cause for such activities. Similarly, in the post-trade environment, MiFID would be a secondary driver to consolidations, as a number of mergers are already consummated or in the advanced discussion stage.

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Overall, Bennett believes that, while MiFID’s objectives are beneficial, many of the changes that the industry is undergoing are caused by market factors other than the Directive. The Directive will certainly assist, but, given that its objectives keep on being modified, it is too early to state with any degree of certainty what its long-term implications would be over and above what the industry was experiencing prior to its introduction.

Conclusion Reading through the contributions made by the authors in this book, it becomes clear that we are living through some of the most exciting times in the history of exchanges. How the future pans out will not be an easy thing to predict. But predict we must, given the mandate imposed on us by the publishers of this book. So, where do I see the future of the industry going? Before I answer that question, I must admit that I was one of the first people to buy into the concept of using new technologies to pretty much disintermediate a number of activities conducted by financial institutions.38 But the reality turned out to be quite different. Not only did the disintermediation of financial advisers not take place, if anything the crash of March 2000 made investors more aware of their own shortcomings and they flooded back to the offices of their brokers and private bankers. Of course, maybe we can blame the crash for the fact that many of the predictions about the benefits of the internet did not come true, since subsequent to the crash most people were physically hurt by anything that sounded like e-business. But, despite that, the fact remains that advice became important once again and people realised that, unless the markets continuously go up, they would need advice in order to improve the performance of their investments, assuming of course that advice can in fact help, which I still do not believe to be the case. Nevertheless, if nothing else, losing money due to someone else’s advice is less painful as you now have someone to blame. Based on the same premise, I genuinely do not believe that new technologies will be able to fully disintermediate the major exchanges. I also do not believe that complex trading tools could remove the need for brokers for anything other than average-sized vanilla trades. Certainly the competition will help to reduce costs, but for large complex trades the involvement of brokers will be essential. As the use of derivatives increases in global portfolios – something that should have happened a long time ago – the value of the brokers will in fact increase in the eyes of the professional investment community. Add to that the blurring of the lines between traditional managers and hedge funds and it becomes clear that trades will continue to get larger and more complex, increasing the value of brokers. With regard to the exchanges, the same logic seems to hold true. While major brokerage firms will work on creating their own versions of MTFs, they will find it hard to replace the national exchanges, assuming of course that the exchanges do react effectively to the new threat of competition. The steps taken by Deutsche Börse, by introducing new reporting services to help clients comply with the pre- and post-trade reporting and transparency requirements of MiFID; Euronext, developing a new transaction platform that will enable banks and brokers to internalise trades; and the NYSE, such as its hybrid market, are good examples of the ways in which the exchanges are fighting back. I believe that the resulting fragmentation of liquidity and the lack of experience brokerage firms have in competing on trading technology with national exchanges and established ECNs will over time result in the markets returning to those same old pools of

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liquidity. Online trading in a number of financial assets has been quite successful, but in situations where the original market has reacted successfully they have been able to regain the market. The foreign exchange market is a good example of that. Even the equities markets have experienced losing volumes to ECNs, to later reclaim some of the lost business back. The combination of exchanges being the natural sources of liquidity and the increasing demand for liquidity in the future means that the future might even look brighter for those same national monopolies that many are writing off today. As for global exchanges, so long as the US is afflicted with the Sarbanes-Oxley Act, which makes creating a single global platform extremely unattractive to the companies that list on their overseas partners, such a scenario would be extremely unlikely. Of course, there might be two exchanges based in two different continents within the same holding group, but I would not call that a global exchange. I personally foresee a number of major regional exchanges in each major region, such as the US, Europe and Asia, with a number of unified regional exchanges in the smaller markets, such as the Middle East, Africa and South America. I also see a greater number of stock and derivatives exchanges combining to take advantage of economies of scope, which given the limitations imposed on global stock exchanges might have a greater chance of success. Finally, I hope that you will enjoy reading this book and that it helps provide you with a better understanding of the root causes of the major changes facing the world of exchanges and where the forces of change might take us in the future.

1 Stout, L. A. (2005), ‘Inefficient markets and the new finance’, Journal of Financial Transformation, 14: 95–105. 2 Shojai, S., P. Reyniers and Z. Berger (2001), ‘The London asset management market’, Journal of Financial Transformation, 2: 93–105. 3 We have used the year 2000 as the end date to demonstrate the impact of the bubble on each exchange, which burst in March 2000. 4 By the end of 1999, just prior to the crash, Nasdaq was almost 80 per cent larger than the LSE, in terms of market capitalisation. 5 Myers, D. (2002), ‘The rush to be the ultimate trading environment’, Journal of Financial Transformation, 5: 71–3. 6 OMX Group was the first exchange to demutualise and go public. It demutualised in 1983. 7 By 2002, the American Stock Exchange was part of Nasdaq. 8 Steil, B. (2002), ‘Changes in the ownership and governance of securities exchanges: causes and consequences’, Brookings-Wharton Papers on Financial Services. 9 Domowitz, I. and B. Steil (1999), ‘Automation, trading costs, and the structure of the trading services industry’, Brookings-Wharton Papers on Financial Services. 10 Steil (2002), op. cit. 11 Russo, D. and C. Papathanassiou (2006), ‘The governance of the securities clearing and settlement industry’, Journal of Financial Transformation, 17: 20–3. 12 Hughes, J. P., W. W. Lang and L. J. Mester (2002), ‘Do bankers sacrifice value to build empires? Managerial incentives, industry consolidation, and financial performance’, Working Paper No. 02-2, The Wharton Financial Institutions Center. 13 Malkamäki, M. (1999), ‘Are there economies of scale in stock exchanges activities’, Bank of Finland Discussion Papers No. 4/99. 14 Shojai, S. and S. Wang (2005), ‘The new wave of liquidity: impact of friction’, Journal of Financial Transformation, 14: 51–9. 15 Kindly note that these figures include both explicit, such as commissions and taxes, and implicit costs, such as market impact.

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16 Of course currency movements also impact these rates, but not in the case of Euronext, Italy and Deutsche Börse, which all use the Euro. 17 The market impact of trades on Euronext increased six-fold between 1999 and 2005. In most other markets it either remained the same or did in fact fall. On Nasdaq and Tokyo it fell by around 5 per cent. 18 This was a term devised by a former colleague, Michael Scotti, currently editor of Traders Magazine, to describe stocks that are part of a major national index, such as FTSE 100, but are not large enough to make it into a narrower pan-European index of the largest 50 firms. As a result trading in their shares falls because index-tracking institutions will no longer invest in them. In addition, studies have found that liquidity increases in shares that enter major indices, and vice versa; see Amihud, Y. and H. Mendelson (1986), ‘Asset pricing and the bid-ask spread’, Journal of Financial Economics, 17(2): 223–49. 19 Malkamäki (1999), op. cit. 20 Hobson, D. (2000), ‘Assertions versus arithmetic’, Global Custodian, Winter: 66–78. 21 Despite the fact that the Dow Jones Industrial Average is breaking records, the Nasdaq index was, as of November 2006, still around 50 per cent of what it was in March 2000. As a result, it would be unlikely that the two indices combined would be able to make up the losses incurred during the crash of 2000 by 2010, which matches the 10-year period it took the markets to recoup their losses after the Crash of 1929. 22 Greenspan, A. (1996), ‘The challenge of central banking in a democratic society’, Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research, Washington, DC, December 5. 23 Shojai, S. and S. Wang (2003), ‘Transformation: the next wave’, Journal of Financial Transformation, 9 (December): 11–16. 24 Burton, M. and N. Hyde (2006), ‘Success for the sell-side in an unbundled world’, Journal of Financial Transformation, 18: 115–18. 25 Formaini, R. L. and T. F. Siems (2005), ‘Sarbanes-Oxley: corporate transparency or cost trap?’, Journal of Financial Transformation, 14: 128–32. 26 The Sarbanes-Oxley Act is divided into 11 major areas, covering public company accounting oversight, auditor independence, corporate responsibility, enhanced financial disclosures, analyst conflicts of interest, commission resources and authority, studies and reports, corporate and criminal fraud accountability, white-collar crime penalty enhancements, corporate tax returns, and corporate fraud and accountability. 27 Aggarwal, R. and S. Dahiya (2006), ‘Demutualization and cross-country merger of exchanges’, Journal of Financial Transformation, 18: 143–50. 28 Pozen, R. C. (2004), ‘Can European companies escape US listings?’, Discussion Paper No. 464, John M. Olin Center for Law, Economics, and Business, Harvard University. 29 Grant, P. and B. Moher (2004), ‘US delisting trickle set to become a flood’, Accountancy Age, 25 November. 30 Marosi, A. and N. Z. Massoud (2006), ‘“You can enter but cannot leave . . .” – US markets and foreign firms’, Working Paper, University of Alberta. 31 Aggarwal and Dahiya (2006), op. cit. 32 Decimalisation of shares also reduced the spread that ECNs could make on their trades. 33 As part of the deal, Nasdaq sold off Instinet’s Institutional Broker division to Silver Lake Partners, a private equity firm. 34 Jack, I. and M. O’Conor (2006), ‘The day of the MiFID: applying to all, different implications for each’, Journal of Financial Transformation, 17: 24–7. 35 UBS is also allowing its clients to access most external ATSs, ECNs and exchanges through its ATS. 36 ’The collection and distribution of market data accounted for 15.9 per cent of the NYSE’s total revenues, net of Section 31 fees, in 2005’ (NYSE Annual Report 2005). The recent decision by the SEC to allow the NYSE, and its electronic trading arm, Archipelago, to be able to charge US$5 a month per user for real-time data feeds makes the impact of such competitors even more pronounced. 37 As of January 2007 Slovenia has also become a member of the euro-area. 38 For a review of how many of my previous predictions on the implications of the internet on the world of finance had turned out please refer to Shojai, S. and S. Wang (2005), ‘The new wave of liquidity: impact of friction’, Journal of Financial Transformation, 14: 51–9.

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Part I

Transformation of the industry

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Chapter 2

Cross-border mergers and alliances between exchanges A global perspective1 Iftekhar Hasan Rensselaer Polytechnic Institute Tina Hasenpusch European Business School Heiko Schmiedel European Central Bank

Introduction The securities exchange, clearing and settlement industry has been experiencing a decade of rapid transformation and restructuring. At the global level, there has been growing interest among institutional and individual investors to maximise the positive effects of international portfolio diversification, resulting in a rapid expansion of cross-border securities transactions. Technological innovations have stimulated these crucial changes, causing less dependency on physical market locations. As a result of this, market participants are increasingly exposed to a more competitive environment in the global arena. The marketplaces operated by exchanges have grown at an unprecedented pace, giving them a central role and responsibility in the global financial system. The continuing process of internationalisation of modern financial markets also determines the strategic behaviour and competition for market shares. Historically, the securities exchange industry has been fragmented along national lines, thereby leaving substantial room for operational inefficiencies and unexploited economies of scale and scope.2 Nowadays, many securities exchanges and clearing and settlement organisations operate on a global scale and have started to respond to this new and changing environment in two ways. First, many securities exchanges and clearing and settlement service providers have switched from a business structure based on a mutual membership association with inside ownership to for-profit, publicly listed companies accountable to shareholders.3 Secondly, securities exchanges and settlement companies seek to outperform their competitors by creating network strategies, alliances and business consolidation. Numerous cooperative agreements, mergers, joint ventures and other forms of link-ups have been announced and established.

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Part I: Transformation of the industry

Recent empirical evidence also suggests that the adoption of network strategies by stock exchanges creates additional value in the provision of trading services and fosters further market integration.4 In the field of derivatives clearing, Hasenpusch (2007) establishes that different network strategies help clearing houses realise economies of scale and scope, network effects, and thereby lower overall transaction costs. Russo and Rosati in Chapter 6 set out lessons that can be learnt from Europe in the field of securities clearing and settlement integration. Against this background, this chapter deals with a number of important issues that have emerged in the forefront of the debate on current developments in securities markets. Essentially, the way one may conceive the future of the securities trading industry will depend on empirical evidence related to its market structure, business and strategic behaviour. Our primary objective here is to introduce a comprehensive and balanced picture of the landscape of cross-border mergers and network cooperation among exchanges worldwide. We put forward the inherent perspectives and stylised facts associated with the significant evolution of mergers and acquisitions (M&A) activities between securities exchanges. This chapter also seeks to identify the factors that are most relevant for a successful marketplace in the future. Moreover, it discusses the possible implications of increasing networked and interconnected marketplaces for future policy and market design. This study contributes to the literature on networks and cross-border cooperative arrangements in various ways. While there is a large body of literature in finance that introduces and describes the potential benefits of network arrangements in terms of increased participation, liquidity, efficiency and transaction costs, there is little scientific evidence available to help us get a better understanding of mergers and cooperation across exchanges.5 While there have been investigations into the motives and consequences of cross-border listings and cross-listed stocks,6 none of them has dealt with the issues associated with networks or implicit mergers. In this chapter, we attempt to fill this gap in the literature by analysing the most recent details of network cooperation among exchanges from a global perspective. This chapter provides evidence that the adoption of network and merger strategies has become popular not only among the world’s major stock exchanges, but also among exchanges all around the globe, albeit with different dynamics at play. Although geographical proximity has limited the scope of partnerships among exchanges in the past, M&A will increasingly take place on a cross-regional scale in the future. The remainder of this chapter is structured as follows. The next section introduces the concept of networks, cross-border mergers and alliances and is enriched with a brief literature review. This is followed by a description of the data, variables and classification schemes. ‘Evidence on cross-border mergers and alliances’ reports descriptive statistics and results. This is followed by a section outlining ‘Future trends, options and implications for securities market infrastructures’ and, finally, a section in which we present our conclusions.

Networks, cross-border mergers and partnerships among exchanges The concept of network externalities represents an important field in economics, as it applies to a variety of industries, such as telecommunications, airlines, railways, etc.7 In a typical network, any additional new consumer or network participant increases the value of the network for all

28

Cross-border mergers and alliances

12222 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 35 6 7 8 9 40111 1 2 3 44222

participants. In the context of securities markets, trading, clearing and settlement systems bear the characteristics of a network industry, as the benefit to one market participant transacting, clearing or settling on a given platform or system increases when another participant also chooses to do business in that network. Put differently, liquidity plays a pivotal role in financial exchange markets where order flow attracts order flow.8 Analysing market implications of alliances among stock exchanges, Shy and Tarkka (2001) establish that alliances are very likely to improve total welfare and increase profits for stock exchanges. Other recent research by Hasan and Schmiedel (2004, 2006) reveals that adopting a network strategy is significantly associated with higher liquidity, market capitalisation and lower transaction costs among stock exchanges. Based on evidence from the Euronext countries, Pagano and Padilla (2005) find that the integration of stock exchanges produces a number of significant efficiency gains, some of which are passed on by the exchanges to their users – that is intermediaries, investors and issuers – in the form of lower fees, and some of which accrue directly to users. Economides (1993), Hasan and Malkamäki (2001), Hagel III (1997) and Saloner and Shepard (1995) emphasise the role of critical mass and time dimensions in evaluating the true impact of network scope. The beginning of the new millennium has brought important changes in the exchange landscape, which has made the adoption of network strategies increasingly attractive and most likely indispensable to the future success of stock exchanges. The two most crucial drivers include the sophistication of technology and the changes in ownership and governance structures. Sophistication of technology has allowed for a reduction in costs, a more global distribution and higher liquidity, flexibility and reliability. The majority of today’s stock exchanges have shifted their traditional ownership and governance structures, such as non-profit, mutual or cooperative organisations, towards a for-profit orientation, being listed companies on their own markets. The increasing trend towards electronic trading and demutualisation of stock exchanges allowed for not only technical, but also financial room for manoeuvring, that is to engage in M&A deals. The changing nature of the securities industry has also complicated the interaction of various, sometimes vested, interests. These vested interests can be viewed from the perspective of the users, owners and management of the exchanges. For example, investors demand the deployment of the most sophisticated electronic trading system, reliability, liquidity and a low-cost environment; whereas issuers call for a preferable regulatory environment, access to global capital, and distribution. Moreover, in order to satisfy the demand of shareholders for an ever increasing value of shares and of dividend payments, stock exchanges are required to further leverage their technology and client base, integrate new products and geographies, and restructure to increase efficiency and responsiveness to market demand. The developments of the most recent merger deal negotiations between the world’s major exchanges – Deutsche Börse, Euronext, London Stock Exchange (LSE), Nasdaq and New York Stock Exchange (NYSE) – illustrate the dynamics and constraints of network deals among exchanges. In terms of objectives each party pursued cooperation initiatives with the goal of making their business grow, expanding their markets, providing cheaper and better quality service, and staying attractive for issuers. Moreover, the circumstances and constraints leading to the failure of some of these initiatives are exemplary for any cross-border network deal. Any form of cooperation requires the support of the different stakeholders as well as economic justification. The issues at stake are of immense importance to the interest groups, regulators,

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Part I: Transformation of the industry

politicians and financial centre interest groups. There are also national interest issues to be considered. And, of course, the transaction also has to satisfy the needs of employees and shareholders, many of whom increasingly tend to hold a portfolio of various exchanges. As mentioned before, one of the important objectives of this chapter is to highlight the fact that it is not only the world’s largest stock exchanges that are engaged in network deals, but that in fact exchanges all over the world are actively pursuing network strategies – albeit with slightly different dynamics at play. While some exchanges with a global reach tend to expand globally, others opt for increased regionalisation. This allows and supports the infrastructure development of regional capital markets through the help of network strategies. Those exchanges – mostly a lot smaller in size, with a domestic focus, serving investors and issuers regionally – use different forms of cooperation to further develop and strengthen their regional position. This in turn can make them an attractive partner for the largest exchanges wanting to gain a foothold in emerging markets and developing economies.

Data and variables To pursue our research objectives, data on cross-border mergers, alliances and link-ups among international securities exchanges were collected from a number of sources. The most important data source represents the publicly available, monthly newsletters and press releases from the World Federation of Exchanges (WFE, 2000–06) and the Federation of European Securities Exchanges (FESE, 2000–06). Additional data is taken from internet pages, press archives and ad hoc announcements of individual stock exchanges involved in network deals. This study also updates and expands the work of previous research by providing a comprehensive global perspective of the most recent exchange network deals.9 The data for the exchange sample covers the period from 2000 to 2006 (see Exhibit 2.1). The year 2000 was chosen as the start date in order to capture, to the greatest extent possible, most of the recent trends in the securities market infrastructure’s cross-border M&A activities. Overall, a consistent data set has been constructed, including 271 different deals worldwide, in which 149 exchanges have been involved. In order to examine network linkages, a set of variables has been constructed to reflect all mergers, strategic cooperation and market interconnections among securities exchanges worldwide. Tracing the development of each deal to its date of announcement, implementation and establishment yields the data on the experiences of the securities exchanges from 2000 to 2006.

Exhibit 2.1 Overview data sample

Number of observations Source: Authors’ own

30

Period

Deals

2000–06

271

Exchanges Countries

Regions

149

7

69

Cross-border mergers and alliances

12222 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 35 6 7 8 9 40111 1 2 3 44222

As highlighted by Cybo-Ottone et al. (2000), classification of networks is not readily available and there is only limited access to information and details on announcements and implementation status of cooperation and linkages among exchanges. Accordingly, when gathering such information it should be noted that the underlying categorisation might differ from the official views stated by the exchanges themselves. However, the information available in this study provides a comprehensive view of the cross-border merger activities and link-ups in the securities exchange industry. Since the study takes an international approach, it provides a comparative assessment of the involvement of securities exchanges in different forms of network activities. Each deal in the data sample involves one or more exchanges or a clearing and settlement company. It should be noted that only regulated exchanges are included in the survey; deals between regulated exchanges and electronic communication networks are thus not part of the data set. These deals were grouped according to the following criteria.10 First, the deals can be classified according to the market focus of the networking entities: • • • • •

Cash–cash – a cooperation, merger or alliance takes place between cash exchanges. Cash–derivatives – the deal involves cash and derivatives exchanges. Cash–clearing and settlement – the transaction involves cash trading, clearing and settlement. Derivatives–derivatives – the transaction concerns only derivatives exchanges. Derivatives–clearing and settlement – the deal involves derivatives trading, clearing and settlement.

Secondly, the deals can be classified by the network form of cooperation or partnership: • Mergers and acquisitions (M&A) – full integration of both entities through a merger, but also comprising an acquisition of control or minority stakes. • Joint venture – all types of mixed integration using some form of common vehicle. • Contractual partnership – stipulation of long-term contracts for the supply of technology, cooperation in terms of information-sharing, product developments or other kinds of collaboration (Memorandum of Understanding (MoUs), Memorandum of Cooperation (MoC) etc.). Thirdly, the deals were distinguished by the type of technological integration: • Outsourcing – outsourcing of IT or one exchange using another exchange’s trading technology for independently operating its own market. • Common access – common access to previously separate trading platforms. This often involves so-called cross-membership agreements – common front-end, but systems or partners continue to operate independently of one another. • Common systems – implementation of a jointly used system. Products are traded on this joint system, but the partners independently operate the system, that is processes such as risk control, market supervision, post-trade processes, etc. are handled separately by each of the partners. • Common operation – besides using a common system as a technical platform, partners also integrate the operation of the trading. For example, risk control, market supervision, etc. are integrated; only post-trade processes are handled separately.

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Part I: Transformation of the industry

• Complete system integration – complete integration of value chain, such as trading and posttrading. • Other types of integration – the cooperation agreement focuses on products, such as crosslistings, joint product developments and information-sharing, but does not include sophisticated forms of technical integration. Fourthly, the deals can be described by their international scope: • Cross-border – the partnering entities are located in different countries. • Domestic – the partnering entities operate in the same country. Finally, the deals are grouped into seven different regions: euro-area; outside the euro-area, but within Europe; North America; South America; Asia-Pacific and Central Asia; Africa; and Middle East. Exhibit 2.7 in the Annex (p. 41) provides an overview of the variables and classification. Overall, it should be noted that every effort has been made to ensure that the data used in this study is comprehensive, accurate and comparable. However, some cases required some subjective judgement to classify and determine the underlying merger and network deals of the partnering exchanges. Possible remaining shortcomings are due to data inconsistencies, errors or omissions borne by the reporting entities.

Evidence on cross-border mergers and alliances Exhibit 2.2, which provides frequency data on the number of M&A deals classified by market focus over the seven-year sample period, demonstrates that, while the total number of cooperation activities remains relatively stable and at a high level compared to earlier periods,11 a majority of the deals were of a horizontal nature. Horizontal cooperation involves M&A activities among exchanges at the trading level, that is exchanges providing similar services in different markets or jurisdictions, such as link-ups and integration efforts among the same products or even across different market segments. This M&A model appears to be the dominant and preferred method of integration pursued by the exchanges. Most of the network deals (185 out of 271) have been undertaken on the cash market side. In contrast to a horizontal cooperation, vertical mergers involve network deals of institutions providing different, but integrated services, such as integration of different activities that are processed along the securities transaction value chain within a single entity or group (that is deals that involve post-trade processes). Out of the full sample, vertical integration initiatives can only be observed in 8 derivatives and 22 cash market combinations. With respect to the form of the network and partnerships, M&A reflect the strongest and closest type of integration or cooperation. However, Exhibit 2.3 shows that only 20 per cent of transactions involve a true, wide-scale merger or acquisition between exchanges. Joint ventures represent about 15 per cent of transactions, while, more strikingly, 65 per cent prefer a weaker type of integration or partnership based on contractual arrangements. As mentioned above, most mergers or network partnerships among securities exchanges have been purely legal mergers or contractual arrangements, that is the systems are still operating separate technical platforms. This assessment is confirmed when we analyse the deals based on

32

Cross-border mergers and alliances

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Exhibit 2.2 Frequencies of the number of deals by market focus, 2000–06 Variables

Years

Focus

2000 2001 2002 2003 2004 2005 2006 Total

Cash–cash Cash–derivatives Cash–clearing and settlement Derivatives– derivatives Derivatives–clearing and settlement Total

39

22

21

26

16

32

29

185

4

3

1

3

2

5

2

20

1

3

6

7

0

2

3

22

1

8

6

10

4

5

2

36

1

1

1

1

1

2

1

8

46

37

35

47

23

46

37

271

Source: Authors’ own

Exhibit 2.3 Relative percentages of deals by type of cooperation among exchanges 20%

15% 65%

Mergers and acquisitions

Joint ventures

Contracts

Source: Authors’ own

the type of technology employed by the exchanges. As can be seen in Exhibit 2.4, about half of all cooperation agreements focus on product relationships, that is cross-listings, joint product development and information-sharing. These network initiatives do not include sophisticated forms of technical integration. Besides cooperation at the product level, the split according to common technology shows that exchanges are involved in the promotion, diffusion and sharing of securities trading, clearing and settlement services, technologies, and special mechanisms and schemes. Common technology – in the form of common access, common systems and common operation – accounts for about 24 per cent of all partnership deals. Complete integration along the value chain, such as trading and post-trading, represents 13 per cent of all exchange cooperation.

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Part I: Transformation of the industry

Exhibit 2.4 Relative percentages of deals by type of technology used by exchanges 13%

11% 9% 24%

8% 7%

52%

Other type of integration Outsourcing Common access

Complete system integration Common system Common operation

Source: Authors’ own

Contrary to the findings by Cybo-Ottone et al. (2000) for earlier periods, it is apparent that in more recent years the vast majority of the deals (235 deals out of the total of 271) took place across borders (see Exhibit 2.5). At the national level, many of the deals have been mergers of regional exchanges and between the cash and derivatives markets. This transformation at the domestic level seems to have paved the way for further cross-border mergers and alliances.

Exhibit 2.5 Frequencies of domestic versus cross-border deals among exchanges Focus Cash–cash Cash– derivatives Cash–clearing and settlement Derivatives– derivatives Derivatives– clearing and settlement Total Source: Authors’ own

34

Domestic Cross-border Total 11

174

185

7

13

20

6

16

22

8

28

36

4

4

8

36

235

271

Cross-border mergers and alliances

12222 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 35 6 7 8 9 40111 1 2 3 44222

In addition, Exhibit 2.6 reveals that most partnership deals between exchanges are undertaken within the same region. Possibly due to factors related to cultural and geographical proximity, exchanges tend to prefer to merge or cooperate across borders with exchanges from the same region or neighbouring countries. Consequently, relatively little evidence on crossregional mergers can be found over the sample period. In particular, current American merger initiatives with European stock exchanges, such as the NYSE-Euronext and Nasdaq-LSE deals in 2006, have been undertaken only very recently. The Asia-Pacific region, the euro-area and the within Europe but non-euro-area have all experienced relatively high degrees of cross-border merger activities. Exchanges located in South America, Africa and the Middle East appear to be less active in cross-border merger and cooperation activities. In summary, different cross-border M&A projects between exchanges have been identified and classified in this section. Although some of the surveyed deals among stock exchanges have failed or were abandoned, it seems that regional differences exist in which stock exchanges are more active in pursuing strategic cooperation. Without advocating one particular model, the way towards further integration of securities markets seems to follow two paths. The first and most frequent way is by horizontal integration. Here, securities exchanges create horizontal alliances and link-ups in order to expand services to other products or regions. In other words, securities markets are likely to benefit from greater international integration and cooperation between the trading service providers. The second form, albeit one adopted less often, concerns vertical integration. This concept foresees closer cooperation and integration across the entire transaction value chain, that is involving securities trading, clearing, and settlement and custody services. Vertical cooperation seeks to explore synergies resulting from a diversified portfolio of transaction services. However, no evidence can be found that vertically integrated exchanges

Exhibit 2.6 Frequencies and geographical distribution matrix of mergers, alliances and cooperation among exchanges From

To Euroarea

Euro-area Europe North America South America Asia-Pacific and Central Asia Africa Middle East Total

Europe

North America

South America

Asia-Pacific and Central Africa Asia 12 1 9 2

29 4

31 39

4 4

3 2

8

4

14

0

20

1

0

1

2

1

2

1

0 1 44

0 0 76

0 0 24

Middle Total East 7 2

87 62

0

0

46

1

0

0

5

0

63

0

0

67

0 0 7

0 0 105

1 1 5

1

2 2 271

10

Source: Authors’ own

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Part I: Transformation of the industry

are more efficient.12 The final outcome of increased merger and partnership between exchanges remains to be seen, but it is likely that interconnected clusters and/or groups of systems with greater integration will emerge over time.

Future trends, options and implications for securities market infrastructures Organic growth and restructuring opportunities undertaken by traditional exchanges seem to have been largely exhausted. However, the adoption of network strategies is a viable and promising alternative, as the acquisition of a fast-growing target can support the growth of a bidder even more.13 Some exchanges wish to continue to emphasise their opportunities and potential for organic growth and their decision to remain independent. However, it will be increasingly difficult for them to justify this strategy to their shareholders if they lack access to the important growth areas of the future. Combined with the fact that some exchanges do not profit from revenues emanating from vertical integration of post-trade processes, such as clearing and settlement, the pressure to grow their businesses becomes even greater. Getting access to growth markets and new products seems to be difficult through organic growth, as liquidity is usually sticky. Most exchanges thus have chosen to pursue a network strategy instead of organic growth. Consistent with our findings at the national level, many of the deals have been mergers of regional exchanges and between the cash and derivatives markets. This shows the desire of exchanges to integrate future growth markets. Those exchanges that lost out on the integration of strong growth segments might be well advised to consider network deals in this context. The adoption of network strategies has evolved to become a key strategic element in the development of the world’s largest stock exchanges. In the 1990s, the focus of the strategic orientation of the top management of any of the world’s major stock exchanges was firmly on organic growth, by implementing sophisticated technologies. In today’s modern financial markets, this strategic perception has been increasingly compounded with external growth through some form of network activity. Whereas our findings suggest that from 2000 to 2006 strong forms of cooperation have largely been pursued with partners in geographical proximities, the developments described in this chapter show that in 2005–06 strong forms of integration, such as mergers, were no longer limited to regional counterparts. Already in the recent past, there have been some examples of transatlantic cooperation. Today, stock exchanges are even more determined to implement such cross-regional deals. In general, there is a clear and visible trend towards network deals in the world of exchanges. In the 1990s, the focus of network deals was domestic,14 resulting in consolidated and integrated trading and post-trading arrangements in the US and European markets on a local level. At that time, other regions, such as Asia and Africa, were only about to start to establish regulated exchange marketplaces. However, more recently, the picture has changed. Our research finds evidence that strong forms of cooperation (M&A) are now occurring mainly at the cross-border level, but within the same region in the established markets, such as the US and Europe. In other regions, such as Asia and Africa, strong forms of cooperation occur predominantly at the domestic level, and it seems that they are following in the footsteps of their larger peers in Europe and the US, and currently undergoing their own domestic integration phase.15

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Cross-border mergers and alliances

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In conclusion, the US and Europe have largely consolidated on a regional level. Other regions, such as Africa, Asia and South America, have started to consolidate at the domestic level, thus gaining momentum and attractiveness in terms of being potential partners for established markets.16 Not surprisingly, we observe that weaker forms of cooperation are the preferred form of network deals across regions. The most recent developments, as described in ‘Data and variables’ (p. 30), provide indications that the future trend will be towards cross-regional cooperation among exchanges and related financial market infrastructure entities. In the first phase, it is likely that this trend will mainly cover transatlantic alliances; but once Asia, South America, Africa and the Middle East have further consolidated regionally, they will become attractive targets for stronger forms of cooperation with their US and European counterparts, and even their peers in the other regions. Overall, one may conclude that once regional consolidation is exhausted, more cross-regional and stronger forms of cooperation will emerge. As seen in ‘Evidence on cross-border mergers and alliances’ (p. 32), merger and vertical integration activities between exchanges and clearing and settlement providers are relatively seldom. Most recent deals have taken place at the horizontal level between securities trading entities. Against this background, the consequences for clearing and settlement are relatively insignificant at this stage. Schmiedel and Schönenberger (2006) support this view. They show that there have been some changes in market infrastructure integration in the euro-area in recent years and these have pointed towards increased integration and consolidation among market infrastructure providers. However, despite the single currency, the euro-area securities infrastructure remains fragmented. The most relevant factors underlying the less advanced state of integration of the financial market infrastructures are likely to be not only persistent crossborder differences in tax regimes, procedures and laws, but also vested interests among users, owners and managers of the systems. The current fragmentation of the EU securities clearing and settlement infrastructure presents a major obstacle to the further integration of European securities markets. A closer integration and harmonisation of securities clearing and settlement systems will be crucial to lower the posttrading costs of cross-border securities transactions, to exploit the potential economies of scale and to establish a level playing field in Europe. Given the heterogeneous nature of the obstacles to integration, there are currently many initiatives under way, led by market participants and public authorities, in order to align the transformation of the market and the challenges to fostering integration. As Russo and Rosati emphasise in Chapter 6, it is of key importance that the mix of actions pursued by the public and private sectors are coordinated in order to fully exploit synergies and reinforce reciprocally their ability to achieve the desired objectives. Overall, stock exchanges and financial market infrastructure providers need to devise their strategies to meet the challenges of a globalising world. Although no specific picture exists of how the future trading and post-trading landscape will look, there are a number of findings that appear to have particular relevance and that can be used to extrapolate current trends for the possible future of the securities industry. Tomorrow’s securities markets will be characterised by ongoing integration and consolidation initiatives. In this process, stock exchanges and settlement providers will devise strategic responses in a number of directions in order to best meet investors’ demands of lower trading costs, improved liquidity and immediate access to international trading and settlement. Key in this development

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Part I: Transformation of the industry

will be economies of scale, efficiency gains and the adoption of network technologies encouraging competition and consolidation among securities trading service providers. Economic research suggests the existence of large potential efficiency gains across exchanges. Investments in standardisation and new technologies will pay off in productivity gains, and automated trading will overcome distance constraints and improve efficiency. Hence, the ongoing formation of alliances and networks compounded with enormous investments in new technologies and trading system upgrades will probably help to enhance efficiency, as exchanges take advantage of all aspects of increased scale economies. Over the past decade, in securities markets technology has been already sufficiently advanced and available at very modest costs to enable investors to trade via networks. Concerning the future shape of the modern global securities market infrastructure, one may anticipate continued and increased merger activities and alliances among exchanges and settlement institutions across regions. Consider, for example, recent European initiatives demonstrating some integration efforts pointing towards an increased networked and integrated securities landscape combined with efficient governance practices. In particular, transatlantic networks and mergers appear to become popular and valuable strategic options among exchanges.

Conclusions In today’s financial markets, securities exchanges operate on a global scale, in a dynamic and highly competitive environment. The globalisation and integration of all types of financial markets, along with technological changes and deregulation, have transformed the competitive norms and business targets of the trading service industry. As a result, securities exchanges behave increasingly like business firms and have responded to the new competitive environment. Many exchanges have been switching from a business structure, based on a mutual association of exchange members with inside ownership, to for-profit, publicly listed companies accountable to shareholders. Almost 70 per cent of the world’s total stock market capitalisation is now on publicly listed exchanges, totalling over US$45tn. Exchanges merge and create alliances and partnerships at a record rate in order to meet the increasing need of corporations to broaden their shareholder base and raise capital beyond local markets.17 Moreover, institutional and individual investors seek to maximise the positive effects of international portfolio diversification, resulting in the rapid growth of cross-border securities transactions. M&A among exchanges not only become popular and beneficial among issuers, as an alternative to multiple listings across markets, but are equally important to exchanges, allowing them to avoid direct competition from stronger markets and the fragmentation of liquidity. These types of arrangements are natural in the development of a competitive environment, where the most efficient exchanges will eventually win the confidence of investors, traders and companies.18 The emergence of these types of consolidation will bring common trading platforms among exchanges who are willing to open up to each other’s markets for cross-listing and trading purposes with ample freedom for brokers and traders to operate across markets. Network arrangements will help in gaining new demand for exchange products and are also likely to bring efficiency gains through economies of scale and scope. This chapter reports evidence that the adoption of network and merger strategies has become popular not only among the world’s major stock exchanges, but also among exchanges all around

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the globe, albeit with different dynamics at play. At the beginning of the new millennium, geographical proximity prevailed in determining partnerships and cooperation among exchanges. More recently, however, mergers and alliances are no longer limited to regional integration, but increasingly take place on a cross-regional scale. Concerning the future shape of the global securities exchange industry, it can be anticipated that any form of network, mergers and alliances, and partnerships among exchanges will become increasingly important for exchanges’ strategic decision-making process, performance and growth.

1 The usual disclaimer applies. The views expressed in this paper do not necessarily reflect those of the European Central Bank. 2 Hasan and Malkamäki (2001); Hasan et al. (2003); and Schmiedel (2003). 3 Arnold et al. (1999); Pirrong (1999); Aggarwal and Dahiya (2006); Russo et al. (2004); and Serifsoy (2007). 4 Hasan and Schmiedel (2004, 2006). 5 Cybo-Ottone et al. (2000); Di Noia (2001); and Hasan and Schmiedel (2004, 2006). 6 Blass and Yafeh (2001); Chaplinsky and Ramchand (2000); Domowitz et al. (1998); Foerster and Karolyi (1998); Karolyi (1998); and Pagano et al. (2001, 2002). 7 Shy (2001). 8 Domowitz (1995); Domowitz and Steil (1999); Economides (1993); Economides and Siow (1988). 9 Cybo-Ottone et al. (2000); Domowitz (1995); Domowitz and Steil (1999); Lee (1998); and Licht (1998). 10 The classification adopted in this paper is largely consistent with previously proposed schemes by Cybo-Ottone et al. (2000) and Book (2001). 11 Cybo-Ottone et al. (2000). 12 Serifsoy (2007). 13 Beitel et al. (2004). 14 Cybo-Ottone et al. (2000). 15 Ibid. 16 Refer also to Russo and Rosati in Chapter 6 for a detailed discussion on the lessons to be learned from the European securities market infrastructure integration. 17 Domowitz et al. (1998); Steil (2001); and Pagano et al. (2001). 18 Cybo-Ottone et al. (2000).

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Domowitz, I., J. Glen and A. Madhavan (1998), ‘International cross-listing and order flow migration: evidence from an emerging market’, Journal of Finance, 53: 2001–27. Domowitz, I. and B. Steil (1999), ‘Automation, trading costs, and the structure of the trading services industry,’ Brookings-Wharton Papers on Financial Services, 1–52. Economides, N. (1993), ‘Network economics with application to finance’, Financial Markets, Institutions & Instruments, 2(5): 89–97. Economides, N. and A. Siow (1988), ‘The division of markets is limited by the extent of liquidity (spatial competition with externalities)’, American Economic Review, 78(1): 108 – 21. FESE (European Federation of Securities Exchanges) (2000–06), Monthly Newsletter, Brussels. Foerster, S. and A. Karolyi (1998), ‘Multimarket trading and liquidity: a transaction data analysis of Canada–US interlistings’, Journal of International Financial Markets, Institutions and Money, 8: 393–412. Hagel III, A. G. (1997), Net Gain, Harvard Business School Press, Boston. Hasan, I. and M. Malkamäki (2001), ‘Are expansions cost effective for stock exchanges? A global perspective’, Journal of Banking and Finance, 25(12): 2339–66. Hasan, I. and H. Schmiedel (2004), ‘Networks and equity market integration: European evidence’, International Review of Financial Analysis, 13: 601–19. Hasan, I. and H. Schmiedel (2006), ‘Networks and stock market integration: empirical evidence’, in Bagella, M., L. Becchetti and I. Hasan (eds) Transparency, Governance, and Markets, Elsevier, pp. 395–417. Hasan, I., M. Malkamäki and H. Schmiedel (2003), ‘Technology, automation, and productivity of stock exchanges: international evidence’, Journal of Banking and Finance, 27: 1743–73. Hasenpusch, T. (2007), ‘Clearing services for global markets: a framework for the future development of the clearing industry’, European Business School, forthcoming. Karolyi, A. (1998), ‘Why do companies list shares abroad? A survey of the evidence and its managerial implications’, Financial Markets, Institutions & Instruments, 7(1): 1–60. Lee, R. (1998), What is an Exchange: The Automation, Management and Regulation of Financial Markets, Oxford University Press, Oxford. Licht, A. N. (1998) ‘Regional stock market integration in Europe’, Harvard Institute for International Development, Consulting Assistance on Economic Reform II Discussion Papers, No. 15. Pagano, M. and J. Pudilla (2005), ‘Efficiency gains from the integration of exchanges: lessons from the Euronext natural experiment’, Report for Euronext, May. Pagano, M., A. Röell and J. Zechner (2002), ‘The geography of equity listing: why do companies list abroad?’ Journal of Finance, 57(6): 2651–94. Pagano, M., O. Randl, A. Röell and J. Zechner (2001), ‘What makes stock exchanges succeed? Evidence from crosslisting decisions’, European Economic Review, 45: 770–82. Pirrong, C. (1999), ‘The organization of financial exchange markets: theory and evidence,’ Journal of Financial Markets, 2: 329–57. Russo, D., T. Hart, M. C. Malaguti and C. Papathanissiou (2004), ‘Governance of securities clearing and settlement systems’, European Central Bank Occasional Paper Series, European Central Bank, Frankfurt 21. Saloner, G. and A. Shepard (1995), ‘Adoption of technologies with network effects: an empirical examination of adoption of automated teller machines’, Rand Journal of Economics, 26: 479–501. Schmiedel, H. (2003), ‘Technological development and concentration of stock exchanges in Europe,’ Research in Banking and Finance, 3: 381–408. Schmiedel, H. and A. Schönenberger (2006), ‘Integration, regulation, and policy of securities market infrastructures in the euro area’, Journal of Financial Regulation and Compliance, 14(4), 328–47. Serifsoy, B. (2007), ‘Stock exchanges business models and their operative performance’, Journal of Banking and Finance, forthcoming. Shy, O. (2001) The Economics of Network Industries, Cambridge University Press, New York. Shy, O. and J. Tarkka (2001), ‘Stock exchange alliances, access fees and competition’, Bank of Finland Discussion Paper Series, Bank of Finland, Helsinki 22/2001. Steil, B. (2002) ‘Changes in ownership and governance of securities exchanges: causing and consequences’, BrookingsWharton Papers in Financial Services, 61–96. WFE (World Federation of Exchanges) (2000–06), Monthly Newsletter, Paris.

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Cross-border mergers and alliances

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Annex Exhibit 2.7 Overview and classification of key variables Variables

Description

Additional information

Focus

Cash–cash

If deal is between cash and cash markets.

Cash–derivatives

If deal is between cash and derivatives markets.

Cash–clearing and settlement

If deal involves cash and clearing and settlement.

Derivatives–derivatives

If deal is between derivatives and derivatives markets.

Derivatives–clearing and settlement

If deal involves derivatives and clearing and settlement.

Mergers and acquisitions

Full integration of both entities with a merger or an acquisition of control or acquiring minority stakes.

Joint ventures

All types of mixed integration using some type of common vehicle.

Contracts

Stipulation of long-term contracts for the supply of technology or any kind of collaboration (MoUs, MoCs, etc.).

Outsourcing

Outsourcing of IT or one exchange uses another exchange's trading technology for independently operating its own market.

Common access

Common access to previously separate trading platforms. Often involves so-called crossmembership agreements, common front-end, but systems or partners continue to operate independently from one another.

Common system

Implementation of a jointly used system. Products are traded on this joint system, but the partners independently operate the system. For example, processes, such as risk control, market supervision, post-trade processes, etc., are handled separately by each of the partners.

Common operation

Besides using a common system as technical platform, partners also integrate the operation of the trading. For example, risk control, market supervision, etc. are integrated; only post-trade processes are handled separately.

Complete system integration

Complete integration of value chain, trading and post-trading.

Other type of integration

Cooperation agreement focuses on products, such as cross-listings, joint product development and information sharing, but does not include sophisticated forms of technical integration.

Network

Technology

Source: Authors’ own

41

Chapter 3

Electronic trading Rival or replacement for traditional floor-based exchanges? Wayne H. Wagner ITG Solutions Network and OM/NI

Introduction More so than for most human endeavours, speed, information and reliability are valued in the exchange of securities. Thus advances in automation and communication of vital data clearly add liquidity value to investors, and exchanges have usually been among the first to embrace technological enhancements. Exchange automation began with the stringing of the first Atlantic telegraph cable in 1886, which reduced order-to-completion time cycles from six weeks to a matter of hours. Transaction latency reduced by a ratio of roughly 500:1. In recent years, we have seen increases in speed of the same 500:1 order of magnitude by switching from manual order submission to DOT (designated order turnaround), and similar speed enhancements as we move to fully electronic trading. Each of these innovations has reduced time delay (latency), decreased implementation costs and, by allowing investors to react to ever smaller nuggets of information, enhanced liquidity. The catchwords today are efficiency and effectiveness. The buy-side is trying to better coordinate strategy and execution to make the process more effective and efficient. Thus both the buy-side and the sell-side are driven by a continual search for higher productivity and lowercost alternatives. Monitoring effectiveness before, during and after the trade is becoming universal. The current debate rages over whether there remains any need for physical interaction at the centre of the exchange process, such as that which occurs on the New York Stock Exchange (NYSE), the only one of the big stock exchanges that still operates a floor. At the end of 2006, news sources were filled with indications that the exchange and the floor community were hedging their bets: ‘Floor brokers look for lifeboats’; ‘Big Board specialists join forces to deal stocks on CBOE’; and, most impressively, ‘Big Board plans to close 20 per cent of trading floor’.1 Barron’s featured ‘Death of the floor’ as the cover story in its 20 November 2006 issue. Many believe that floors are obsolete, a premise the NYSE hotly disputes. They believe that the NYSE hybrid model represents the best of two worlds, and can do a better job than Nasdaq in trading less liquid stocks.2

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Electronic trading: rival or replacement?

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It seems too early to predict the demise of the physical trading floor, although the tide is clearly running against it. As Martin Sexton points out: The changes at NYSE and elsewhere show the way forward for all exchanges. Whether or not it follows the route of demutualising and listing, an exchange must be run as a business, not a club. Sentiment must be replaced by well thought through business plans that give customers – investors and traders – what they want. Technology must be used to enable buyers and sellers to come together in a regulatory environment that ensures honest dealing but doesn’t get in the way of growth. Exchanges that refuse to accept change must recognise that they have no right to exist and at best will end up as museums living off state subsidies – until the subsidies are removed.3 As Sexton suggests, demutualisation plays a key role in changing the adaptability of an exchange. The original exchanges were mutual societies dedicated to the interests of the limited number of participants. Naturally, voting power was retained by the members whose livelihood – even their own sense of self-worth – was tied to ‘the way things have always been done’. Seatholders would not choose to open the door that would lead to their own disintermediation and destroy their accumulated human capital. Thus the exchange was run by the inmates; and attempts to innovate invariably led to tedious arguments, compromised decisions and vicious power plays. A good term for the activity that used to predominate on the floor was ‘information-central’. When there was interest in a stock, floor brokers would gather around the specialist to work things out. The floor brokers were representing institutional orders, although they were usually bound to ‘best efforts’ rather than specific instructions. The institutions had very little direct control; they relied on the relationship with and clout over the brokerage firm. They may not even know the name of the person representing their order in the crowd. The old NYSE design granted the specialist an enormous advantage of seeing more than anyone else could see about order flow. But the specialist’s role was conflicted – representing public orders while at the same time being allowed to trade for their own account. This conflict was tightly constrained by Exchange rules, but history teaches us that the temptation to exploit loopholes never goes away. While actual cases of specialist malfeasance have been remarkably few, each has left a bad taste in the mouths of institutional traders and regulators. The operative phrase describing the floor negotiations was ‘nobody looks bad’. In other words, the price movements were controlled by the specialist so that everyone got a good enough deal, presentable to the investors. The floor brokers placed a lot of faith in this system, but to the investors it looked mighty suspicious. The floor was quaint, it was fun, the relationships were rich and rewarding, the sense of being part of ‘the greatest market in the world’ was intoxicating, and if you were any good you could make a handsome profit year after year. But to the customers it was opaque, slow, uncontrollable and prone to mischief. In a casino, the house always wins, and the nagging thought of institutional traders was that they were the suckers in this game. It is easy to understand the members’ desire to see the floor survive, in the same way it is easy to understand nostalgia for steam trains. Walking onto the floor is a magical experience that thrills all who experience it. The pulse of action, the camaraderie and the sense that something

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Part I: Transformation of the industry

immensely important is being conducted in a very clever manner cannot fail to impress. The problems of the exchange floor may be similar to those of the steam train: while peculiarly both quaint and impressive, it was too noisy, too dirty, too slow and, most importantly, technologically outdated. John Thain’s clever solution to this problem was to buy off the seatholders by buying them out. In a situation where seat prices had declined from $2.6m to under one million, seatholders were attracted to a premium that recognised the value of corporate control. Substituting a corporate culture for the mutual benefit society gave the exchange the flexibility to innovate. The quid pro quo to the former members was an attempt to retain a relevant functionality for the floor in the hybrid market. Many observers conclude that the floor-based exchanges are outmoded: aren’t all marketplaces going to be electronic in the near future? Assuredly, the floor was a vital institution for centuries, evolving with the changing needs of its customers. The pace of change is quickening, calling into question the floor’s very survival. This raises some important questions: does the floor still add value? Will it survive? Is the vaulted eye-to-eye interaction truly necessary? Or will the floor population find it more convenient to operate the same functions in a computer-filled floor booth, in an upstairs office or at home in their pyjamas? To answer these questions, we need to consider the value-added functions of any exchange, and discuss how they have been allocated to the floor. We will explore the steps that got us to where we are, then discuss what an ideal market might look like and conclude with how close to that ideal we are likely to come. In the process we will discuss whether a fully automated exchange is likely or desirable. By ‘fully automated exchange’ we mean one in which the computer performs, among other automated functions, the drawing of liquidity and price discovery.

Competition on commissions, then on spreads Some might date the beginning of the demise of the floor (if that is what it turns out to be) to the regulatory changes that instituted fully directed commissions on 1 May 1975. Everyone knew deep down that commission schedules based on retail-sized orders could not survive the rapidly growing domination of institutional trading, yet no one knew what the post-May Day world would bring. Commissions fell as expected, but the sky did not fall as many feared. The fortress was breached, and the focus of the exchange became far more customer-oriented. Changes in commission structure were gradual and evolutionary. Commissions fell quickly from roughly 40c/ per share to half that amount, then gradually slid to the 5–10c/ prevalent in the 1990s. Institutional investors were pleased, and responded to the lowered commissions by trading a whole lot more. The next big change forced on the exchanges came with decimalisation and the Order Handling Rules implemented in mid-2001. The preceding years had seen much electronic innovation both inside and surrounding the exchanges. The infrastructure was highly developed. The NYSE found ways to speed order introduction to the floor, Nasdaq operated happily without a floor and electronic communication networks (ECNs) found ways to compete for a portion of

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Electronic trading: rival or replacement?

the pie. But cutting the minimum spread changed the trading business profoundly. It became obvious that the spread, not the commission, facilitated and protected the previous business structure and incentives. When spreads fell to pennies, many long-standing broker practices became unprofitable. Nasdaq market-makers by the thousands sought new careers, even though institutional buy-side traders bewailed the silence on the other end of the phone line. Most importantly, the news was not depressing for investors. Institutional trading costs have declined precipitously since decimalisation. According to measurements from the Plexus Group4 universe of institutional trading, large cap trading costs fell from 1.57 per cent in the second quarter of 2001 to 0.55 per cent five years later, a decline of almost two-thirds. Small cap trading costs fell even more, from 2.54 to 0.79 per cent. Exhibit 3.1 shows that, despite decimalisation, total transaction costs remained high to the end of the frenzied internet market. They began to decline steeply in 2003 and have continued downward in recent quarters, even as the market returns have recovered. Clearly, investors benefited from the regulation-induced changes. The cause-and-effect runs something like this: the buy-side, eager to trade at lower cost, pressures regulators to modify the exchange rules. The regulators set rules that reduce spreads. As spreads collapse, the sell-side pulls capital and people from the now unprofitable marketmaking function, which makes it harder for the buy-side to complete big trades. Small investors celebrate lower costs, but traders at large investors confront communication gaps that make their job more difficult. How, then, are the big blocks previously assigned to institutional brokers for execution to be done? One popular solution for highly liquid issues is through the use of algorithms. The most popular algorithms chop large trades into retail-sized pieces that can be completed without human intervention, executed in such a rapid-fire succession that only a computer can provide the moment-to-moment responses. While algorithmic trading often gets the job done, it reduces

Exhibit 3.1 Cost of US institutional trading 250 200 Cost (bp)

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150 100 50 0 1997 1998 1999 2000 2001 2002 2003 2004

Large Cap

Small Cap

Source: Author’s own

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Part I: Transformation of the industry

trade activity to tiny increments and stretches out execution time. A 2001 study performed by Plexus Group5 found that 46 per cent of manager orders, but 85 per cent of NYSE trades, were for fewer than 2,100 shares. On the other end of the scale, over 35 per cent of the dollars traded by managers were in trades of over 250,000 shares, while only 1.1 per cent of the dollars traded were in orders over 250,000 shares. Steil6 identifies the mismatch succinctly: The problem is that continuous electronic auction markets, as useful as they are, have flaws that are apparent to any institutional trader. They require institutional-sized orders to be chopped up into small bits, each often as little as 1 per cent of actual order size, and executed over days or weeks in order to avoid huge market impact costs. That’s why in every major US or European marketplace – New York, Nasdaq, London, Frankfurt, Paris – about 30 per cent of trading volume is executed in blocks, ‘upstairs’, away from these systems. More importantly, new electronic systems are expanding to make this block trading more efficient. Liquidnet is the most prominent example. By foreswearing limit-order display, or ‘pre-trade transparency’, in favour of a structure in which potential matches are revealed only to the relevant buyer and seller, institutions are encouraged to reveal their true order size to the system. Algorithmic trading appears to be more of a work-around than a work-through solution. Dicing the order slows down the trading, which increases adverse price movement risk before the trade is complete. Failure to execute quickly imposes a dangerous liquidity cost that can work against the portfolio manager’s objectives. Worse, it does not work well for imbalanced trading in illiquid names, the traditional providence of information-central.

The exchange as a process What is this thing called a market? The dictionaries’ definitions of a market or marketplace are not especially insightful. For example, describing a market as ‘a body of persons carrying on extensive transactions in a specified commodity’ might be technically correct but not very illuminating. We need to think of ‘exchange’ as a verb, not a noun. The standard economist’s model of an effective market describes a forum in which indications of trading interest are publicly displayed and are ranked by price and time of submission within price, and in which the execution of orders is strictly determined by this priority. In this model, all trades are interactions between visible limit orders and demands for immediacy in the form of market orders. Again, the focus is on the mechanics. This model works when all traders are roughly the same size and arrive frequently enough to offset buying and selling interest. That might be a nice description of a farmers’ market, but is deficient in describing today’s equity markets for several reasons. First, institutional players need to trade in amounts that dwarf the trading desires of individual investors. This imbalance creates most of the difficult problems confronting market designers. Secondly, these traders are often more interested in size than price; they may be willing to forgo better market prices at tiny volumes to get their enormous block done expeditiously. Thirdly, the traders are acutely aware that displaying their trading interests would only serve to motivate frontrunners and copycats to

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Electronic trading: rival or replacement?

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jump ahead while causing potential trading partners to withdraw or delay until a clearer picture (and likely an inferior price) develops. Finally, in a market where the best price may evaporate in a flash, certainty of trade completion might be more important than strict price priority. Martin Sexton7 defines the purpose: ‘[to] enable buyers and sellers to come together in a regulatory environment that ensures honest dealing but doesn’t get in the way of growth.’ Again, a focus on the mechanics. Picot et al.8 provide a better starting point: ‘a discovery and learning process which rewards the best informed participants with the greatest knowledge arbitrage profits.’ That is worth dissecting. It defines the purpose: parties that trade with the most knowledge use the exchange to secure the value of that knowledge. It recognises that the purpose of the exchange is to arbitrage out special information so that the prices of assets represent true economic value. Finally, by describing the exchange as a process, it focuses on the dynamics, not the floorboards. However, it misses the central reason for the existence of a securities market – the pricing of assets and investment risk, and thereby expected returns. A definition that includes this goal – and gets rid of that awkward ‘knowledge arbitrage profits’ phrase – would read as: ‘a discovery and learning process that prices assets and investment risks and rewards the best-informed participants with the greatest returns from research and risk-bearing.’ With that in mind, we can go back and consider some of the working parts that an exchange provides: • A forum; a place where buyers and sellers can come together. The forum may be physical or electronic. • A means for buyers and sellers to address that forum, either in person, through an agent or by self-representing electronic messages. • A means of discovering a price satisfactory to both buyer and seller. • A means of intermediating time so that buyer and seller who arrive at uncoordinated times can find each other. • Dissemination of information about (1) prices and quantities of available merchandise, and (2) records of executed trade prices and size. This is advertising, plain and simple. • Rules for orderly conduct so that transactors are not taken advantage of by unscrupulous exchange insiders or outside parties. Investor confidence is essential to any market competing for business. • Efficient payment and delivery systems; a guarantee that counterparties will perform or the exchange will step in as guarantor of the trade.

Balancing varied interests So far we have been concentrating on the problems of managing the interaction between a buyer and a seller. But running a successful exchange requires a delicate balancing of the dynamic tensions between multiple constituencies: • Buyer vs. seller – buyers want the lowest possible price, sellers want the highest. Both sides must be made equally unhappy but satisfied with what they perceive to be a fair deal.

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Part I: Transformation of the industry

• Institutional traders vs. retail traders – retail traders have little to fear about revealing their trading interests; institutions can easily lose research and risk-bearing profits by revealing their interests indiscriminately. • Market orders vs. limit orders – market orders are buyers of immediacy; limit orders are sellers of time. Limit orders offer valuable liquidity to the market, and are particularly valuable to an exchange because they display available inventory. • Sell-side vs. buy-side interests – a traditional member-controlled exchange extracts monopoly profits; the buy-side wishes to pay only for the value-added. • Floor operators vs. investors in the exchange itself – floor-operated exchanges were owned by the floor operators and were often non-profit organisations. The dynamics changed with demutualisation. • Listings vs. investors – companies which list on a market are vitally interested in seeing that their current and potential shareholders get a square deal from the exchange. • Regulators, media and the political class – all are anxious to preserve and protect investors against the power of the exchange.

What can electronics bring? Electronics have been part of the brokerage process for as long as computers have been commercially available. IT budgets have grown steadily among buy-side firms, sell-side brokers and exchanges. Information systems are well developed in the securities industry, applying order management systems, trading algorithms and routing systems using the widely accepted FIX protocol. Integration effects and connectivity to exchange systems are being rapidly enhanced. Matching of orders for liquid securities is easily handled, as is the direct connection of institutional buyers and sellers through the ECNs. Electronic clearing and settlement is well under way, although more rapid clearing is still around the corner. Electronic exchanges have proven their worth in matching small trades. Trading algorithms exploit that facility by turning large trades into small trades timed so they do not create a trading imbalance. But what about those institutional-sized trades that do not meet a flow of liquidity on the other side? In 2002 Plexus Group performed a study9 of market liquidity per stock by counting the number of trades per day. Only nine NYSE stocks traded more than 5,000 times a day; 68 per cent of stocks traded fewer than 500 trades a day – roughly once every 1.25 minutes; and 20 per cent of stocks traded fewer than 500 trades a day – once every four minutes on average. This study shows that for many stocks the ‘continuous’ auction concept breaks down due to an insufficient number of trades or depth. How can an electronic market deal with these infrequently traded issues? What happens when the number of shares offered by sellers far exceeds the number of shares demanded by buyers (or vice versa)? What is the electronic computation that times the sequences of prices that clears the market? What is the value of human interaction at this critical juncture? Is that human interaction best performed on a trading floor? And does this situation occur often enough to warrant the maintenance of a trading floor? Large trades cannot simply be presented to the market. Signalling by price trend – with a great deal of advertising – may fill the order over a long sequence of trades, but the risk is that

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Electronic trading: rival or replacement?

the pattern becomes readable. This opens up a plethora of unpleasant reactions: sellers withhold orders for fear of upsetting the market; buyers hold back in the hope of getting a better price; alarming signals are sent to the outside world about the state of the market, possibly provoking panic selling; market orders are executed at dissimilar prices; and one-sided markets generating very rapid price movements can easily create positive feedback and out-of-control price instability. Liquidity can be described as lying in layers.10 Strata near the surface are easily accessed but thin. Deeper layers can reveal much larger amounts of liquidity, but usually at higher transaction cost. Exhibit 3.2 illustrates the relationship between trade size, the cost of trading and the strata of liquidity required to fill orders of increasing size. Cheapest, easiest-to-reach liquidity is at the upper left. As we move down, the amount of available liquidity increases. We will show how it arrives and why it comes at a higher price.

Revealed liquidity The first step is to dip into the ebb and flow of the everyday liquidity stream. This is ‘natural liquidity’, where the trading counterparty arrives as a result of an independent exogenously determined decision process. In other words, trading motivation comes from outside the exchange, representing an external decision process.

Exhibit 3.2 Layers of liquidity Size of trade 25%

Higher cost of trading

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Percentage of daily volume

100%

Revealed Flow Hidden For hire

M or e hi liq gh ui er dit co y a st t

Last resort

Source: Author’s own

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Part I: Transformation of the industry

Trading in this most accessible layer is not as easy as it sounds. The trader must be careful not to trade in a noisy fashion that tips off market participants such as day traders, technical traders, short-term momentum traders and hedge funds. These traders feed off the flow of information that indicates potential trading interest. They know that institutions have an information edge and that institutional size will dominate the volume until it is satisfied. They hope to go along for the ride. And in today’s markets, these hungry sharks drastically outnumber the institutional whales. But where is the liquidity? In today’s fractionalised markets, the institutional traders need to systematically search all the uncoordinated venues. Traders may try low-cost (electronic) venues first, then trading floors. The undone portion of the trade often falls to the hands of a block broker to perform an ‘information-central’ role.

Flow liquidity Flow liquidity is like revealed liquidity, except that it has not arrived yet. The problem for the institutional trader is that he cannot anticipate when, or even whether, someone else will independently decide to sell what he wishes to purchase. If the order awaiting liquidity has a low information content, waiting may not be a problem. In contrast, if an information ‘edge’ underlies the order, delay might be costly as other investors become aware of the information. This leaves the trader with the fundamental trading decision: is the best strategy to wait for liquidity to arrive, or is it more effective to seek quicker – often more expensive – liquidity by other trading techniques? Since information or trading necessity underlies all the largest and most important institutional trades, most institutional traders tilt towards trading faster rather than awaiting natural flow liquidity. But when the stream of liquidity is inadequate, it is necessary to look deeper for pockets of liquidity.

Hidden liquidity Hidden liquidity lies a step below the revealed and flow liquidity. The commitment to trade has been made; the order is live. The order may be known only to the trader holding a large institutional order, or it may be revealed to his block broker (that is ‘participate, do not initiate’ orders). The buy-side trader may keep it in his pocket. Hidden liquidity can easily be larger than revealed liquidity. On the floor of the NYSE, the traditional information-central market-maker is aware of the liquidity but trusted to keep it secret. If the market-maker senses an opportunity to put together a buyer and a seller, the hidden liquidity can be revealed to both parties. If free-riding and front-running were rare events, we would not be talking about them here. To the contrary, these are all day/everyday occurrences. They are, for example, the raison d’être of the day traders and many hedge funds. They are a major concern to institutional traders. Thus large trading interest is seldom shown publicly in order to protect the proprietary value of the order. Information on the desire to trade will not be revealed without a suitable quid pro quo: the information will be traded either for an execution or for information – trading or fundamental – of perceived equal value. It will not be intentionally released to untrustworthy

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Electronic trading: rival or replacement?

12222 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 35 6 7 8 9 40111 1 2 3 44222

parties who can gain from the knowledge at the expense of the initiator. A primary duty of an institutional trader is to protect the value of this information to secure the research and riskbearing profits for his clients. Active managers act from an information edge, particularly motivating the very largest orders. Trading is necessary to capture the knowledge profit, and size is a requisite for significant portfolio impact. But the initiator cannot act in the marketplace in size unless someone of size is willing to trade with him. The order cannot be completely hidden; it must be known to someone who (1) can be trusted to protect the information and (2) is situated to know when a counterparty arrives. If both buyer and seller notify a market-maker of potential trading interest, alias hidden liquidity, the market-maker can effect a trade.

For-hire liquidity Above we described trades occurring through the matching of exogenous trading decisions. But what happens when no ‘natural’ arrives to balance buying and selling interests? The last two categories of liquidity derive from market participants who respond to calls for liquidity. They will accommodate liquidity demand by buying at a discount or selling at a premium. In other words, they sell liquidity to any party anxious enough to pay for it. The information edge these traders work from is endogenously determined, inside-the-box information about the market. The order itself is the inside information. From the institution’s perspective, liquidity providers can be incentivised by giving up a portion of the potential alpha in order to coax out the desired liquidity. The trade will be profitable as long as the payment for liquidity does not exceed the potential alpha. There are many sources of endogenously determined liquidity. First, a market-maker might undertake this role. Secondly, the block trading desk or proprietary trading desk of a large brokerage firm can commit capital to accommodate good customers. Finally, aggressive nonbroker traders, such as hedge funds, may take a short-term position if they believe they can turn a profit. One of the roles of information-central is to alert these potential liquidity sources. At first glance, signalling these endogenous liquidity providers appears to breach the confidential nature of the order. While knowledge of the trade is a valuable proprietary asset of the initiator, it is also knowledge that the market-maker purveys as his stock in trade. The marketmaker aids his customer by transmitting information that attracts liquidity. The distinction is not clear-cut: no bright line distinction exists between ‘trying to find the other side’ and ‘tipping off his pals to front-running possibilities’. The market-maker cannot accelerate liquidity arrival without revealing trading interest. Nor is the institutional trader able to complete his order expeditiously without revealing at least a peek. The trader must balance the costs of revealing information against the cost of failing to find liquidity. It is tempting to call this false liquidity, since the accommodating sellers, who are not investors, will have to turn around and buy stock to clear their short position. This cat-and-mouse situation frustrates the institutional trader. They must trust their agents but cannot verify their fidelity. Potential conflicts of interest are rife among the parties he must deal through. Even worse, he has no ability to monitor the market-maker’s information dispersal. No paper trail exists, no phone records can be relied on; information could be passed on by a code, a blink, a hesitation or silence at the pregnant moment. It gets worse. As information moves

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Part I: Transformation of the industry

down the chain of trading, other parties with no connection or obligation to the customer tune in. A weak market-maker may have neither the capital to finance the trading nor the treasured relationship with the institution, and may ‘daisy chain’ the trading by laying off positions to other brokers or hedge funds. Liquidity providers can be drawn from a myriad of directions. The most innocent way to find potential sellers is to call up those who are known to own the security and those who have been recent sellers. This is clearly part of the information-central role. An options market-maker might find a way to profit from an arbitrage against the options. A hedge fund might sell stock and buy a mathematical hedge of other companies to control the exposure. If these are such effective methods of raising liquidity, why did the buy-side trader not try them himself? Mainly because he would prefer they did not know what he was doing. By calling them he might be giving away important information about his intentions. Furthermore, he does not have the time or the resources, and in particular the contacts, to do that. Ah, but the market-maker does have the contacts. It is the heart of his business. Maintaining this network of contacts is time-consuming and expensive. Only someone with an ongoing, everyday mission to be privy to everything knowable about a stock’s supply and demand can profit enough to cover the high cost of network maintenance.

Last-resort liquidity Suppose a company unexpectedly restates earnings, leading to a panic of intensely motivated sellers. Everyone, including the for-hire liquidity providers, hangs back until price reaches a bottom. In this situation there are no buyers at the current price, and stock for sale will overhang the market until the price reaches a level where last-resort liquidity comes into play. Who are these buyers of last resort? Deep contrarians who are motivated to trade by a deep, deep discount. Donald Keim11 has documented how one fund manager, Dimensional Fund Advisors (DFA), systematically adds value by standing as buyer of last resort. The lower line on Exhibit 3.3 shows that stock prices decline on average 10 per cent over 20 days prior to DFA block purchases, then bounce back and stabilise. This is the price pattern we would expect to see from a buyer of last resort. Value investors are constantly on the prowl for these situations and will likely uncover them without market-maker assistance. They will step in when the price falls further than their assessment of the fundamentals. The danger is the unknown information motivating the other side. Consequently, these are risky trades that demand big price concessions to offset the risks of buying too soon or buying fatally damaged goods.

‘Colour’ There are two ways to correct a buyer/seller imbalance: advertise the imbalance through an easily read pattern of consistent price movements and wait until investors react, or stimulate interest on the other side by signalling those parties that are likely to respond. Securities traders like to describe the latter with the word ‘colour’. Barclay et al.12 provide a definition for the treasuries market that is perfectly applicable to equity markets: ‘Market color can best be

52

Electronic trading: rival or replacement?

Exhibit 3.3 Buyers of last resort Buys only 1.02 1.00 All regular trades

0.98 Wealth ($)

12222 2 3 4 5 6 7 8 9 1011 1 2 3111 4 5 6 7 8 9 20111 1 2 3 4 5 6 7 8 9 30111 1 2 3 4 35 6 7 8 9 40111 1 2 3 44222

0.96 Previous day’s close

0.94

Trade day’s close

0.92

All block trades

0.90 0.88 –21

Trade price –15

–10

–5

0

5

10

15

21

Days relative to trade date (TD) Source: www.dfafunds.com

described as non-payoff relevant information about short-lived variations in supply and demand that voice brokers collect from interactions with their customers.’ They further suggest that when a dealer calls a voice broker, the voice broker may collect more information than just the price and quantity to which the dealer is willing to commit. This additional qualitative information, which often is referred to as ‘market color,’ can be valuable to the voice broker’s customers because it allows the broker to match natural counterparties that otherwise would have difficulty finding each other. The better matching of customer orders compensates the dealers for the higher commissions charged by the voice brokers. This is information-central at work, in this case conducted without face-to-face contact. Electronic orders, in contrast, are anonymous and indistinguishable. Written in the stiff, stilted language of high-speed messaging, they are black and white – without discernible personality. Reading this torrent of electronic messages to interpret market conditions and reactions is problematic. Electronic exchanges have tried to replicate the function of the voice broker with limited success. For example, auto-refresh algorithms, reserve orders and dark pools of liquidity are all attempts to add at least a tint of colour to trader communication without granting or incurring a competitive disadvantage. Accessing dark liquidity is still shooting in the dark. Another way to safely provide colour is to filter the lines so that only selected individuals have access to it. Liquidnet and crossing networks like ITG’s Posit restrict membership to institutional traders; Pipeline sets a high threshold for minimum trade size. Both systems filter out most free riders and quote jumpers. The problem, as always, is that separate pools inhibit total liquidity. And illiquidity is not without cost.

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Part I: Transformation of the industry

The prudent act for the seller might be to issue private notification to a highly selected list of potential counterparties. The public quote and transaction dissemination system is clearly not designed for private messages, for vetting information to assess its authenticity or for judging its relevance. Colour is not information, it is knowledge. Failure to distinguish the two leads to much confusion. For example, we speak loosely of ‘information technology’, which is little more than switching technology for routing a stream of bits we call a message. The ‘information’ passed makes no distinction between truth and falsehood, reality or fantasy. It is just bits – the technology has no means to assess the quality of the information being transferred. Using such a system requires tacit knowledge – understood without being openly expressed – and is subject to errors of interpretation. That is why we occasionally see a Corinthian College fiasco where the computer sees no difference between a ten share trade and a ten million share trade. The point is that the issue of the electronic provision of colour, necessary to almost any market, has as yet not been resolved. There may be no electronic solution. Colour is valuable, but it is costly to provide. It requires the continuing maintenance of a network of information. Those who provide colour expect to be compensated for their efforts. Colour can be provided on the floor of the exchange, but there is no monopoly. Institutional block desks and third-market brokers provide similar services.

Governance From negotiated commissions to decimalisation to the National Market System rules, Reg. NMS, we have seen that the will of the market regulators plays a role in defining future markets, second only to the role of technology. Most of the Securities and Exchange Commission (SEC)’s efforts have resulted in substantial benefits to investors, although with significant unintended consequences along the way. The recommendations appear well researched and carefully thought out, but the possibility always exists for a major problem to crop up. Sarbanes-Oxley is one that comes to mind. The sustained plunge in average trade size is surely aided by the regulatory environment. As one observer said, ‘The SEC set up a market for retail-sized trades and then was surprised that all they got were retail-sized trades.’13 Larry Tabb14 has pointed out: The financial markets are highly regulated and the playing field is anything but level. While we as market participants believe we are in control of our own destiny, it is the regulators who own the ball, the field and make the rules. They may be wise or they may not, but they have the power. The regulatory solutions strive to consider the needs of all parties – buyers and sellers, retail and institutional, market orders and retail orders, giant trades and small trades, legislators and public opinion. (Each, of course, trying to make their own interests primary.) A ‘wise’ solution meets all those needs, but it is easy to mess up and end up with thorny unintended consequences. If the solution is not perfect, the buy-side and sell-side will collaborate on a less effective workaround (for example algorithmic trading) so that the essential trading can be completed. Alternatively, someone will set up another venue or ECN that provides an improved solution.

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Electronic trading: rival or replacement?

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Mandated changes can be very expensive to implement, and the value does not necessarily accrue to those who are required to pay for them. For example, the tsunami of messages let loose by the decimalisation rules – and in all likelihood the new Reg. NMS – forces all market participants, from the buy-side to the sell-side to the exchanges, to invest heavily in computer and communication equipment just to handle the messaging load. Needless to say, the investor ultimately foots the bill.

Proliferation of alternatives The NYSE hopes that its new Hybrid system will draw back volume that has been lost to the ECNs over the past decades. As hinted in the previous section, most are, or were initially, niche oriented: finding some subset of trading interests that is not well covered by the central markets. In recent years, the distance of the ECNs from the central market-making has decreased. There are clear disadvantages to this proliferation of venues. The first is congestion: under Reg. NMS each system must communicate with all others, sending and receiving messages and interpreting the implications for processing their own order book. Costly excess capacity and fail-safe backup systems must be in place and instantly available to handle storm-of-the-century message flows. Sounds expensive. More importantly, a market fractured into separate pools is inherently less liquid and slower. But liquidity is highly valued by investors; the implication is that prices are lower in illiquid markets. Lower prices in turn lean heavily on the cost of capital and the multiples at which new issues can be brought to market. On the other hand, the spunky little ECNs have scared the behemoths by stealing market share. Now is a time for experimentation, so the more the merrier; let a thousand flowers bloom. All but a few will ultimately wither or consolidate. Out of this adaptive and experimental process would come workable solutions that will provide the facilities that investors want now or will come to want in the future. Clem Chambers15 eloquently points out the centripetal forces drawing liquidity together. Chambers states: Stock exchanges are natural monopolies because their scale is a direct benefit to their customers. Liquidity is the advantage that traders value most and trading naturally flows to the largest player with the most liquidity. This is a self re-enforcing process. Liquidity is the fuel of any market and the lower the cost of trading the greater the liquidity. The greater the liquidity the lower costs can be, and the more liquidity will be created if the costs are optimal for the customer and the exchange. This loop is the factor that protects the customer from the monopoly and in practice this appears to be what happens . . . In the modern world liquidity is as vital as oxygen . . . Traders, brokers and exchanges themselves live or die by the availability of liquidity, because in the end the market is its liquidity and for once scale is on the side of ‘the angels’. The value of intermediaries lies in their ability to enable transactions that would not have occurred in a timely manner and anonymously. These intermediaries may be brokers who proactively

55

Part I: Transformation of the industry

search for counterparties, auctioneers who bring together large numbers of potential traders, or dealers who take positions in order to get transactions done. When costs of waiting are high, liquidity is valuable and exchange-provided services will demand a premium. However, they are not always needed, particularly in situations that are naturally highly liquid. Thus the sell-side is poised to capture this business by automating the handling of large institutional orders, internalising where possible, and intelligently routing to limit information leakage.

Information-central For the vast bulk of trading, the electronic solutions embedded in Reg. NMS are sufficient; frequently optimal. But Reg. NMS is a black-and-white solution for a world that also needs colour on very important and influential trades. Yet the sense is that the markets are still searching for a better solution to the size-meets-size problem. If the German experience is at all applicable, about half of all volume might be done off-exchange, according to Pagano et al.16 Recall that Benn Steil’s estimate was 30 per cent. Capturing a significant portion of that negotiated big-block trading is nirvana to the NYSE. Market data drives all the interconnectivity and automated trading. Without ultra-lowlatency access to (clean) market data, none of this electronic trading is feasible. And who controls the dissemination of quotes and trades? The exchanges. Thus we can expect that revenues from market feeds will become an increasingly important source of revenue for the exchanges. Companies that list on an exchange have to pay for the privilege and listing fees are an important source of exchange revenue. The NYSE trades off its prestige in setting listing fees, and needs to maintain the primacy of its market to continue its pricing power over listing fees. Reg. NMS is not likely to be the final solution to the problems of market microstructure. If our forward thinkers get some of the details wrong, traders who must complete their orders will figure out how to make it right. The need for market-makers is clear, but their role can be accomplished as well by phone as through physical contact, although the crowd concept will give way to one-on-one conversations.17 Under Reg. NMS, the trade has to go to the best price, wherever that price can be found. Thus all exchanges will be interconnected in real time, and all will have the opportunity to compete for the order on equal terms. If the NYSE wants to retain market share it must offer as good a price as anywhere else. To accomplish that, it must attract the liquidity and put that to use by the specialists in forming best prices. The old floor population of the NYSE used to tout that ‘this is the best market in the world’. Maybe, maybe not. But it is also a very expensive market to operate and the costs come out of investors’ pockets. They are not happy about it, and the regulators who represent their interests are determined to make the exchanges work to investors’ best advantage. As Picot et al.18 conclude: Complete replacement of human intermediaries will not take place. But it is likely that there will be an unbundling of the activities of intermediaries so that consultative [emphasis mine] and pure order handling activities are separated. Standard transactions will become more

56

Electronic trading: rival or replacement?

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and more automated, even their price discovery, as long as the orders are atomistic and one order has no significant impact on the price. Intricate transactions will still need human intermediaries but may be conducted with electronic support. Anyone who provides an electronic facility that proves Picot et al. wrong will make a fortune. So far, it has eluded the finest minds in the business. The NYSE thinks they have a handle with the Hybrid market, but this half of their solution is not truly electronic. As we suggested above, it may never be possible. Silicon-based systems complement rather than replace ‘carbon-based’ human solutions. Perhaps the floor will survive, but at this point the economics and history are working against it. Assuredly, what functions in the new world will be a pale shadow of the former hustle and bustle. From a practical perspective, it may matter little whether it survives or not. No doubt the NYSE will survive, with or without the floor. As Clem Chambers points out,19 it has all the advantages in the world in terms of reputation, depth and, with its new corporate structure, the flexibility to compete in the trenches. They will experiment with trading hours, trading stocks in other countries, trading bonds, options, futures and who knows what else. They will continue to earn revenue through listing fees and data access fees. Look for a change in name: from the New York Stock Exchange to the New York Securities Exchange. Investment advice? Go long NYS and short downtown NY real estate.

1 Chapman, P., Traders Magazine, 29 September 2006; Bresiger, G. Traders Magazine, 20 October 2006; Luchetti, A., Wall Street Journal, 31 October 2006. 2 Pagano, M. S. , R. A. Schwartz and P. Davis (2006), ‘Life after the Big Board goes electronic’, Financial Analysts Journal, 62(5): 14–20. 3 The Handbook of World Stock, Derivative and Commodity Exchanges, 2005 edition. Available at www.researchandmarkets.com/reports/300254/300254.htm#. 4 Now part of ITG Solutions Network, LLC. Schwartz, R. A., Byrne, J. A. and Colaninno, A. (2006) ‘Electronic vs. Floor Based Trading’, Springer US: 50. 5 Plexus Group (2001), Wagner, W. H., ‘The nature of institutional order flow’, presented at the Institute for Quantitative Research in Finance, Spring 2003. A summary can be found at www.q-group.org/summaries. 6 Steil, B. (2006), ‘The end of history and the last trading system: Fukuyama comes to Market Reg’, The Handbook of World Stock, Derivative and Commodity Exchanges, op. cit. 7 The Handbook of World Stock, Derivative and Commodity Exchanges, 2005 edition. Available at www.researchandmarkets.com/reports/300254/300254.htm#. 8 Picot, A., C. Bortenlanger and H. Roehrl (1995), ‘The automation of capital markets’, Journal of Computer-Mediated Communication, 1(3). 9 Plexus Group (2002), ‘How big is the strike zone?’, Plexus Group Commentary No. 72, September 2002. Available at www.waynewagner.com. 10 Wagner, W. H. (2004), ‘The market-maker in the age of the ECN’, Journal of Investment Management, 2(1): 14–25. 11 Keim, D. (1999), ‘An analysis of mutual fund design: the case for investing in small-cap stocks’, Journal of Financial Economics, 51: 173–94. 12 Barclay, M. J., T. Hendershott and K. Kotz (2006), ‘Automation versus intermediation: evidence from treasuries going off the run’, Journal of Finance, 61(5): 2395–414. 13 Tabb, L. (2006), ‘Global market consolidation: read the rules carefully’, Wall Street & Technology, 16 June. 14 Tabb, L. (2006), ‘Global market consolidation: read the rules carefully’, Wall Street & Technology, 16 June. 15 The Handbook of World Stock, Derivative and Commodity Exchanges, 2005 edition, op. cit.

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16 Pagano et al. (2006), ‘Life after the Big Board goes electronic’, Financial Analysts Journal, 62(5): 14–20. 17 With all this talk of inexorable electronic advances driving market evolution, it might seem that all securities markets are destined to operate electronically. Andy Nybo of the Tabb Group (www.tabbgroup.com/in_the_news_dec.php, summorised in the subscriber-only section of www.FT.com.) points out that, despite significant investment in bond trading systems during the 1990s, bond trading remains in large part a voice-based marketplace with the bulk of activity dominated by large institutions and dealers. ‘The roles of the major participants have seen little change for more than a century,’ says Nybo. ‘The darker, less liquid sectors of the bond market still are traded in a traditional over-the-counter market whereby the sell-side is a “market-maker” and the buy-side is a “market-taker.”’ Why has automation failed to conquer the bond markets? Nybo points out that the biggest stakeholders are happy with the way things are. Dealers are so far able to retain control of the oligopoly, buy-side firms are satisfied with the status quo, and regulators are looking elsewhere; that is the equity markets. Stand pat is still the order of the day. The moral of the story is that, in the absence of organised customer dissatisfaction and regulatory complacency, nothing will change. Only under strong compulsion or outright market disaster will the insiders alter a lucrative franchise, kicking and screaming their way into the future. Unfortunately for the aficionados of the NYSE floor, their customers are vocal and organised and the regulators are on their side. 18 Picot, A. Bortenlanger, C. and Rohrl, H. http://jcmc.indiana.edu/vol1/issue3/picot.html (1995). 19 The Handbook of World Stock, Derivative and Commodity Exchanges, 2005 edition, op. cit.

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Chapter 4

The outlook for global derivatives market competition1 Jens Nystedt Deutsche Bank

Introduction ‘Growth in the global derivatives industry is accelerating and new competitors are emerging in exchange, over-the-counter and other unregulated markets.’2 The growth in exchange-traded derivatives has been nothing short of impressive and far outstrips the growth (turnover) in, for example, the cash market (see Exhibit 4.1). Both exchangetraded derivatives and those traded OTC (over-the-counter) have seen spectacular and consistent growth rates.3 The total open interest of financial derivatives, according to the Bank for International Settlement (BIS), approached US$434tn by the end of June 2006. Eight years earlier, mid-1998, the open interest was a still an impressive US$87tn. Hence, over those eight years there was a cumulative growth rate of close to 400 per cent, which translates to an average annual growth rate of 22 per cent. Moreover, there is still no sign that this growth rate has slowed down or is about to reverse. In fact, during the year ending June 2006 total open interest grew by 31.5 per cent, the third highest annual growth rate over the previous eight years. The popularity of derivatives reflects a number of diverse factors and does not always increase. In fact, there have been instances when derivative use has actually shrunk (one has to, however, go back to the early 1990s to find such an episode) and hence the spectacular growth trend in derivatives cannot be taken for granted. Popular explanations for the growth in the use of derivatives reflect: • A general maturation of the instrument and increased comfort on the part of end-users – In an exchange-traded context, the first financial derivatives in modern times were launched in Chicago in 1973. Derivative usage has had its successes and spectacular failures. In general, the near-disastrous derivative experiences of Procter and Gamble, Orange County, Metallgesellschaft, Barings, LTCM, etc., have taught valuable lessons of ‘buyer beware’ and ‘know what you use’. While there invariably will be more misuses of derivatives in the future, the end-user base has expanded and grown more experienced with derivatives and has also created systems to handle and value them. By now derivative use is considered so ‘plainvanilla’ that even retail clients have ventured into the field and have the analytical firepower in the form of computer systems, etc. that were not even available to the top banks 10 years ago.

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Part I: Transformation of the industry

Exhibit 4.1 Derivatives turnover far outstrips that of the cash markets (in US$tn) 180

1,600

160

1,400

140

1,200

120

1,000

100 800 80 600

60

400

40

200

20 0 Dec-86

0 Dec-89

Dec-92

Dec-95

Dec-98

Dec-01

Dec-04

Turnover exchange-traded derivatives (equities – futures and options) Turnover cash equity market Turnover exchange-traded derivatives (non-equity, right scale)

Source: BIS and World Federation of Exchanges (WFE)

• The growth in demand for derivatives through the growth in institutionally managed assets and the broad-based expansion of hedge funds – One of the few variables that has expanded quicker than the 20+ per cent growth rate in derivatives has been the assets under management of the hedge fund community. Hedge Fund Research estimates that the average annual growth rate of these assets has been in the neighbourhood of 28 per cent4 and that they are rapidly approaching US$2tn. However, this is not only a hedge fund story; assets under management of traditional institutional investors, such as mutual funds, insurances companies and pension funds, have also increased significantly, as an ageing population is putting more of its savings into the financial markets. • Increased innovation, in the form of new financial derivatives, making the risks that can be hedged or speculated upon even more varied – Derivatives on equity indices or catastrophe derivatives, for example, have both, in their different ways, attracted end-user interest as they either made hedging particular risks cheaper or allowed the end-user to gain exposure to risks that are uncorrelated with the rest of his/her portfolio. • Much lower transaction costs due to technological developments – The gradual move away from open outcry towards electronic trading has led to a sharp decline in costs. • Regulatory changes and harmonisation have opened up derivatives to a broader group of potential clients – Regulation and supervision are increasingly being harmonised across the globe. Within the EU there has been a natural incentive to do so and the advent of the euro

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Global derivatives market competition

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sparked a huge shift away from using derivatives to hedge pure currency risks towards now hedging interest rate risks. • The emergence of new derivatives markets globally – With increasing macroeconomic stability among emerging markets, these countries have been able to experience some of the most spectacular growth rates in derivatives use (see Exhibit 4.2). The Korean derivatives market is now the world’s largest market in terms of equity derivatives turnover. Brazil’s stock exchange (the Bovespa) and futures and derivatives exchange (the BM&F) are both in the top ten. While the growth rate in the traditional industrialised country derivatives markets has been high, it pales in comparison to the growth rates seen in emerging markets. It is too early to say whether the spectacular growth rates in emerging market derivatives markets could be sustained. We will know more once we go through another global growth cycle (that is have a recession). A presumably important reason why derivatives usage has grown so large is partly cyclical, that is the abundance of global liquidity and the absence of large macroeconomic risks in the context of generally favourable world economic growth from 2002 to today. Given the rapid growth in derivatives use, why are there concerns about competition? There seems to be enough trading volume for almost any derivatives exchange. This is not necessarily true, especially in the more mature industrialised markets. There have been several episodes of both internal and cross-border competition in and between derivatives markets in the US and the EU. The potential for a competitive relationship with the OTC derivatives markets has also been frequently highlighted as both a concern5 and an opportunity.6 The competitive pressures from the technological revolution, regulatory changes, innovations and changing end-users have all created incentives for derivatives market consolidation both within a given country and crossborder. As has been commonly cited as a maxim, ‘liquidity goes where liquidity is’, that is there are clear network effects of creating ever-larger derivatives markets where participants can pool

Exhibit 4.2 Open interest in exchange-traded and OTC derivatives (in US$tn) 500 450 400 350 300 250 200 150 100 50 0 Jun98

OTC derivatives

Jun99

Jun00

Exchange-traded derivatives

Jun01

Jun02

Jun03

Jun04

Jun05

Jun06

Source: BIS

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Part I: Transformation of the industry

and net their risks and thereby generate low-cost execution of their hedges or speculative positiontaking. In this chapter, I discuss in more detail the competitive pressures facing exchange-traded derivatives globally. I will start with an overview of the current landscape of organised derivatives exchanges and the type of derivatives traded on them (see Exhibit 4.3). Next, I will present what the academic literature can provide us with in terms of lessons and insights into how to gauge the trends we identified in the introduction. In the third section, I will discuss the drivers of competition in exchange-traded derivatives. Following that, I will discuss the competitive, and potentially symbiotic, relationship with the OTC derivatives markets. I will end the chapter with some conclusions and an outlook.

Recent trends in exchange-traded derivatives markets As noted in the introduction, the growth in derivatives, both in terms of open interest and turnover, has been impressive. However, since 2001 most of this growth has been driven by the increased popularity of options, especially equity options. Having been the poorer cousins of the world’s futures exchanges the open interest in options constituted 70 per cent of the total derivatives exchange-traded open interest (see Exhibit 4.4) by mid-2006. Together, open interest in exchange-traded options and futures approached US$84tn from only US$0.6tn in 1986. Regionally, the most rapid growth in the open interest of exchange-traded derivatives has been in North America. Since the beginning of the millennium open interest has increased 7.7 times, compared to 6.4 times for Europe and roughly two times for Asia-Pacific. In terms of their relative importance, 63.7 per cent of the open interest is found in North America, 30.3 per cent in Europe and a fairly small 5.4 per cent in the Asia-Pacific region (the highest share Asia-Pacific has seen during the 20 years of data that BIS provides was in September 1995, when its share of open interest approached 30 per cent (see Exhibit 4.5)). The recent spectacular growth in both open interest and trading volume in North America reflects the increased competition driving down transaction costs from sources, such as the launch of the International Securities Exchange in May 2000, which introduced electronic trading in US options. Many of the smaller derivatives exchanges in Europe, on the other hand, started off with electronic trading in the 1980s and have held a technological lead over their American counterparts ever since. Even those European exchanges, such as Marché à Terme International de France and eventually London International

Exhibit 4.3 Definitions of different derivatives markets Standardised Cleared, regulated Not cleared, self-regulated Source: Nystedt (2004)

62

Exchange-traded derivatives on markets (ODE) such as CBOE, CME/CBOT and Eurex International currency and swap market

Not standardised Tailor-made clearing Pure OTC derivatives

Global derivatives market competition

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Exhibit 4.4 Global open interest in exchange-traded derivatives 90

Options Futures

80 70 60 50 40 30 20 10 0 Dec-86

Dec-89

Dec-92

Dec-95

Dec-98

Dec-01

Dec-04

Source: BIS

Financial Futures and Options Exchange (Liffe), that had trading floors were somewhat quicker in adapting to the electronic trading realities than their American counterparts. The global market share held by European derivatives exchanges was steadily increasing until it flattened out and eventually declined, starting in mid-2004. Presumably, the large increase in the share of European markets from 2001 to 2004 partly reflects the fact that open interest is measured here in terms of US dollars, in a period during which the dollar weakened significantly. Since then the policy rate-hiking cycle of the US Federal Reserve (US Fed), starting in 2004, has had a significant impact on the attractiveness of using US interest rate derivatives to express views or hedge interest rate exposures. As a result, the market share of US derivatives has recovered much of its previously lost ground and is currently hovering at around two-thirds. In Asia, a number of significant obstacles have hampered the development of the derivatives exchanges in the late 1990s and the early 2000s, such as the Asian crisis and the poor economic performance of Japan. In general, trading volume on derivatives exchanges is clearly linked to the overall economic and stock market performance (in cases where the underlying security is a stock). Hence, during the economic turmoil that swept the region from mid-1997 the growth of exchange-traded derivatives trading slowed or reversed. Since 2003, however, Asia has caught up. The most heavily traded option contract is now in Korea (the Kospi 200 index option). To determine what types of exchange-traded derivatives have seen the most impressive growth we again look at the open interest calculations. According to the latest BIS data, limiting the sample to the post-1999 period, the largest growth in open interest was in interest rate derivatives (up 6.6 times), followed by equities (up 3.8 times) and currencies (up 3.2 times). In terms of the relative importance of the different segments, exchange-traded currency derivatives are almost negligible in terms of open interest (US$0.2tn in mid-2006, or 0.2 per cent)

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Part I: Transformation of the industry

Exhibit 4.5 Regional market share for exchange-traded derivatives 90%

90% 80%

80%

North America Asia-Pacific Europe

70%

70%

60%

60%

50%

50%

40%

40%

30%

30%

20%

20%

10%

10%

0% Dec-86

0% Dec-89

Dec-92

Dec-95

Dec-98

Dec-01

Dec-04

Source: BIS

compared to the size of the interest rate (US$76.7tn, or 91.4 per cent) and equities (US$7.1tn, or 8.4 per cent) derivatives markets. The growth outlook for currency-based derivatives is bright, however, in light of Chicago Mercantile Exchange’s (CME) joint venture with Reuters to launch spot foreign exchange trading through their market space initiative. The trends identified above are useful to have as a background when discussing the performance of individual derivatives markets and contracts. Looking at turnover statistics in terms of millions of contracts traded, we see that the Korea Exchange (the stock exchange merged with the futures exchange in 2005 and was named Korea Exchange or KRX) stands out because it has both the largest overall turnover and it lists the most actively traded options contract, the Kospi 200 equity index option (see Exhibits 4.6 and 4.7). The Kospi 200 index option has about ten times the turnover of the second most heavily traded option, the eurodollar options on the CME. The KRX has been at the top of such volume rankings since 2001.7 Looking at the top ten, another interesting finding is the increased role of emerging markets in terms of the size of their derivatives markets and their trading volumes. If we include Korea as part of the broad group of emerging markets, emerging derivatives markets take four out of the first ten spots and seven out of the first twenty spots (a relative newcomer is the Chinese Dalian Commodity Exchange, which comes in at number 17). Despite the increased importance of the new centres for derivatives trading, with the exception of the KRX, the rest of the top five come as no surprise. Eurex’s second place has already been taken over by the alliance of CME with the Chicago Board of Trade (CBOT) and together these two US derivatives exchanges can probably challenge Korea for the top spot in the next few years.

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Global derivatives market competition

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Exhibit 4.6 Top ten derivatives exchanges by volume

(Millions of contracts)

06 to Jan–Apr Jan–Apr 05 % 2005 2006 change

Korea Exchange

738

908

23.0

Eurex

416

497

19.4

CME

345

422

22.2

CBOT

234

250

6.7

Euronext-Liffe

260

242

-7.0

CBOE

145

205

41.3

ISE Mexican Derivative Exchange

143

193

35.2 69.3

56

95

Bovespa

94

88

-6.6

BM&F

60

86

43.3

Source: Futures Industry Association (FIA)

Exhibit 4.7 Top ten derivatives contracts by volume

(Millions of contracts)

06 to Jan–Apr Jan–Apr 05 % 2005 2006 change

Kospi 200 Options, KRX

720

887

23.2

Eurodollar Futures, CME

133

155

16.4

Euro-Bund Futures, Eurex

106

111

5.2

TIIE 28-day Futures, MexDer

53

91

71.3

Eurodollar Options, CME

64

88

37.0

10Y T-Note Futures, CBOT

74

78

5.8

E-mini S&P500 Futures, CME

67

74

11.4

Euribor Futures, EuronextLiffe

54

64

17.5

Euro-Bobl Futures, Eurex

55

60

9.7

Euro-Schatz Futures, Eurex

47

58

24.5

Source: FIA

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In terms of growth rates in 2006, derivatives markets in emerging markets posted the most impressive gains. Among the top ten, the Mexican derivatives market posted a year-to-date increase of nearly 70 per cent compared to the same period one year earlier. Looking outside the top ten, the National Stock Exchange of India posted a growth rate of 116 per cent. Among the industrialised country markets, the highest growth rate so far in 2006 has been observed at the Philadelphia Stock Exchange (PHLX), which saw its turnover increase by more than 80 per cent. A similar story can be told regarding the popularity ranking of individual contracts. Again, emerging markets do reasonably well, with Mexican interest rate futures posting the highest growth rate so far in 2006. Interestingly, not all derivatives exchanges posted growth rates; Euronext-Liffe actually saw a decline in turnover, but this reflects a decision to multiply the contract sizes by ten during the course of 2005, which biases the data. Meanwhile, equity options trading on the Bovespa declined, but that reflects some stabilisation after more than a 14 per cent growth rate in 2005. The growth rate seen in CBOT turnover was only a third of that of the CME during the first four months of 2006. Some of this sluggishness perhaps helps explain why, at the end of the day, the CBOT turned in favour of the merger with its cross-town rival in October 2006.

Academic literature on derivatives market competition Compared to the large market microstructure literature available about stock exchanges, competition within the world of derivatives markets has attracted limited interest from the academic community. While there are gradual signs that this is changing, since turnover is clearly increasing and the pace of growth is higher within exchange-traded derivatives than the cash market, there are still many topics that are left to explore. In terms of outright derivatives market competition and the role played by financial innovation, Duffie and Jackson (1989) represents one of the first and most useful attempts to address the issues of optimal financial innovations and transaction costs in an incomplete market setting. Innovations are used in this strand of literature as a term to reflect the best additional derivatives contract to launch by a derivatives exchange given previous contracts. Duffie and Jackson find that the optimal contract is the one that maximises turnover by addressing the demand to hedge a previously unhedgeable risk. Tashjian and Weissman (1995) used the Duffie and Jackson approach to analyse a futures exchange that can launch several contracts to see how it affected trading volumes. Clearly, the futures market will always design the next new contract in such a way that is likely to generate the highest additional revenue for the exchange, that is it will target those investors that have the highest unfilled demand for hedge weighed by their risk aversion. Their conclusion is that markets will always be incomplete as all risks are not economical to hedge or provide a hedge for (in the case of the exchange). More recent approaches to analysing multiple exchange competition have applied a variety of different modelling frameworks to the concepts of innovations, competition, etc. Rahi and Zigrand (2004) analyse the issue of market competition and financial innovation from the point of view of arbitrageurs/speculators. Rather than assuming, as is common in the earlier literature, that derivatives exchanges design the innovations/contracts, Rahi and Zigrand argue that profitseeking end-users that trade on the exchanges play an important role in the ultimate design of a financial contract. The authors assume that investors that are predominantly interested in hedging

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their endowments are limited to their ‘local’ exchange. By assuming trading restrictions for one class of end-users Rahi and Zigrand’s model helps explain why many of the financial innovations actually seen in the real world are in many cases redundant, that is they could have been created through a combination of previously existing assets or they already exist in other markets that are not accessible to all. The most recent attempt at analysing organised derivatives market competition looks at some of the implications on transactions costs of having nearly the same derivative listed on multiple exchanges. While at first blush it may appear that having multiple instances of similar contracts on different exchanges may be socially wasteful, it can, according to this strand of literature, actually enhance liquidity and market-making qualities across markets. Recent additions include Mayhew (2002), De Fontnouvelle et al. (2003) and Battalio et al. (2004).8 Mayhew started by investigating whether the bid/ask spreads on derivatives on multiple exchanges were in general lower than if the derivatives contract was only listed in one place. He finds that bid/ask spreads are clearly lower for multiply listed, and comparable, options contracts. However, for those contracts that see large trading volumes, the single listing effect on bid/ask spreads largely disappears, that is the role of inter-market competition is most pronounced for derivatives contracts that are not as actively traded but are multiply listed. Mayhew’s dataset did not cover the period during which multiple derivatives listings surged post mid-1999. De Fontnouvelle et al., however, studied directly the August 1999 decision by several equity derivatives exchanges to compete head-on and cross-list each other’s equity options. Within a month, 37 per cent of trading volumes had shifted from single- to multiple-exchange trading. Moreover, the authors note that there was on average a 35 per cent decline in bid/ask spreads for cross-listed derivatives, which was both nearly immediate and sustained. Interestingly, De Fontnouvelle et al. also record that trading volumes in total increased when the cross-listings took place (as could be expected from the lower transaction costs), but the higher trading volumes did not motivate through economies of scale arguments the large decline in trading costs. Hence, increased competition in the US equity derivatives market did have a rapid and sustained effect on costs. Battalio et al. found a more mixed picture, arguing that there is not yet an effective national market system for options. In fact, using a month of data from mid-2000, the authors concluded that multiple listings of stock options triggered an erosion of the market share of the dominant exchange, but that there were still plenty of transactions that were closed at noncompetitive levels. Hence, the first-mover advantages of the derivatives exchange was indeed significant as it managed to hold on to a dominant position despite the slip in market share. A national market system that provides ‘fair’ pricing was still considered somewhat distant given that Battalio et al. found that there were a number of transactions on US derivatives exchanges that were ‘executed at prices which appear to be economically inefficient’. Hence, they argue that there still exists some significant potential for further competitive gains in the quality of the execution and transaction costs in the organised US equity derivatives market. To explain the relationship between exchange-traded derivatives markets (or organised derivatives exchanges (ODEs)) and OTC markets, Nystedt (2004) extended the original Duffie and Jackson/Tashjian and Weissman models to include cross-market competition. At the time, ODEs were increasingly highlighting the competitive threat posed by OTC derivatives and noted, particularly in the US, that the regulatory playing field was not level. Hence, OTC derivatives, facing a much lower regulatory burden, had, in the view of US derivatives exchanges, an unfair

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competitive advantage. Nystedt, however, argued that, in a modelling context, as well as in reality, the ODE and OTC markets are interrelated and have to take into account each other’s financial innovations and transaction costs when considering their next optimal financial innovation. For the ODE market, the optimal contract is still of the classic Duffie and Jackson type, that is strictly geared towards hedging systematic risks. However, the ODE market’s optimal transaction cost now reflects a competition dimension, that is the best way for an ODE market to compete is through transaction costs. The OTC market selects to launch an OTC contract similar to the ODE market’s innovation, which does not, optimally, out-compete the ODE market. Hence, in equilibrium, both contracts, which compete regarding their ability to hedge, will face some demand and both play a useful role in maximising the transaction volume, lowering monopoly rents and increasing the degree of socially optimal hedging. Nystedt’s model also tries to capture a sense of OTC counterparty credit risk, stemming from the costs of customisation, which results in some additional interesting implications. Given the counterparty credit risk associated with OTC derivatives, the OTC market has an incentive to try to off-load whatever risk it can to the ODE market. Hence, it turns out that, in the context of counterparty risk and a risk-averse OTC market, one of the best clients of an ODE is the OTC market. Hence, Nystedt concludes that, in equilibrium, the ODE and OTC markets have both a competitive and a complementary relationship. It is actually in the ODE market’s interest to ensure that the OTC market provides as much tailor-made innovation as possible, since the ODE market will benefit from, in return, hedging some of the risks the OTC market incurs. This model implication is in line with the recent initiatives by several ODE markets to introduce tailor-made clearing services for some OTC contracts (Eurex, Euronext-Liffe, the OM Group and the CME all offer similar approaches for extending their clearing services). This means that the rapid growth of OTC markets does not need to be a threat to those ODE markets that are quick to adapt by providing clearing services. The more recent approaches have, as discussed above, shed more light on the various aspects of what new financial derivatives contracts a market may launch and how this might change in the presence of competition. Moreover, it seems clear that, at least in the US context, derivatives market competition brought about a very rapid decline in transaction costs. A decline that seems to have been subsequently sustained. There have been no attempts made to explore the impact of stepped-up derivatives market competition in Europe. However, there has been some work completed on how exchange-traded derivatives interrelate with OTC derivatives. This latter line of work suggests that, rather than being only competitors, dynamic hedging by OTC markets could be a very attractive business opportunity for ODE markets either directly or by the provision of clearing services.

Competition between exchange-traded derivatives exchanges The history of modern derivatives markets, especially options markets, starts in the US. The Chicago Board of Options Exchange (CBOE) launched the first equity options in April 1973. The American Stock Exchange (Amex) and the PHLX became CBOE’s first competitors when they launched their own options in 1975. According to Mayhew (2002), the Pacific Exchange and Midwest Exchange followed in 1976. The most recent major addition was the International Stock Exchange (ISE) in 2000. Clearly, the electronic trading networks, such as Archipelago (and

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other electronic communication networks (ECNs)), have played an important role in recent years in helping create a more modern electronically based US financial market in both cash and derivatives trading. Large established stock exchanges, such as the New York Stock Exchange (NYSE), responded by buying Archipelago in 2006. Archipelago in turn had bought the Pacific Exchange in 2005 and the Archipelago purchase has now allowed the NYSE to play a more attractive role in equity derivatives. Given that the growth in exchange-traded derivatives is far higher than cash trading, it is quite typical to see a stock exchange either having a separate derivatives entity or being owned by an ODE. Many European countries also followed in the footsteps of their US peers and established their own derivatives exchanges during the 1980s. However, due to the fragmented nature of European markets, the pace of consolidation was more pronounced. The factors that have been influential in driving competition within the exchange-traded derivatives market are: (1) regulatory changes that stifle or open up for competition, (2) technological innovation, (3) competition in launching the next successful contract, and (4) demutualisation of exchanges, which changes their organisational structure and profit motivations, as a result of which there has been a series of mergers across the industry.

Regulatory changes Changes in regulations or supervisory practices can have a major impact on the competitive landscape that derivatives markets face. While many examples stem from the US experience, attempts to harmonise and update financial sector regulations in the EU have also been very important. While analysis of the various legal changes and their implications for the derivatives markets are beyond the scope of this chapter, it is worthwhile to note that the best execution initiatives that have been introduced, such as the Markets in Financial Instruments Directive (MiFID) in the EU and Reg. NMS in the US, will have far-reaching implications for exchangetraded derivatives and the OTC markets in 2007. An analysis on both the negative and positive impacts of regulation on derivatives market competition is provided by Mayhew (2002). The author describes the regulatory process that triggered intense derivatives market competition in the US. Initially, in the 1970s, even though options were allowed to be listed on multiple exchanges only very few were. Starting in 1980, competition took a back seat as multiple listings were forbidden and a lottery system to determine where new options would trade was introduced. Starting in 1985 smaller stocks were allowed to have multiple listings and this was the state of play until 1990 when the Securities and Exchange Commission (SEC) opened up all stock options to be multiply listed subject to a transition rule for those stock options that were already listed. By 1994, the SEC’s transition rule had largely expired, although exchanges stuck to the old rule of not cross-listing each other’s stock options. However, this ‘gentlemen’s agreement’ eventually attracted allegations of anticompetitive behaviour and in August 1999 the then existing derivatives exchanges agreed to start cross-listing and eventually they reached a settlement agreement with the SEC. The impact on transaction costs, as noted in the literature overview, was almost immediate. However, regulatory triggers for competition, while important, may in the end not have made too much of a difference in the US case. As Mayhew points out, the ISE was just about to launch and change the competitive landscape for US equity derivatives significantly.

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The role of technological innovation It is not very often that a completely revolutionary technological advancement is introduced that can overturn the dominance of established derivatives exchanges. However, there is a handful of examples, of which we will mention two. Both of them are related to the impact of the electronic trading revolution on the open outcry market. The first one is the successful challenge by the Deutsche Termin Börse (DTB later Eurex)9 on Liffe’s dominance of the German Bund futures. The second is the rise of the ISE, which went from being a complete newcomer in equity options trading to being the US’s largest equity options market in terms of turnover value. During the second half of 1997, DTB launched an aggressive strategy of winning back trading in long-term German Treasury futures from Liffe (so called Bunds). The strategy had several components, but was of particular interest as it reflected one of the first instances where an electronic trading platform went up against an open outcry system trading the same set of instruments. Up until that point a debate had raged among academics and practitioners on what represented the better trading system and which one could deal with large surges in liquidity. Until 1997 DTB’s trading volume in German Bund futures had remained stable at roughly a third of the trading volume seen at Liffe. Moreover, Liffe had by the third quarter of 1997 overtaken its traditional Atlantic rival, the CME, to be the second largest derivatives exchange in the world. However, DTB’s aggressive strategy of electronic execution, lower transactions costs, installing trading terminals in other countries and lowering the reserve requirements on repos had almost immediate results. By the end of 1997 the two exchanges were tied regarding their market share in the Bunds contract and by the end of the first quarter of 1998 DTB had about 65 per cent of the market share. By the third quarter of 1998, nearly all trading in the longer-term Bunds futures had shifted to what was by then called Eurex Germany. The lesson from this episode is that it was nearly impossible for Liffe to respond to a new technology. Trading costs were so quickly lowered that Liffe could not keep up and given that, to start with, DTB already had a market share of about a third, liquidity was not much worse if a client decided to change the trading venue. The traditional main advantage of an incumbent is the pre-existing liquidity pool, but in the case of DTB the exchange had the benefit of not having to start from scratch when trying to attract liquidity. Moreover, the imminent launch of the euro was beneficial to the German derivatives exchange. At the time, there were signs of repatriation of German money back to the home market. In addition, the market turbulence of 1998 also helped to make German financial assets a safe haven. Hence, the timing of DTB’s aggressive push for market share was near perfect. However, the exchange did not have as much success with interest rate options as it had done with futures. Eventually though, once the liquidity centre had moved, option trading shifted to DTB/Eurex as well. In addition, it is interesting that DTB’s market share gains actually did not trigger a decline in trading volume for Liffe. In fact, for several quarters trading volumes remained steady, suggesting that DTB was successful in attracting new volumes in a rapidly growing market. By the end of 1998, Eurex Germany was the second largest derivatives market in the world in terms of turnover.10 The experience of ISE, which began operations in May 2000, is somewhat similar to what happened between DTB and Liffe. A new entrant sporting a new technology, that is electronic trading, took on the established US equity markets. However, ISE’s performance is even more remarkable considering that it started completely from scratch. Latest turnover data suggests that

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ISE’s market share had gone from 0 per cent in early 2000 to 33 per cent by the end of 2005 (see Exhibit 4.8). Part of ISE’s strategy was to offer lower transaction costs and attract trading volumes. According to Carrier et al. (2006), ISE continues to offer competitive transactions costs that are still lower than its main rivals. However, the competitive landscape for US derivatives markets is also clearly changing and the other equity derivatives markets have invested a significant amount in technology to catch up with ISE (much of the electronic platform offered by ISE was provided by the Nordic derivatives market OMX). Moreover, transaction fees across the major competitors have converged and in August 2006 NYSE/Arca-owned PHLX cut transaction fees dramatically to below those of ISE. However, transaction fees only represent one part of what market-makers and end-users find attractive in an exchange and, as Carrier et al. note, high quality markets, liquidity and other efficiencies can be more important. Are there only successful examples of using an edge in technology to compete in a new or existing market? No, there have been plenty of failures as well, but probably not because of the technology employed. Open outcry derivatives exchanges initially sought out initiatives, such as after-hours electronic trading and alliances with other derivatives markets or data providers such as Reuters, rather than moving to an electronic platform. Eurex-US represents a failed attempt at cross-border competition with CBOT.11 Eurex-US’s attempt to take its successful futures trading model across the Atlantic was made possible thanks to the regulatory changes introduced by the Commodity Futures Modernization Act of 2000. Having launched with great media attention in 2004, the new Eurex-owned US derivatives exchange, which trades futures as getting regulatory approval for new options exchanges has proven difficult, failed to attract any significant following. In fact, in anticipation of the entry of Eurex-US, CBOT lowered its transaction costs significantly to pre-empt any minimum liquidity to shift to the new exchange. Hence, the larger derivatives market’s price concessions were sufficient to make it difficult for

Exhibit 4.8 US derivatives market share in 1999 and 2005 50% 45%

1999

2005

40% 35% 30% 25% 20% 15% 10% 5% 0% CBOE

Amex

PCX

PHLX

BOX

ISE

Source: ISE

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Part I: Transformation of the industry

Eurex-US to establish a sustainable threshold in the US. Having tried for almost a year, EurexUS gave up and sold the fledgling derivatives exchange to the UK’s Man group (a family of hedge funds). CBOT responded to the exit of Eurex-US by increasing transaction fees by at least three times. The lesson one can draw from the Liffe and Eurex-US experiences is that, in order for an incumbent to be seriously challenged and eventually lose, the challenger needs an edge in the form of technology and lower transaction costs, and also for the incumbent to be slow to react. Moreover, there is a need to establish some minimum amount of liquidity early on, perhaps by reaching agreements with key derivatives users before launch. In the case of CBOT, the exchange acted aggressively and pre-emptively and was given a substantial amount of extra time due to the delays in getting regulatory approval for Eurex-US.

Competing in financial innovations While it may be hard to successfully compete for market share in an already existing derivatives contract, new innovations have the potential for shifting the playing field in the direction of a new entrant. However, by their very nature the derivatives contracts launched on exchanges are fairly standardised and simple, that is they can be fairly rapidly copied. An interested end-user of a new financial derivative needs to know in quite some detail how the new derivatives contract is structured, which invariably means that eventually the innovation becomes common knowledge. This is in marked contrast to the OTC market, where the ability to tailor-make derivative solutions and to keep the entire process fairly discrete means that many of the innovations in derivatives start off in the OTC market and slowly migrate to the ODE world. One of the few ways around this, that is for a derivatives exchange to launch a proprietary product, is to license an index and build derivative products around that index. The most attractive index families are those that are household names such as Dow Jones, MSCI, Nasdaq, etc., and all of these have in turn been licensed. The growth of the exchange-traded fund (ETF) industry has also triggered a wave of innovation to provide options around popular ETFs, such as SPDRs, Diamonds, QQQ, etc. While innovation and product development is an important part of a derivatives exchange’s business plan, it is not always easy to tell whether the new innovation will be particularly successful. In fact, the innovative derivatives exchange can at best count on a few months’ head start for a new derivative product before its competitors launch similar products. For a true success, the lead provided by innovating must be enough to generate the firstmover advantage, which would make it difficult for another exchange to win over the liquidity in the new instrument. However, it is always possible that a new innovation is successfully launched by one exchange only to see it take off somewhere else where the liquidity or trading infrastructure was in general seen as better.

Demutualisation, consolidation and diversification The fairly slow response of key derivatives exchanges to the new realities of electronic trading showed some of the strains of the traditional mutual non-profit ownership structure of several US, UK and Continental European derivatives exchanges. In the example about Liffe above, the organisation’s slow response to the competitive threat posed by DTB was later attributed to the self-interest of floor traders, frequently owning an exchange seat, which played an important role

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in determining the future direction of the exchange. Nevertheless, Liffe was quick in demutualising and responding to the competitive threats and on 9 June 1998 demutualised (although it was by then too late for the Bund futures contract). The global trend towards demutualisation is still ongoing, but most of the major derivative and cash markets have changed their governance structures and become for-profit entities. As a result, decision-making has been speeded up and there has been a much more determined drive towards consolidation. In a business that is facing commoditisation of its main products and has large fixed costs but few variable costs, size matters. Carrier et al. note that the marginal profit for each dollar of new revenue for the ISE is about 70 per cent, that is most derivatives exchanges operate at very high margins; at least in the US.12 Given the move towards electronic trading and the cost of maintaining the infrastructure, successful consolidation attempts can generate significant synergy gains as one of the two trading systems is phased out (Carrier et al. (2006) estimate that synergy gains in the ISE could be around 30 per cent if it is taken over). There are, therefore, natural drivers to spark industry consolidations both in Europe and the US. The most recent, and potentially the largest example to date, is the 17 October 2006 announcement of a US$25bn merger between CME and CBOT. While the two historical rivals had already shared the CME clearing services since 2003, the announcement is a major step forward in derivatives market consolidation in the US and creates the largest, most diverse derivatives exchange in the world. In the press release announcing the merger the two exchanges made clear that competitive pressures drove the merger. CME’s CEO Craig Donohue reportedly said:13 Growth in the global derivatives industry is accelerating and new competitors are emerging in exchange, over-the-counter and other unregulated markets . . . As a combined company, we will be better positioned to capitalize on these trends and compete more effectively as our industry continues to transform. As the main strategic benefits of the transaction, CME/CBOT noted that they expect the merger to add to the bottom line in 12–18 months, that synergies would save around US$125m by year two, and eventually much more as the two trading floors would be merged into one, and that this would result in improvements in strategic position. There are, however, important market concentration issues surrounding the merger and it remains to be seen how easily it will be for the Chicago exchanges to receive regulatory approval. Given the favourable stance of the US regulatory authorities towards consolidation in recent years, one would think that the CME/CBOT merger will go through. Nevertheless, the exchanges announced in the beginning of December that they had received requests for additional information by the anti-trust division of the US Department of Justice and that they expect more such requests. Regulatory approval is nevertheless expected some time in 2007. Another source of consolidation, as was mentioned earlier, would be the cash markets seeking out higher growth areas. The NYSE and Nasdaq are both clearly observing that their markets’ growth rate has probably peaked. Hence, the two exchanges are both reportedly actively in talks with potential targets about buying derivatives or stock exchanges abroad. In the case of the NYSE the target is Euronext-Liffe, and for Nasdaq the immediate target seems to be the

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London Stock Exchange. It is indeed possible that, should either of these two stock exchanges’ most recent takeover attempts fail, they will seek out some other derivatives markets to continue their diversification of business lines. Of course, cross-border consolidations are always difficult and require, given the highly concentrated nature of the organised derivatives markets, regulatory approvals from both supervisors and competition authorities. This can be a very long process, but, in general, it seems that authorities are quite in favour of consolidation and recognise the significant amount of competition already present in the market. That is, the decision on whether to allow further mergers in Europe or the US among the derivatives markets has to take into account the costs for a US rival entering the European markets and vice versa. In addition, the competitive dimension provided by the OTC market should also keep competitive pressures high, even if we see another large wave of consolidation in the world’s derivatives markets. The topic to be discussed next is that of the OTC derivatives market.

The relationship between ODE and OTC derivatives markets OTC derivatives markets put even the impressive size of exchange-traded derivatives to shame. In terms of their open interest, OTC markets are roughly four times the size of the open interest in exchange-traded derivatives. There are entire sets of instruments that are largely traded only on OTC, such as foreign exchange. Moreover, as discussed above, OTC markets are a hotbed of innovation and many of the instruments that are now seen as staple products in the exchangetraded world started off only being available OTC. However, is it really correct to talk about one OTC market? Clearly not. The global OTC market is really a peer-to-peer loose affiliation of the world’s largest banks and increasingly hedge funds. These institutions engage daily in trillions of dollars of trading activity in the form of derivatives without a central clearing and settlement system to help them manage their credit risk. Instead, the risks are transferred to and concentrated at the largest banks in the system. Hence, the Office of the Comptroller of the Currency estimated in 2004 that over 90 per cent of the OTC derivatives outstanding were being held by the top 10 banks in the US. This is nearly unavoidable as large in-house exposures of OTC derivatives allow for the netting of collateral. Moreover, the more standardised forms of OTC derivatives have become increasingly fungible across OTC participants, but still, once the OTC derivative becomes anything but standard the classical drawbacks of these contracts, such as counterparty credit risk, lack of transparency and in general an unregulated market, reappear.

Recent trends in the OTC market OTC derivatives are dominated by interest rate derivatives, such as plain-vanilla swaps. OTC derivatives linked to interest rates account for roughly 75 per cent of total outstanding interest. Currency derivatives come next with a share of open interest of around 11 per cent. Just like interest rate forwards and swaps, the vast majority of trading and open interest in OTC currency derivatives is of a highly standardised type. Equity and commodity-linked OTC derivatives account for roughly 2 per cent each, with the remainder accounted for by other OTC derivatives, such as credit default swaps, etc. In terms of growth, the fastest-growing area, since the end of 1999, has been OTC derivatives in the commodities space (up almost 11 times) (see Exhibit 4.9). Meanwhile, interest rate derivatives experienced growth of more than three times, while

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Exhibit 4.9 The composition of OTC derivatives (open interest in US$tn) 400 350 300 250 200

Other Commodity Equity-linked Currency Interest rate

150 100 50 0 Jun-98

Jun-00

Jun-02

Jun-04

Jun-06

Source: BIS

the remaining areas roughly doubled. Overall the open interest of global OTC derivatives has been estimated by the BIS at US$370tn by mid-2006, but if the actual gross market value is taken into account (capturing the replacement value and hence an indication of the actual credit risk in the system) the amount was a still significant, albeit much smaller, US$10tn. Given this spectacular growth, which is roughly of the same magnitude as the growth in exchange-traded derivatives, a reasonable question is what can be done to mitigate the potential systemic risk that OTC derivatives can pose to the global financial system? It is true that, given their size, OTC derivatives, if they are incorrectly used or managed, can have devastating effects and bring down not only the potential client that is in trouble but also the financial institutions involved. The collapse of Long-Term Capital Management (LTCM) represented one such instance when the OTC derivatives markets were severely tested. In the end, the markets withstood the test, but lessons have been learned from each OTC derivative debacle and large international banks have spent considerable resources upgrading their risk management systems, collateral management systems and overall infrastructures to handle the rapid growth in OTC derivatives.

The regulatory environment for OTC derivatives The shifting regulatory environment has also played a very important role in the development of the global, and initially largely US, OTC derivatives market. Moreover, the shifting attitude

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among regulators and supervisors towards the need to regulate OTC markets has also determined the size of the comparative advantage it has had, from a regulatory perspective, over exchangetraded derivatives. Regulatory agencies, such as the Commodity Futures Trading Commission (CFTC), have generally been cognisant of the potential competitive and systemic threat posed by the OTC market and never felt comfortable about leaving the OTC market largely unregulated and unsupervised. For exchange-traded derivatives markets, the light regulatory touch facing OTC derivatives meant that the ODE markets were at a disadvantage, but regulators have in general also felt uncomfortable about deregulating the ODE markets. Hence, regulatory initiatives have in general dealt with tighter regulation and oversight of OTC markets. This has been especially true in the aftermath of some of the negative headline-grabbing events during which OTC derivatives were implicated. The state of regulation globally with respect to OTC swaps and derivatives has therefore been uncertain since the birth of the OTC market. The lack of clarity of the US regulation governing OTC markets was used at times by disgruntled investors, after losing substantial amounts of money due to an OTC transaction, to claim that the transaction was illegal to begin with, thereby potentially nullifying the transaction and recovering their losses. A further result of inadequate legislation occurred when US-based organised derivatives exchange markets, such as the CBOT and the CME, started to seriously feel the competitive pressure from the OTC market, and lobbied the CFTC to take action on OTC derivatives based on the Commodities Exchange Act.14 Regulatory uncertainty also eventually forced the OTC derivatives markets offshore.15 Other financial centres, most notably London, benefited and only significant pressure on the CFTC by the Treasury, the Federal Reserve and industry groups stabilised the situation in the US. The latest bout of uncertainty regarding the regulatory status of OTC derivatives occurred after the crash of LTCM in 1998. The CFTC issued a comment letter on a regulatory action and a concept release,16 which were widely interpreted as a move to increase regulation and CFTC supervision of the OTC market. This caused some concern because it would almost by necessity increase the transaction costs and perhaps cause the OTC market to again move offshore. Again the Treasury, the Federal Reserve and industry groups pushed back and convinced Congress to impose a stay on the CFTC. It was clear that the regulatory system on which many other countries were modelling their own OTC regulation failed to keep pace with the rapid market developments. OTC markets had developed fast, and old definitions and exemptions were no longer adequate. Furthermore, ODE markets were increasingly pressing the CFTC for their own regulatory relief and a level playing field. In the aftermath, Congress gave the key regulatory agencies, through the so-called President’s Working Group on Financial Markets, the task to present reforms that would address the OTC markets’ key concerns and take steps to reduce systemic risk. The regulatory agencies’ findings led quickly to the passing of the Commodity Futures Modernization Act (CFMA) by the end of 2000, which at least for now has increased the regulatory certainty of OTC derivatives in the US and is intended to stimulate inter-market competition. Interestingly, contrary to previous instances, most US ODE markets largely welcomed the initial report and the eventual passing of the CFMA law. However, ODE markets remained disappointed since the CFMA, in their view, leaves the non-level regulatory and supervisory playing field broadly intact. In fact, ODE markets have continued to support regulatory efforts to increase the disclosure requirements for OTC participants.

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Competition and cooperation between ODE and OTC markets Much of the concern among ODE markets regarding OTC derivative competition has receded over the last couple of years. Instead, ODE markets are increasingly realising that, while OTC markets represent a competitive threat, they also represent a tremendous opportunity given the size of their open interest and trading volume. In fact, in its 2004 outlook for the European derivatives exchanges,17 the Futures Industry Association said that the competitive relationship between ODE and OTC markets in Europe may actually flip in the ODE market’s favour. Van Steenis noted that there was substantial scope for the cannibalisation of OTC derivatives’ trading of equity-linked products in particular. In addition, the author argued that concerns about credit risk, capital usage and processing efficiency was increasing the attractiveness among end-users of exchange-traded derivatives. The scope for a symbiotic relationship was also emphasised, with the strategy of providing and leveraging the ODE market’s clearing services seen as critical to an ODE market’s success. A key incentive for OTC market participants to look more seriously at using the clearing services of the ODE market is related to the OTC derivatives market’s own success. In some cases, the main banks, being at the centre of the OTC derivatives market, are heading into capacity limits regarding their credit and counterparty risk exposures. The ongoing consolidation between banks in the US and Europe has further aggravated these constraints. Standardised OTC derivatives can now frequently be cleared through various initiatives by CME/CBOT, EuronextLiffe and Eurex. However, these wholesale clearing services are still in relative infancy and are not yet a core part of an ODE market’s revenue stream. Furthermore, cooperation among clearing houses and the still exemplary track record of most of them suggest that there is still plenty of potential for symbiotic growth. As Exhibit 4.10 shows, if anything, the market share of exchangetraded derivatives is increasing relative to that of OTC markets since 2000. This suggests that the world’s derivatives exchanges are handling the competitive pressures from the OTC market rather well. Exhibit 4.11 suggests that this performance is predominantly based on ODE markets winning back market share in equity-linked products, where their share recently exceeded 50 per cent. The ODE market share for exchange-traded interest rate derivatives has been relatively stable, while its market share in currencies is still negligible. In terms of what the end-users themselves think, the annual survey by Financial News on the views of European asset managers is quite telling. There seems to be an increased perception of the risks of using OTC derivatives in 2006 compared to 2005. At the top of these fund managers’ concerns is the lack of transparent pricing for OTC products. Next is the fear of banks mis-selling complex products to their clients. Rounding out the top three is the fund managers’ lack of understanding of the product. Concerns about systemic risks only come in as the fourth issue of concern. The survey suggests that ODEs have a significant lead over the more complex OTC products in terms of transparency and ease of use and that this is indeed appreciated among institutional investors. So why are OTC derivatives used if asset managers broadly share concerns about pricing and whether or not they are using the right product? Interestingly, the number one reason (53 per cent of respondents, down from 58 per cent the year before) for using OTC derivatives, according to the Financial News survey, is that the required product is not offered on an exchange. This would suggest that there is still tremendous potential for additional innovation among ODEs to meet their clients’ needs. The next reason for trading OTC was a measurable indirect cost benefit (12 per cent), and only in third place the discretion provided by

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Exhibit 4.10 Share of open interest by type of derivatives market 90%

20%

89%

19%

88%

18%

87%

17%

86%

16%

85%

15%

84%

14%

83%

13%

82%

12%

81%

11%

80% Jun-98

Jun-99

Jun-00

Jun-01

Jun-02

Jun-03

Jun-04

Jun-05

10% Jun-06

OTC derivatives Exchange-traded derivatives (right scale) Source: BIS

trading OTC (9 per cent, down from 16 per cent the year before). There is, of course, no reason why the clearing services that OTC derivatives markets find attractive have to be linked to an existing ODE. Existing ODE markets that have kept the clearing operation as part of their corporate structure are likely to benefit from both significant first-mover advantages and the fact that clearing is a business with large economies of scale. Hence, there seems to be significant, if increasingly tapped, potential for ODE derivatives markets to evolve into clearing specialists, off-loading and effectively managing the risks taken by OTC markets. From a supervisory perspective such a development should be rather welcome, since the authorities’ main concern has been the systemic stability of the OTC market as a whole and any concentration of credit risk in a particular financial institution.18

Conclusions and outlook ‘We have no issues with competition. We welcome the competition. We thrive on it. We have done it for 105 years. We will for another 105 years.’19 Global competition has become a fact of life for most derivatives exchanges. Having once benefited from significant first-mover advantages and been protected by borders and distances, the environment is changing to one where only the best and the largest derivatives exchanges survive. While there has been a clear pick-up in the frequency of consolidations in the industrialised countries, derivatives exchanges in emerging markets have yet to be subject to this

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trend. Trading volumes are still expanding so rapidly that there is yet little perceived need for consolidation. Overall, the competitive climate is intensifying while volume growth is still very strong and annual growth rates are in the neighbourhood of 20 per cent. Nevertheless, organised derivatives exchanges are in a business that can relatively easily be commoditised, and eventually will be. There is a clear trend towards ever lower transaction costs and hence there is a race to take advantage of economies of scales and innovation. So what are the risks associated with ever increasing derivative trading volumes and the ongoing reshaping of the traditional derivatives markets landscape due to competitive pressures? The first risk comes from regulation. In general, regulation is intended to foster competition, but the record has been mixed so far and further attempts would be needed to level the playing field and allow for a more aggressive challenge to the position of the large US derivatives exchanges. The CFMA, when enacted, took a step in the right direction towards encouraging cross-border competition, but as the example of Eurex-US shows (and there have been no real attempts after that), taking on the US derivatives exchanges directly has been difficult (and in fact there is ongoing litigation regarding Eurex-US and the CBOT). Moreover, the CBOT’s decision to increase transaction fees, once the Eurex-US challenge was overcome, suggests that increased direct competition could be beneficial to the clients of US derivatives exchanges. A second challenge to the unimpeded growth of exchange-traded derivatives will

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probably come from the large broker/dealers that are active in both OTC and ODE markets, rather than the OTC markets. There is a growing tendency by the large broker/dealers to try to match trades in-house before going to an exchange to trade. This is a natural response to save transaction costs, but does reduce the price discovery process of trading and in the end will slow volume growth. Moreover, large international banks are increasingly cooperating to set up rival trading venues in cyberspace where clients can trade. A recent initiative to trade equities in Europe by several of the world’s major banks by the end of 2007 is only a sign of things to come. With clearing services being separated from the exchanges themselves, tailor-made cash and derivatives exchanges can be created where the traditional exchange-based market develops into a service provider. Derivatives exchange consolidation is likely to continue to be a theme for the next couple of years. Note that it is only in the past few years, after exchanges demutualised, that this development has picked up speed. It would be natural to expect that, once consolidation has been completed in the US and Europe, it will spread to Asia-Pacific and Latin America. At the end of the day, the largest derivatives exchange is likely to be able to provide the most attractive terms for clients and, as long as derivatives exchanges generate most of their profits from maximising volumes, the consolidation trend will continue. This will mean not only that US cash and derivatives exchanges cross into Europe, but that there will be attempts by European derivatives exchanges to grow through acquisitions in Japan and Asia, which seems to be the most promising, relatively new, market. Regarding the outlook for the relationship between exchange-traded and OTC derivatives, it seems that the symbiotic relationship is taking hold. Eurex launched its wholesale clearing services at the end of 2005 and Euronext-Liffe recently decided to expand its OTC clearing services. Products, such as flex options and their clearing, mimic, to a large extent, the plainvanilla options (and eventually swaps) that OTC markets provide. The role for the regulator, therefore, is to continue to stimulate competition between the two types of markets. However, the regulator should try to also encourage the burgeoning growth in the symbiotic relationship between exchange-traded and OTC derivatives. The implications for better risk management would be significant.

1 The author wishes to thank colleagues at Deutsche Bank for helpful comments. Any remaining errors are those of the author. The views expressed in this chapter are those of the author and do not necessarily represent those of Deutsche Bank. 2 Press release announcing the merger of CME and CBOT, available at www.cme.com/about/press/cn/06-148 CMEandCBOTMerger.html/. 3 In this chapter we will refer to exchange-traded derivatives (OTC) and organised derivative exchange (ODE)-traded instruments interchangeably. The reference to OTC derivatives is broadly meant, that is derivatives that are traded off-exchange and are frequently of a tailor-made nature. 4 Appleby and Hashemy (2006). 5 Melamed (2000). 6 Nystedt (2004). 7 WFE/IOMA (2006). 8 To the best of my knowledge, there are very few similar papers looking at European derivatives exchanges. One

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9 10 11 12 13 14 15 16 17 18 19

attempt was the 2003 paper presented by Bartram and Fehle. They study the competition between Eurex and EuWax (a bank-issued options market) and investigate how different market structures impact the competition game. Deutsche Börse and the Swiss stock and derivatives exchanges agreed in July 1997 to create a joint subsidiary called Eurex to create pan-European stock indices to prepare for the launch of the euro. BIS (1998). For a good description of the initial Eurex strategy, see Mehta (2003). Appleby and Hashemy (2006) and Carrier et al. (2006). Press release announcing the merger of CME and CBOT, available at www.cme.com/about/press/cn/06-148 CMEandCBOTMerger.html/. Schinasi et al. (2000). Nystedt (2004). CFTC (1998). Van Steenis (2003). Schinasi et al. (2000). www.futuresindustry.org/fimagazi-1929.asp?a=1073&iss=163.

References Appleby, S., and S. Hashemy (2006), ‘Chicago Mercantile Exchange: global derivatives powerhouse (revised)’, New York, Deutsche Bank, September 18. BIS (Bank for International Settlements) (1997–2006), various issues, ‘International banking and financial market developments’, BIS, Basel. BIS (Bank for International Settlements) (1998), ‘OTC derivatives: settlement procedures and counterparty risk management’, BIS, Basel. BIS (Bank for International Settlements) (2005), ‘Triennial central bank survey: foreign exchange and derivative market activity in 2002’, BIS, Basel. Bartram, S., and F. Fehle (2003), ‘Competition among alternative option market structures: evidence from Eurex vs. EuWax’, Working Paper, University of South Carolina. Battalio, R., B. Hatch and R. Jennings (2004), ‘Does a national market system exist for US exchange-listed equity options?’, Journal of Finance, 59: 933–62. Carrier, M., G. Schorr and K. Murray (2006), ‘International Securities Exchange: lots of optionality, but fairly valued’, UBS Investment Research, July 12. CFTC (Commodity Futures Trading Commission) (1998), ‘Concept release on over-the-counter derivatives’, CTFC, Washington DC. Duffie, D., and M. Jackson (1989), ‘Optimal innovation of futures contracts’, Review of Financial Studies, 2: 275–96. De Fontnouvelle, P., R. P. H. Fishe and J. H. Harris (2003) ‘The behaviour of bid-ask spreads and volume in options markets during the competitions listings in 1999’, Journal of Finance, 58(6): 2437–64. Financial News (2006), ‘Derivatives in fund management: reaching the tipping point’, May. Mayhew, S. (2002), Competition, market structure, and bid-ask spreads in stock option markets’, Journal of Finance, 57(2): 931–58. Mehta, N. (2003), ‘Eurex comes to America’, Futures Industry Magazine, Outlook 04. Melamed, L. (2000), ‘Futures markets in an e-commerce world’, speech delivered at Canadian Annual Derivatives Conference, Montreal Exchange, Montreal, October 15–17. Nystedt, J. (2004), ‘Derivative market competition: OTC markets versus organized derivative exchanges’, IMF Working Paper No. 04.61, IMF, Washington DC. Rahi, R., and J. Zigrand (2004), ‘Strategic financial innovation in segmented markets’, Working Paper No. 4176, Centre for Economic Policy Research.

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Schinasi, G., R. Craig, B. Drees and C. Kramer (2000), ‘Modern banking and OTC derivatives markets’, IMF Occasional Paper No. 203, IMF, Washington DC. Tashjian, J. and M. Weissman (1995), ‘Advantages of competing with yourself: why an exchange might design futures contracts with correlated payoffs’, Journal of Financial Intermediation, 4: 133–57. Van Steenis, H. (2003), ‘The outlook for European exchanges: investors demand innovative and bold moves’, Futures Industry Magazine, Outlook 04. WFE/IOMA (World Federation of Exchanges/International Options Market Association) (2006), Derivatives Market Survey 2005, WFE/IOMA. Available on-line at www.world-exchanges.org.

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Chapter 5

Electronic markets heat up; micro-exchanges arrive1 Eric Benhamou Pricing Partners Michel Everaert GFI Group Thomas Serval Baracoda2

Introduction Advances in technology, competition and increasing regulation have created fertile ground for online trading technology. Brokers, investment banks, exchanges and technology start-ups are all rushing to build electronic marketplaces. It is so competitive that not a day goes by without reports of battles for liquidity or mergers seeking competitive advantage and economies of scale. Competition is fuelling international consolidation as well as increased service provision. This has brought previously disparate markets and services together in previously unimaginable combinations. While media attention is focused on the larger players’ battles for liquidity and control, entrepreneurs continue unabated, starting new electronic exchanges in niche, and sometimes not so niche, markets, using newly ubiquitous technology and networks. Will micro-exchanges emerge to challenge established exchanges – and, if so, where? In this chapter we look at the hot topic in financial and commodity markets: the intermediaries. Some successful (and not so successful) financial intermediaries are: • Aggregating marketplaces: Tradeweb, MarketAxess, FXAll, Atriax, Currenex, CFOWeb, etc. • Technology-based brokers: ATFox, Blackbird, ICOR, Enron Online, Creditex, Creditrade, Imarex, Swapstream, etc. • Exchanges: Euronext-Liffe, Deutsche Börse, CME, CBOT, ICE, Nasdaq, NYSE, Nymex, CBOE, LSE, Eurex, EEX, ISE, etc. • Technology providers: Integral, AVT, Cognotec, Trayport, Cinnober, Fenics, SuperDerivatives, GL Trade, Royalblue, Trading Technologies, etc. • Bank consortia: BrokerTec, Liquidityhub, Volbroker, ATFox, EuroMTS, Swapswire, Economicderivatives, Swaptrade, etc.

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• Hybrid brokers: GFI, ICAP, Tullett, Cantor/eSpeed, etc. • Market data providers: Reuters, Bloomberg, Thomson, etc.

The internet bubble Technology is the key enabler in electronic trading. Software and hardware become faster and cheaper and new players and incumbents are continuing to use technology to gain market share and liquidity. While exchange technology has been around for more than 30 years, what really changed the landscape was the availability of a ubiquitous network – that is the internet – and the widespread adoption of increasingly standardised, internet-compatible protocols and systems. Technological advance created the network effect: interactive systems between market participants at a fraction of the cost of traditional methods. The dotcom boom of the 1990s promised vast riches to ‘first movers’ – those who enhanced information distribution, collaboration and intermediation by exploiting new disruptive technologies. In retail markets, the winners of this land grab, such as eBay, Amazon and Google, are now global household names with company valuations to match. At the time of writing this chapter, Google’s market capitalisation at US$44bn, similar to IBM’s.3 The financial sector also, never a slouch in adopting technology, latched on to new technologies with the obvious area for innovation being financial intermediation. This rapidly led to electronic communication networks (ECNs) challenging traditional exchange markets; voice brokers going hybrid; bank sales desks launching single-dealer and multi-dealer trading venues; and financial aggregators emerging. Everyone seemed to have an internet strategy and, if you did not, or you were not a first mover, you were dead in the water. A new vocabulary emerged with terms such as ‘internet time’, ‘attracting eyeballs’ and ‘gaining mind-share’. What happened? Eyeballs focused on websites did not translate to the hoped-for transaction volumes and the per-transaction business models rarely came even close to meeting promised business plan revenue projections. Business managers, who only months earlier were throwing money at e-business plans, were quick to swap their chinos for business suits and started asking the awkward question: how was all of this going to make money? The rationale of pumping millions into e-commerce was questioned and inevitably investment, and with it growth, slowed. In April 2000 the bubble burst. Starved of cash, many start-ups closed or rapidly rewrote their business plans, focusing on the only asset they possessed: their trading technology. Banks spun off e-business units. Consortia were sold to brokers and exchanges. Was it all hype and no substance? Would this be the end of e-trading? Would the only positive be the creation of the world’s biggest flea market: eBay? For some time after the bubble burst, e-trading was questioned. Some of the arguments raised were as follows: • Electronic markets fuel transparency. This compresses spreads and reduces margins. This could lead to less liquidity as trades become less profitable. • In large block transactions, trading large volumes on screen, especially in illiquid markets, can impact prices significantly. This results in worse prices than those achieved through a less transparent mechanism.

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• Electronic markets encourage price sniping and latency arbitrage, reducing a market’s orderly operation and the trust a trader has in the trading venue. • It is easier to make errors on electronic systems – ‘fat-finger’ errors – causing serious losses for the trader or, worse, an overall impact on the market. • Electronic markets, especially illiquid ones, can be manipulated more easily by unscrupulous traders. However it was not even close to the end: it was merely the beginning. Seven years later, price earnings ratios of listed exchanges, brokers and other technology-savvy intermediaries are among the highest in financial services – perhaps proof that 1997’s euphoria surrounding ecommerce was justified. Technology-driven intermediation can indeed deliver superior value. What was wrong was the concept of ‘internet time’: the time taken to adopt new technology. Habits, business processes and technological challenges proved more difficult than anticipated to shift online. But, ten years on, trading technology is being used more and more.

The future of trading technology The momentum of online trading seems unstoppable. Examples of markets that have moved online are everywhere: European interest rate futures moved from the Liffe floor onto Eurex; US treasuries moved from voice brokers onto eSpeed and BrokerTec; foreign exchange is now largely traded on EBS and Reuters; credit derivatives are actively traded online through GFI and Creditex trading systems; energy contracts now routinely trade on electronic platforms provided by OTC brokers or on ICE (Intercontinental Exchange).4 A new ‘Nintendo generation’ of traders has appeared. They have used PCs, chat software, blogs and advanced games consoles for years and they are now in the trading room. Online trading is second nature to them so they demand it from their chosen intermediary. While many an older trader bemoans the lack of the personal touch, electronic trading is a reality in most markets today. But what happens next?

Consolidation Exchanges have transformed themselves from member-owned utilities to public companies looking for growth and shareholder value. Yet technology has helped others encroach on their markets. A recent study by Boston’s AITE Group5 showed that the NYSE and Nasdaq together account for 78 per cent of turnover in US equities, but forecasts that by 2010 they will lose ground to regional exchanges, alternative trading systems, broker internalisation and electronic crossing. The result is exchange consolidation with the main players in Europe – Euronext-Liffe, Deutsche Börse/Eurex and the London Stock Exchange (LSE)6 – all eyeing each other. The US has seen a flurry of exchange acquisitions, culminating in the largest to date: the CME acquiring the Chicago Board of Trade (CBOT). Also, the race is on to create truly global exchange businesses with, at time of writing, the most exciting possibility being a Nasdaq/LSE crossAtlantic exchange behemoth.

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Dealers are reacting to this consolidation – partly out of self-interest to ensure that consolidation does not lead to higher fees, but also to gain from intermediation. Michael Spencer, CEO of inter-dealer broker ICAP, recently said: ‘The position that exchanges have held as monopolies has been thrown into sharp relief by the fact that some banks are now looking to launch a competitor to the equity exchanges.’7 In November 2006 seven large investment banks announced that they were working together under the banner ‘Project Turquoise’. Price reporting, one of the most important functions of an exchange, is being changed by the Markets in Financial Instruments Directive (MiFID).8 This immediately prompted a consortium of banks – ABN Amro, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, Merrill Lynch, Morgan Stanley and UBS – to announce in September 2006 that they would pool trade data and disseminate market data. In November 2006 these same banks took the next logical step and announced their intention to operate a regulated ‘multilateral trading facility’ – in effect a new exchange. In North America too, the street is getting into intermediation with banks, hedge funds and vendors acquiring smaller exchanges. Citadel and Merrill Lynch have invested in the Philadelphia Stock Exchange. Citigroup, Bear Stearns, Credit Suisse, Knight and Bloomberg have each acquired 10 per cent of National Exchange. Inter-dealer brokers, the traditional intermediaries in OTC markets, have not sat still. Rather, they are acquiring trading systems or investing in technology. ICAP has bought successful OTC trading venues such as Volbroker, BrokerTec and, most recently, EBS. OTC markets enable the efficient trading of more complex, non-standardised and often illiquid instruments. Some might think that these attributes make electronic trading difficult – but even here it is making rapid progress. Traditionally the territory of inter-dealer brokers, OTC markets in all asset classes are adopting technology. Many brokers are adopting a hybrid trading model, whereby electronic trading systems complement voice brokers. Clients can trade either electronically, through a broker, or a mixture of the two. This is a pragmatic solution to the particular needs and challenges of the OTC markets. Some markets that are fully electronic, such as European equity derivatives on Euronext-Liffe – are serviced by OTC voice brokers. All contracts are traded on-exchange, yet 70 per cent of these originate in the voice broker market. This hybrid model is well established in OTC markets such as repos, European energy markets and credit derivatives. But other markets are resistant – notably interest rates swaps (IRSs): the largest OTC market with US$260tn notional outstanding. There have been many initiatives to make the IRS market electronic but none has succeeded: SwapClear, Swapstream, SwapTrader, ATFox, Reuters ICOR, etc. all failed to pull the market away from the OTC brokers. This list is not exhaustive but it gives a feeling of the activity in the market. Exhibit 5.1 shows all the interconnections between the various actors and gives a feeling of the multiplicity of interactions between market participants.

Exchange listed vs. OTC – the lines are blurring The exchanges are not resting on their laurels and sticking to traditional products – the size of the OTC markets is too much of a lure. In November 2006, the Bank for International Settlements (BIS) reported9 that outstanding volumes of OTC derivatives had expanded by 25 per cent in the

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first half of 2006 alone; notional amounts of all types of OTC contracts stood at US$370tn at the end of June. Exchanges are keenly eyeing this liquidity. Indeed, a significant part of ICE’s activity is in OTC energy products and CME’s acquisition of the tiny Swapstream (one of the first electronic swap trading platforms) clearly signals its designs on the vast liquidity pool of OTC IRSs. Will this lead to mergers and acquisitions among exchanges and OTC players, mainly brokers but also technology companies? Quite possibly; although ICAP has ruled out buying the LSE, at least for now.

Intermediary vs. buy-side vs. sell-side – the lines are blurring Apart from creating markets, how does technology help intermediaries acquire clients – the main idea behind the network effect? Clearly, participants are seeking liquidity, transparency (when it suits them) and low-cost execution. All of these are hallmarks of online trading. However, technology is breaking down the traditional financial services supply pyramids. As described above, exchanges, banks, technology vendors and inter-dealer brokers are all encroaching on each other’s turf. Ultimately, they all need clients using their services and they are all eyeing each other’s users. Trading relationships based on clearing and prime brokerage remove traditional market participant segregation. While banks and hedge funds differ significantly in structure, the methodologies used by large hedge funds today are on a level with, or even exceed, those of banks. Technology allows them to compete. Electronic trading is thus levelling playing fields and may accelerate the integration of large, traditional buy-side institutions into the dealer market. In equities markets, direct market access is now part of a broker’s or exchange’s product offering, granting larger buy-side funds and hedge funds direct, electronic access to liquidity. Ventures such as EBS Prime deliver this in spot FX (foreign exchange) using a prime brokerage model. Other markets will follow. Attempts to apply exchange models to OTC markets are under way as well with FX Marketspace, a CME/Reuters joint venture, aiming to create the first exchange-based FX market. It remains to be seen if the already highly efficient FX market needs this.

ECNs as an example of consolidation The history of the ECNs operation on Nasdaq is a good example of electronic platform consolidation. In 1997, only four ECNs existed: Instinet, Island, TradeBook and Archipelago. These were joined over the next three years by REDIBook, Brut, Strike, Attain et Nextrade, MarketXT, GlobeNet and Track ECN8. Consolidation started in 2001, triggered by the dotcom bust of the previous year. Archipelago and REDIBook merged (completed in 2002), as did Instinet and Island, and Archipelago with the NYSE within ArcaEx. Of the 12 ECNs created, only a few managed to create liquidity – and these were the first movers. Early ECNs, such as Archipelago and the merged Island and Instinet, saw off later entrants. Also, these first ECNs saw their market shares growing rapidly: from 1996 they doubled to 22 per cent of the Nasdaq transactions in 1999; 40 per cent in 2002; and more than 50 per cent

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in 2005. This explains why Nomura bought Instinet in 2006: it had become a liquid trading alternative to existing exchanges.10

Increased adoption of APIs Efficient markets and electronic liquidity can become a virtuous circle: electronic trading and the transparency it brings mean that trading opportunities disappear quickly. Many trading systems now possess deep electronic liquidity. The only way that opportunities can be exploited is by using direct feeds into the matching engines. Computer algorithms then decide instantaneously whether trades make economic sense or not and then execute trades. The increased use by banks and hedge funds of APIs (application programming interfaces) makes sophisticated programme trading possible, exploiting short-lived inefficiencies. This in turn drives trading to electronic systems. This systemic, or algorithmic, trading is prevalent in equity markets and is increasing in other liquid electronic markets, such as US treasuries and spot FX. Other markets will follow as eliquidity in these products grows. Sixty-one traders interviewed by Tabb Group, a financial markets advisory and research firm, estimated that algorithmic trading would comprise 17 per cent of orders in 2007.11 Banks are following the lead of hedge funds regarding algorithmic (algo) trading by setting up their own internal hedge funds or proprietary trading desks, all making extensive use of algotrading methodologies.

Risk management and accounting An ever-increasing volume of trades puts strain on the back office. This can be addressed only through increased automation, with electronic processing from the very start of the trade. Compliance and risk departments see the advantages of this and they often encourage, if not mandate, increased online trading. Accounting directives such as FAS 133 and IAS 39 force market participants to adopt the faster, error-free systems and processes offered by e-trading.

A new player in electronic markets: micro-exchanges The emergence of micro-exchanges Technology is enabling smaller players to compete with larger intermediaries, or – maybe more wisely – to create smaller electronic markets away from the limelight. These are the microexchanges. Micro-exchanges are based on technology that brings together buyers and sellers. These are typically niche markets where cost reduction and fluid communications for trading all sorts of assets – both physical and intangibles – are the main concern. As cost reduction is one of the main concerns, micro-exchanges rely heavily on the internet, hence accessing a free network. Micro-exchanges combine electronic trading and auctions. However, unlike electronic auctions such as eBay, micro-exchanges are not open to the general public, but only to qualified professional entities or individuals. Micro-exchanges are B2B, while e-auctions are open to

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anyone and are B2B, B2C and C2C. They trade very specific products restricted to certain types and are committed to market-making.

The differences between micro-exchanges and ECNs • Network(s) used: While ECNs use private networks, micro-exchanges rely heavily on the internet since low cost is a major concern. • Targeted market: While ECNs focus on some traditional assets, such as stock, commonly traded in investment bank trading floors, micro-exchanges trade niche markets, such as essential oils, coffee, domain names, private placement exchanges, alternative electronic stock, non-common metal market, etc. • Targeted audience: Micro-exchanges are more often used by qualified individuals and/or professional entities on niche markets, while ECNs are used by trading floors of large investment banks.

Micro-exchanges business model The business model of micro-exchanges is based on low cost, using the internet and outsourcing technology development to developing countries like India. They are very lightly staffed, often with fewer than ten people to support the whole trading platform. Revenues are generated mainly per transaction on markets whose size would not interest traditional exchanges. Micro-exchanges often result from entrepreneurs who have detected pricing anomalies or governments that wish to create electronic exchanges to regulate better pricing on a particular asset or commodity. An often-quoted example of an early micro-exchange is the electronic trading platform of the South African Futures Exchange (SAFEX), the South African agricultural market.12 SAFEX was created in early 1995 at very low cost, with just 26 staff operating a fully fledged electronic exchange and clearing house for futures and options. The goal of this initiative was to reduce direct subsidies to farmers by providing a more efficient market for agricultural goods. This would enable them to sell their produce at a higher price by squeezing the margins of intermediaries. In addition, through its futures and options market, SAFEX enabled farmers to hedge. SAFEX became so successful that it was bought by the much larger Johannesburg Stock Exchange in 2001. Micro-exchanges have grown rapidly because of the availability of turnkey software, sometimes even with online escrow service. A key vendor in this field is Comdaq, an AngloIndian company that provides technology to start an electronic exchange at a very low cost.

Examples of micro-exchanges Typical examples of micro exchanges are: • A coffee–tea exchange in Karnataka state, a state in southern India, normally more known for its software industry and now biotechnology. The exchange is based on a business portal for buying and selling coffees in India (www.coffeeteaindia.com). • A metals market in Karnataka state. Metals covered include gold, silver, platinum, palladium, rhodium, iridium and ruthenium. In addition, physical platinum, unallocated platinum and palladium are traded on a swap and forward basis (www.comdaqmetals.com).

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• An essential oils exchange, based on a transaction website, where growers and traders can come together and list, negotiate and trade (www.eoex.com). • An exchange for worldwide web domain names (www.exname.com). • An angel bourse for small companies, including start-ups (www.ppdaq.com).

A forerunner: Patrick L. Young and EOEX In his books, Patrick L. Young (1999, 2005) – a pioneer of exchange development – predicted that micro-exchanges would invade our everyday life, since everything could be traded electronically. He has himself been deeply involved in the creation of the world’s first essential oils exchange. Young emphasises the benefits of the micro-exchanges. Like any other market, microexchanges help buyers and sellers meet. For buyers, they provide: • • • • •

better knowledge of the market; wider choice and flexibility of suppliers; greater choice and flexibility in products and quality at the best available price; year-round choice of supply; and instant shipping upon payment.

For sellers, they provide: • direct access to the market, squeezing out the middleman; • rapid and efficient clearing processes; and • flexibility and diversification of buyers. The key element is that they make available the benefits of traditional exchanges in new niche markets. Before the arrival of the Essential Oil Exchange (EOEX), growers tended to get around 40 per cent of the price of their oils sold to corporations. Meanwhile, buyers frequently complained that they could not get access to the product, despite 300 middlemen. EOEX aimed to create an auction platform where buyers and sellers could meet easily, removing the need for middlemen and hence enhancing the supply chain with a better price for buyers and sellers and a more regular sourcing of supply. Launched in late 2003, it saw its trading volume reach US$2bn by 2005.

What is the future of micro-exchanges? Micro-exchanges are still few in number but two examples that could show the way are:13 • Sweden’s Options Market (OM) – This is the story of a rapidly growing start-up that swallowed even a traditional exchange. OM was created in 1984 as a privately owned startup company – revolutionary in its time and initiated by entrepreneurial will – in a similar spirit to that of the current micro-exchanges. A few years later, as it had rapidly expanded, it floated itself on the Stockholm Stock Exchange (SSE). A few years after that, it bought the traditional SSE and it is now among the world’s larger exchanges, as shown in Exhibit 5.2.

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• 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.

Conclusion Micro-exchanges have started to appear in niche markets. This is far removed from the creation of cross-border and even pan-continental trading exchanges and the battles between traditional electronic markets, investment banks, brokers and exchanges. Micro-exchanges have very low running costs and focus on markets with pricing anomalies too small for traditional exchanges. They are part of the same process that is creating crossborder exchanges and electronic markets – that is technology-driven change – but at a different stage. Should they manage to create enough liquidity, they might well follow the path of the wellestablished exchanges.

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All comments and opinions are those of the authors and do not necessarily reflect those of their respective companies. The authors would like to dedicate this article to the memory of Delphine Sabourin. Bloomberg, 23 November 2006. Morgan (2004). AITE Group, ‘Agency Brokers and Algorithmic Trading: Here Today, Gone Tomorrow?’. Available at www.aitegroup.com/reports/200611211.php Baladi (2006). Interview with Financial Times, ‘Spencer rings death knell for exchanges’ heyday’, 21 November 2006, http:// newsmoneycentral.msn.com/provider/providerarticle.asp?Feed=FT&Date=20061112&ID=6217978. Henniaux and de Vinck (2006). BIS (2006). ‘OTC derivatives market activity in the first half of 2006’, 17 November, p. 1. Available at www.bis.org/publ/otc_hy0611.htm. Benhamou and Serval (2000) and Oriol (2006).

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11 ‘Wall Street and technology’, 21 November 2006. Available at www.wallstreetandtech.com/showArticle.jhtml; jsessionid=YGLXNCZCRQUXIQSNDLPCKHSCJUNNZJVN?articleID=195300004. 12 See www.safex.co.za. 13 Zwick and McMahon (2006).

References Baladi, A. (2006) ‘NYSE-Euronext – an opportunity for Europe’, International Corporate Governance Network Conference. Benhamou, E. and T. Serval (2000), ‘On the competition between ECNs, stock markets and market-makers’, in Electronic Commerce and Web Technologies, Proceedings of the first international conference, EC-Web 2000, London, September, Berlin/Heidelberg: Springer. Henniaux, E. and O. de Vinck (2006), ‘MiFID, révolution ou évolution réglementaire’, press release, September, PriceWaterhouseCoopers. Morgan, J. (2006) ‘Electronic dreams’, Risk Magazine, 19(9) (Risk inter-dealer rankings 2006): 45–7. Oriol, N. (2006), ‘Electronic communication networks: des nouveaux acteurs internet pour une reconfiguration architecturale des marchés financiers’, PhD thesis, GREDEG1 – Université de Nice-Sophia Antipolis – CNRS. Young, P. L. (1999), Capital Market Revolution, 1st edition, Financial Times/Prentice Hall, London. Young, P. L. (2005), ‘That miniature marvelous microbourse – the market for microexchanges’, in The Handbook of World Stock, Derivative and Commodity Exchanges, MondoVisione. Zwick, S. and C. McMahon (2006), ‘End of an era, going for profit’, Futures Magazine, November: 15–23.

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Challenges confronting exchanges

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Chapter 6

Market integration in the post-trade industry Lessons from Europe1 Daniela Russo and Simonetta Rosati European Central Bank

Introduction During their lifecycle, securities undergo a complex chain of processes, with the involvement of a variety of entities using different technical systems and following complex rules: they are typically issued into central depositories or registrars, traded on exchanges, over-the-counter (OTC) or via alternative trading arrangements, cleared and often netted (sometimes with the intervention of a central counterparty), settled in securities settlement systems, then kept by custodians. The rights to which their owners are entitled (that is dividends, coupons and corporate actions) are executed and processed with the intervention of agent banks, custodians, and payment and settlement systems. It is, therefore, no surprise that the post-trade infrastructure supporting the functioning of securities markets is complex, that it attracts interest from a variety of different quarters, including users, owners, competitors and public authorities, and that, due to its pivotal role in allowing markets to work properly, it is of the utmost importance that it is also efficient and safe. In the past, the need to cope with such a high level of complexity and to reconcile diverging interests while protecting the public good of an efficient infrastructure had often led to a consolidation process at a national level, with the creation of national monopolies operating central infrastructures. In order to avoid the abuse of a dominant position by the monopolies at the expense of market participants, these structures were often either state-owned or governed by user-owners under mutualised schemes. Other strong drivers towards national industry concentration were the advantages of pooling liquidity, and the economies of scale and scope inherent to network industries. In many cases, this process led to a specialisation by market segment (with different trading, clearing and settlement systems for derivatives and for cash securities), while in other cases the existence of economies of scope led to the creation of a common ‘national’ infrastructure. Either way, each national market was operating within a national legal framework (so issues and risks related to conflicts of laws were limited to the relatively small segment of international transactions) under a national tax regime (with the tax treatment of relatively few non-resident investors being governed by bilateral agreements

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between the respective tax authorities). In this relatively simple world, each national market had a national currency, national authorities and a central bank. Today the picture is far more complex. The great changes that financial markets and exchanges have undergone in recent decades have, of course, affected all layers of the securities market infrastructure: trading, clearing and settlement. Technological advances, the huge growth in securities market turnover, product innovation, and increasing competitive pressure brought about by globalisation and increased international portfolio diversification, as well as the appearance of new players on the market scene are, to name just a few, all elements that somehow widened the marketplace, significantly increasing its complexity. Players who were used to playing in relatively closed national marketplaces were increasingly confronted with new competitors, in a larger, more complex environment. All these factors increased the competitive pressure on market participants to reduce the costs of securities processing at all stages in the securities transaction chain. The natural response was in most cases a trend towards further consolidation in financial markets2 (including infrastructures and financial intermediaries) to further realise, through increased size and wider market coverage, the scale, scope and network economies that characterise this industry, thus retaining business and attracting liquidity. As far as the securities markets were concerned, in addition to various initiatives to merge exchanges (both across product segments and across geographical borders), the finger was pointed at the post-trade infrastructure, for two main reasons: first, because of the natural link between the efficiency of the trading and post-trade processes; and, secondly, because this is the area where most of the costs of cross-border securities transactions lie. These global trends are particularly strong, perhaps magnified, in Europe, where EMU and the introduction of the euro have confronted markets and players with the challenge of market integration, and the prospect of a huge growth potential awaiting the fittest. Various studies have shown that the financial market segments have integrated at a different pace in Europe,3 and that it is not a case that the segments in which the market infrastructure is more fragmented are those in which the integration process is less advanced. While this is certainly not the only element explaining differences in the speed of integration (business practices, the legal and tax environment, and investor sentiment certainly also play a role), the availability of an infrastructure allowing participants to access the markets and to trade, clear and settle transactions subject to the same set of rules and costs is nevertheless a necessary condition for fully realising the benefits of the internal market and of the monetary union. In this chapter we describe the securities markets infrastructure, and discuss the main challenges facing exchanges, other market players, and authorities coming from the securities markets post-trade infrastructure. The next section provides the basic definitions and descriptions of the various parts of the infrastructure, explaining who does what and the main economic functions performed by the various players in the securities settlement industry. In ‘Addressing risks in the securities post-trade industry’ (p. 103), against the background of the sources of risk that may arise in the securities clearing and settlement process, we describe the rationale behind the main regulatory solutions and best practices aimed at containing the materialisation of those risks. In ‘The European landscape and its challenges’ (p. 107) we take a closer look at the European reality and its specific features, as this is, as explained above, an area where the general industry

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trends are amplified by the challenging process of integrating the markets of 25 countries, and, moreover, where what were 13 different currency areas is now the single euro financial market. We also briefly trace the development of the euro-area industry over time, highlighting the main drivers of change and the industry responses thereto. There are various areas around the world where sovereign states have undertaken the ambitious and undoubtedly rewarding project of creating an economic union, possibly leading to currency union,4 and the European experience is likely to be helpful in highlighting the main issues confronting the trading and post-trade industry, financial operators and public authorities that stem from the integration of the infrastructures serving a common, cross-border market. In the final section, we offer our conclusions.

Functions and players in the securities market infrastructure An introduction to the securities market infrastructure The lifecycle of a security involves a series of phases with various steps carried out with the direct or indirect involvement of many different market players.5 A stylised description of the lifecycle of a simple security is provided in Exhibit 6.1. In this unavoidably simplified representation, the life of the security starts with issuance. In the past, securities were certificates, issued in paper form and incorporating the rights of their holders (or those who were registered as their owners, such as the initial subscribers, and, later on, the investors who had acquired them). In recent decades, however, most markets have moved towards dematerialisation: this is a process whereby physical certificates or documents of title representing ownership of securities are eliminated so that securities exist only as accounting records. These accounts are held by specialised entities, the central securities depositories (CSDs) that were set up for the purpose of centralising all securities in one place, thus facilitating their transfer. Thus, dematerialisation6 implies that securities are actually issued inside a CSD. This fact highlights the intrinsic, functional link between exchanges and CSDs, which is largely unknown to, or unnoticed by, non-practitioners or the general public: for securities to be tradable there are usually two admission processes – the admission to the trading place or market and the

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admission to the post-trade service provider. Due to the CSD’s function to serve a whole market as a centralised repository of securities, the latter are normally issued in one CSD. An exception to this principle is made in the case of the Eurobond market segment. Eurobonds are international instruments issued outside the home market of the issuer and not subject to the issuer’s or the country of issue’s domestic market regulations, domestic bond market conventions or domestic settlement practices. Eurobonds are issued in the two international central securities depositories (ICSDs), Clearstream Luxembourg and Euroclear Bank.7 For the securities issued in their books, CSDs perform the notary function, which entails a responsibility to ensure that at all times the sum of the securities holdings equals the amount issued.8 Securities are normally traded in financial markets, and negotiations can take place at various market venues (for example stock exchanges, using trading platforms or other negotiation models, or OTC), depending on the relevant legal framework and business practice. Investors can deal directly in these markets, but more often resort to the intermediation of brokers and dealers. The trade execution starts with its confirmation, a process whereby the two parties confirm to each other the terms of the deal (type and amount of securities, price and value date of the transaction). Instructions for trade execution are then created and transmitted to the clearing and settlement systems. In order to reduce the likelihood of errors that would lead to incorrect execution and settlement failure, instructions are typically subject to matching, which can be done at the level of the trading platform by specialised providers of matching facilities or prior to submission to clearing and settlement. Sometimes trades are submitted to a specialised entity, the central counterparty (CCP), which interposes itself by becoming the seller to the buyer and the buyer to the seller and exploits the economies of multilateral netting arrangements (offsetting of positions or obligations by trading partners or participants). The netting reduces a large number of individual positions or obligations to a smaller number of obligations or positions.9 The intervention of a CCP reduces the risk taken by the original counterparties and increases settlement efficiency10 by transferring risks to the CCP, an entity that is specialised and thus more efficient in managing them. Clearing is defined as the process of transmitting, reconciling and, in some cases, confirming payment orders or security transfer instructions prior to settlement, possibly including the netting of instructions and the establishment of final positions for settlement. As an alternative to netting, trades can be directly settled one by one on a gross basis. Settlement is the act that discharges obligations in respect of funds or securities transfers between two or more parties. Settlement of a trade in securities typically involves two legs: the transfer of the securities from the seller to the buyer, and the transfer of cash funds from the buyer to the seller. In order to achieve this objective in the most efficient way, CSDs interact with the payment systems. In the course of the settlement process participants may face constraints in meeting their obligations because of a lack of either the funds or the securities to be delivered. There are various (banking) services aimed at facilitating settlement by covering participants’ liquidity shortages, mainly by providing credit facilities or securities lending programmes. The lack of funds is more easily solved because of the fungible nature of cash and the availability of credit lines with commercial banks or, if the party is eligible, the possibility of obtaining central bank credit. The liquidity of securities varies, so, unless special measures are in place, a lack thereof may often result in delays in settlement, or even settlement failure, which may degenerate into

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a chain of subsequent failures in the case of back-to-back transactions (so called ‘daisy chains’). The latter may result in a build-up of liquidity tensions spreading to the market and creating systemic risk.11 Securities lending programmes have proved very helpful in increasing liquidity and facilitating securities settlement. Such programmes may be set up by CCPs or CSDs or, alternatively, securities lending may be arranged directly by market participants if a developed OTC market exists. Securities lending can also be offered to their customers by custodian banks. The entities providing credit in cash or securities vary depending on specific jurisdiction. In addition to banks, in some jurisdictions, as is the case in some European countries, CSDs are allowed under national regulation to extend credit themselves to their participants in order to facilitate settlement. In other countries CSDs hold a full banking licence and are thus entitled to offer their participants a full set of banking services. For example, the two EU ICSDs serving the Eurobond market hold banking licences. Investors may not be allowed or may not want direct access to the CSDs where securities are held, and thus resort to the intermediations of custodian banks (depending on the local jurisdictions, other types of non-bank financial intermediaries may also be allowed to provide custody services). These investors hold their securities accounts with a custodian, which is also in charge of executing settlement orders on their behalf. The custodian may be the entity that directly holds the securities in an account with the CSD, or it can resort to another intermediary (a sub-custodian). In this way, a custody chain is established. The custody industry is part of the securities infrastructure and is characterised by the presence of different players meeting the demands of different investors in different ways, by providing services that range from very basic safekeeping to targeted, value-added services.12 CSDs may provide custody services directly to the market players that are allowed to participate in their systems (typically banks, although other categories may be accepted, depending on the specific legal and contractual framework). Custodian banks have specialised in providing access services to a multiplicity of markets, and provide a one-stop shop for international investors. These custodians ensure a global presence in many national markets by establishing local subsidiaries or by managing a network of agreements with local (sub-)custodians that access the local infrastructures on their behalf. For this reason they are called global custodians. Custodians receive the instructions from their customers and take care of settlement. In theory, they can either forward the instructions to the CSD or, if both parties (and their brokers) are customers of the same custodian bank, internalise the settlement (that is execute the transaction via book entries in their own accounts). In the latter case the balance of the custodian bank’s account with the CSD would not change.

Links in the securities market infrastructure Links are legal and technical arrangements and procedures that enable securities to be transferred between CSDs through a book-entry process. A link allows securities issued in the CSD of one country to be transferred to the CSD of another country where there is an active secondary market in the security. In practice, interlinked CSDs hold reciprocal accounts in which the transfer of securities is recorded. They also set up a communication interface and IT procedure to transmit the related instructions to each other. After securities have been transferred to another CSD, they can be transferred as if they were domestic securities (that is according to local market practices and procedures). For example, German Bunds are issued in the German CSD,

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Clearstream Banking Frankfurt, but there is a large turnover of these instruments in Euroclear Bank, thanks to the link between the CSD and the ICSD. Links are also established between systems of different currency areas to allow international settlement. However, in Europe at least, links are used only to a limited extent.13 Establishing links between CSDs is a form of market integration, as it allows participants in one CSD to access the services of the linked CSD. In the securities industry, links may also be established at higher level in the industry value chain, such as between CCPs. In this case, they allow participants in the two CCPs to use the services of both entities, without the need for double membership. Such links allow significant economies, as they open up the possibility for members to benefit from cross-netting (across different asset classes cleared in the two institutions) and cross-margining (with the related lower costs in terms of risk management requirements, such as collateralisation). At the level of exchanges, links can take the form of cross-listing, cross-membership or cross-trading agreements.14 Various forms of partnership among exchanges are also discussed in Chapter 2.

Cooperation and competition in the securities infrastructure industry The general overview provided above shows that there are some key industry functions that are performed exclusively by specialised entities and other functions that can be performed by different types of entity (see Exhibit 6.2). As a result, certain players may be active at certain stages of the industry chain, but they may also be in competition in one or more other stages. For example, the notary function is unique to the CSD in which the securities are issued. Settlement services, by contrast, can be provided by both CSDs and custodian banks. Banking services and other ancillary services aimed at facilitating settlement may be provided by banks or, depending on the specific jurisdiction, by other market players. Thus, in the post-trade industry the various players may be linked by a customer–provider relationship (CSDs providing custody and settlement services to custodian banks), and at the same time be competitors (that is CSDs and custodian banks competing for the provision of custody and settlement services or, where allowed, ancillary banking services to investors). The existence of this dual relationship may, under certain circumstances, influence the distribution of market shares in the services subject to competition.15 This may also create vested interests among the different categories of players, and may represent an obstacle to the development of the industry model in the direction of a more integrated and cost-efficient solution.16 Conflicts of interest may arise among different categories of users of CSDs. For example, some users may prefer a highly integrated infrastructure, able to provide an efficient service at the lowest possible cost, while bank-users that build up their customer base by offering investors a one-stop shop access to multiple systems (and that thus benefit from fragmentation) may oppose harmonisation or other forms of integration in order to protect their market share. Bank-users that are also owners of securities settlement systems may prefer the owned entities to be prevented from providing ancillary banking services. Conflicts of interest may also arise between short-term and long-term interests to the extent that the costs and benefits of market integration will be distributed differently among the various categories of market player, providers and users.

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Addressing risks in the securities post-trade industry Containment of risks in clearing and settlement systems Like payment systems, securities clearing and settlement systems are pivotal for the proper functioning of financial markets, and their malfunctioning may seriously affect financial stability. The risk categories and risk approaches have been studied at length by central banks, which have a specific interest in the proper functioning of financial markets due to their responsibilities in the conduct of monetary policy and maintaining public confidence in the currency. In the 1990s and the early part of this decade several sets of standards for the industry have been developed in order to ensure that risks arising from market infrastructures are well understood and addressed. In 2001 the Committee on Payment and Settlement Systems (CPSS) of the central banks of the G10 countries, in cooperation with the International Organization of Securities Commissions (Iosco) published ‘Recommendations for securities settlement systems’, which was followed in 2003 by the ‘Recommendations for central counterparties (CCPs)’.17 These recommendations are part of the 12 sets of standards designated by the Financial Stability Forum as key for sound financial systems and deserving priority implementation. In certain cases, depending on their legal basis, public authorities may include the standards provisions in national regulation (oversight, mandatory standards), possibly after adapting them to the national environment.18 In other cases, they may see them as recommendations to which the relevant market players are invited to conform (soft law, or non-mandatory standards). In the euro-area, the Eurosystem has decided to develop user standards for the use of securities settlement systems in the context of the collateralisation of its central bank credit operations. The Eurosystem only accepts collateral at eligible CSDs, which are compliant with its standards. In their capacity as overseers, the relevant authorities (central banks, often in cooperation with securities regulators or financial stability agencies, depending on the supervisory model in place) regularly assess the degree of compliance of the market infrastructures against the benchmark set by these standards.

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Exhibit 6.3 shows definitions of the risks commonly identified in securities settlement, such as legal, credit, liquidity, custody and operational,19 and the main measures aimed at their containment. The following subsections discuss in more detail the sources of these risks and the best practices in this field.20

Legal risk In principle the legal risks to which participants in securities clearing and settlement systems are exposed do not differ from those inherent in payment systems. For instance, legal validity and enforceability of settlement finality and netting arrangements are equally important and often addressed within the same legal framework. In the EU, for example, the Settlement Finality Directive21 applies to payment systems and securities settlement systems, participants in those systems, collateral provided in connection with participation in these systems and operations of the member state central banks. In the case of securities settlement and clearing, however, the legal complexity (and the need for legal complexity) is greater given the specific characteristics of securities. In particular, legal enforceability needs to be ensured for securities entitlement, custody and collateral realisation. Moreover, the need to settle cash and securities increases the potential for conflict of laws since the two legs (cash and securities) of the same transaction are subject to different rules that may not be clearly defined a priori. The mitigation of legal risks may be particularly challenging in a cross-border context (and obviously in the case of links between systems) due to the increased possibility of conflicts of laws and uncertainty as to the laws governing a certain transaction. Therefore, clear rules on the resolution of such conflicts are essential.

Liquidity risk Participants in post-trade infrastructure may be exposed to significant liquidity pressure because, if incoming funds or securities are not received in time, they may be unable to fulfil subsequent obligations to deliver the same assets to other participants (that is in back-to-back transactions). There are various measures to alleviate liquidity risk, depending on its sources. Here again the need to settle securities (and cash) represents an additional source for liquidity problems and may require the employment of specific risk control measures, such as securities lending. These are all aimed at making sure that liquidity risk is not transmitted from one participant to another, thus potentially leading to credit risk or even having a systemic impact.

Credit risk Like participants in payment systems, participants in securities clearing and settlement are exposed to credit risk vis-à-vis their counterparty until they receive with finality the expected assets or funds. When netting settlement procedures are used, credit risk may also be substantial on an intraday basis (implicit credit among netting counterparties). In the securities world, one way to address counterparty risk is to use CCP services, provided that the CCP has adopted appropriate risk management measures to address these risks.

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In securities transactions that require the settlement of two legs (delivery of assets versus payment of funds), the party that delivers first is exposed to principal risk until its counterparty has also fulfilled its obligation with finality. In securities settlement systems, the adoption of DVP-settlement models22 links both legally and operationally the settlement of the two legs and thus effectively removes principal risk. Replacement cost risk may be contained using a CCP or adopting a series of measures aimed at expediting or facilitating settlement. Examples of these measures are the prompt confirmation of trades and their matching (in order to detect errors as soon as possible), and shortening the settlement cycle (as the exposure to this risk is proportional to the time lag between the time of trade and final settlement). Where the use of central bank money is not practicable or feasible for settlement of the cash leg, and commercial bank money is used as settlement assets, participants are also exposed to potential losses and liquidity pressures arising from the failure of the cash settlement agent.

Custody risk Adequate protection of securities held in custody requires robust accounting procedures and standards, such as end-to-end audit trails and daily reconciliation, and the custodian should segregate customer securities from its own securities in its books in order to ensure that customer securities are protected, particularly against claims from the custodian’s creditors. In particular, it is essential to impede securities debit balances or securities creation23 by the entities holding securities in custody. It is also advisable that an intermediary should obtain a customer’s explicit consent before it can use the customer’s securities for its own business, as is allowed in certain jurisdictions (that is for securities lending or as collateral for its own credit exposures).

Operational risk Operational risk in securities clearing and settlement does not differ from operational risk in payment systems. However, since securities transactions generally involve more infrastructure and intermediaries, the exposure to operational risk is likely to be higher.

Systemic risk National legislation normally assigns to specific financial authorities certain responsibilities in the field of preserving financial stability. This is typically ensured by looking, on the one hand, at entities providing post-trade services and, on the other hand, at post-trade systems themselves, which should be subject to transparent, effective and consistent central bank oversight.24 In the increasingly global market, systemic crises cannot be considered only from the national perspective. This is due to the pervasiveness of linkages and interdependencies across systems, as well as the complex exposures of major players participating in many markets, CSDs and CCPs across the globe. Market infrastructures can be both a major source and a major vehicle for contagion of systemic risk across geographically distant markets. For this reason, in order to avoid potential contagion of risks, cross-border cooperation among authorities is essential.

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The European landscape and its challenges Integration in the European context At the time of the start of EMU, the post-trade infrastructure of the euro-area financial markets resulted from the sum of the national infrastructures of the member states adopting the euro (with the notable exception of the wholesale payment systems where, with the launch of Target, the European System of Central Banks provided the seamless cross-border large-value infrastructure required to ensure the smooth implementation of monetary policy). It is not a case that the euro money market, and particularly its unsecured overnight segment, almost instantly transformed into a single market, as is confirmed by the empirical evidence of a very low dispersion of interbank deposit rates across countries.25 If an integrated market is one where users pay the same price for the same product or service, regardless of their location, then in the securities industry this means that trading, clearing and settlement costs should not distort investment decisions.26 The lack of a proper infrastructure produces a vicious circle: the inherited fragmented securities infrastructure cannot deliver the efficient service required by a cross-border market, but, at the same time, a cross-border integrated trading market cannot fully emerge if it is constrained by the frictions created by a fragmented post-trade infrastructure. Thus, an obvious response to the new challenges of monetary union was to increase the integration of the securities market infrastructure. The market has shown growing interest in cross-border securities holdings. For instance, increased integration in the collateral market can be observed from the available data on the cross-border collateral as a share of the total collateral provided to the Eurosystem to secure central bank credit operations (data purely on market use of collateral are not available). This share steadily increased from 17 per cent in 2000 to 45 per cent in 2005 (see Exhibit 6.4). In general, it has been shown that the degree of integration of the euro financial market varies greatly across the various market segments, and correlates with the degree of integration in the underlying market infrastructure.27 In particular, integration in payment infrastructure was stronger and quicker than integration in securities post-trade market infrastructure (see Exhibit 6.5). One explanation is that market infrastructure is composed not only of the clearing and settlement systems as such, but also of the set of legal provisions governing their functioning, as well as the other rules and procedures applied, including business practices. Securities processing is far more complex than funds transfer processing, thanks to the plurality of legal provisions governing the life and transfer of securities as well as the rights attached to securities ownership. Integrating technical systems is therefore a necessary but not sufficient condition for building an integrated infrastructure. For instance, different tax regimes and rules and procedures for collecting taxes on capital gains, dividends and coupons by nonresidents are also a source of complication. These are areas where the lack of harmonisation represents a barrier to market integration and impedes the realisation of the possible benefits of systems integration. As far as the industry structure is concerned, the markets have explored various ways to increase market integration, ranging from mere technical and business cooperation, to interoperability (with standardisation of procedures and the establishment of operational links between systems), strategic alliances, joint ventures and even full mergers28 (although in many

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cases these mergers concerned the companies that owned or operated the systems, but not the systems themselves, which continue to operate on separate technical platforms). Concerns were raised that, although vertical integration would allow sensitive cost reductions along the securities transaction chains, these savings might not necessarily be passed on to market participants. For example, European Commission (2006) concluded that vertical silos tend to have higher costs for users than horizontally integrated structures, although there are exceptions to this conclusion, with at least one vertically consolidated national structure showing the lowest level of fees. Exhibit 6.6, which provides the current securities post-trade landscape of the euro-area, demonstrates that there are currently 17 securities settlement systems in the 13 countries (20 counting the three Spanish regional systems), and 15 (18) of them are currently eligible for use in Eurosystem credit operations. There are currently 59 eligible links among a subset of them (see Exhibit 6.7). However, notwithstanding the steady increase in cross-border use of collateral for Eurosystem operations, these links are not used as much as initially anticipated. In the case of the total cross-border collateral, in 2004 links were used to transfer about 20 per cent of the cross-border collateral, while the remaining 80 per cent was transferred to the Eurosystem using the Correspondent Central Banking Model (CCBM), a model developed by the central banks as a temporary solution to ensure a comprehensive coverage until a fully fledged market solution is in place. It should be noted that the CCBM cannot be used for private market transactions, but only for collateralisation of Eurosystem credit operations, and that statistics on the general market use

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of links (that is on their use for transactions among market participants, or on the use of links among CSDs other than those eligible for operations with the Eurosystem) are not available. There was an initial industry impetus towards establishing links in the first few years of EMU, and the vast majority of these links were established in the period between 1999 and 2001 (see Exhibit 6.8). In the period between 2000 and 2004 the pace of market integration in the form of consolidation accelerated (see Exhibit 6.829 and Exhibit 6.9) as the market progressively moved from a spaghetti model of integration to consolidation by means of alliances and mergers both at the domestic and cross-border level. In some cases consolidation has taken place horizontally between systems at the same level in the processing chain. In the post-trade industry this means between CCPs, as in the case of LCH.Clearnet, or CSDs, such as the creation of the Euroclear Group including the ICSD, and the CSDs of France, Belgium and the Netherlands. In other cases it has taken the form of vertical consolidation, such as mergers along the securities processing chain, typically with the stock exchange acquiring the control of the clearing and settlement companies. So far this has been witnessed at the national level. Examples are Deutsche Börse Group and Borsa Italiana.30 In conclusion, although some progress has been made, it is clear that the infrastructure is still too fragmented, and it has not yet achieved an optimal equilibrium. Several studies have provided evidence that the cost of clearing and settlement in Europe is higher than in the US, a market of comparable size but with a fully consolidated infrastructure (by class of asset). Even if there is no common view on the exact size of the cost difference

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between the markets, some studies suggest that costs in the EU could be up to seven times higher than in the US.31 In general, there is widespread consensus on the scope for potential cost savings in cross-border settlement in the EU. Furthermore, it has been argued that the impact of costs reduction on economic growth would not be inconsiderable. A recent study by Schultze and Baur (2006) concluded that a more efficient post-trade system, leading to a lowering of transactions costs by between 7 and 18 per cent, could result in a higher level (EU) GDP (on average between 0.2 and 0.6 per cent higher) in subsequent years. There could be various explanations for the slow pace of consolidation. First, Russo et al. (2004) have argued, for instance, that conflict of interests and inappropriate governance solutions may be hindering or slowing down further steps in the direction of greater market integration. Secondly, another possible explanation is that uncertainty about the future regulatory, legal and fiscal environment may also contribute to slowing down the process, as players adopt a wait-andsee approach, postponing strategic decisions where the return is considered too uncertain. In this respect, it has been argued32 that clarity of objectives and accepted models of integration by public authorities might be more effective than (and thus preferable to) a more heavy-handed public intervention approach driving the integration process top-down. Thirdly, according to

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the same authors, ultimately the pace of integration will be determined by, among other things, the balance of two opposing forces, both stimulated by profits: on one side there are the interests of those benefiting from the current fragmentation (that is the intermediaries that offer users the opportunity to bypass the existing barriers, and the small-scale domestic providers who see the barriers as a protection against the possible entry of large foreign competitors); and on the other side there are the providers who hope to profit from the economies of scale in an integrated market (and have started investing in preparation for integration). Finally, resistance to crossborder integration may derive from some degree of nationalism, which is fuelled by those involved in the protection of private interests. In some cases even national authorities may have considered it appropriate to resist cross-border consolidation out of fear that foreign influence would imply the adoption of less reliable rules and regulations than the domestic ones.33

The answers of the public and private sectors Public authorities have specific interests in monitoring developments in the field of market integration of securities market infrastructure in order to ensure the achievement of a social optimum.34 In fact, the post-trade industry is characterised by positive externalities, as not only system participants but the economy as a whole benefits from their smooth functioning. Some of the functions that they perform can be regarded as a public good. In the past the key financial markets infrastructures were operated by the central banks, and in some cases they still are. At the same time, it is widely recognised that market forces may allocate resources more efficiently than public entities. In the presence of market failures, however, market forces cannot be deployed and public intervention may be justified to help the functioning of the market. Currently, there is a lively debate on the nature and optimal degree of involvement of public authorities, including central banks, as well as on the scope for (and cost of) public regulation. In Europe, the authorities that are most actively engaged in the process of promoting integration of the posttrade industry are the European Commission and the Eurosystem, on the basis of the respective responsibilities and objectives as assigned to them by the Treaty.35 In particular, the European Commission has taken action to promote the establishment of market conditions consistent with the functioning of the internal market (that is a market with no segmentation based on the geographical location of the various players and with a healthy competitive environment). This implies the promotion of the removal of not only legal or regulatory barriers but also of conditions that de facto impose restrictions on the free choice of market operators or affect their ability to compete on a level playing field (that is transparency and access rights). At the same time the Eurosystem has a legitimate interest in promoting the achievement of adequately integrated market infrastructure, as this is a prerequisite for the smooth functioning of the financial markets and the conduct of monetary policy. From this perspective, market integration needs to be an orderly process, compatible with the dual objectives of efficiency and financial stability. Thus, it is essential to find an optimal balance between consolidation, which provides the efficiency benefits of increased scale and scope of operations, and risk awareness and management, by avoiding, for instance, a relaxation of risk management practices in the pursuit of commercial objectives and a concentration of undue levels of risks in entities whose malfunctioning would threaten the functioning of the whole of the financial market that they serve. The initiatives of the European public authorities in this field are reviewed in the following subsections.

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Interests of the European Commission, and the Giovannini Barriers In order to identify possible actions to remove barriers to the realisation of the internal market in post-trade services, the European Commission commissioned a group of experts under the chairmanship of Professor Alberto Giovannini. The group produced two reports, in 2001 and 2003; their major contribution to the ongoing debate was to point out two things. First, achieving technical integration and interoperability among infrastructures is not sufficient to promote the establishment of the internal market in this particular industry, as persisting barriers in the form of legal, fiscal and business practices restrict the free choice of location of securities and of settlement by the market participants. This impedes de facto the efficient deployment of competitive forces and contributes to increasing costs. It is, therefore, clear that concerted action by both the private and public sectors is required. Secondly, removing the restrictions on choice of location without having first achieved operational and legal harmonisation and simplification would in fact increase the complexity of the settlement environment, and thus lead to unacceptable levels of operational and legal risk. Thus, the Giovannini Group also established a desirable sequence of actions to create synergies in the overall process (as removing certain barriers would facilitate the subsequent removal of other barriers without increasing risk). The 15 barriers identified and the respective original deadlines are shown in Exhibit 6.10.

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While actions to remove the barriers were initiated in all identified fields, many barriers were not completely dismantled by the agreed deadline. Overall, it has been argued that the private sector has been more effective in carrying out its actions, while the public sector has lagged significantly behind, particularly with regard to the removal of the tax and legal barriers.36,37 Following up on the Giovannini reports, the European Commission issued a ‘Communication . . . on clearing and settlement in the European Union’ in April 2004, setting out its strategy for action in this field. In particular, the Commission intended to study the possibility of issuing a directive on clearing and settlement in order to harmonise the divergent legal environment for clearing and settlement across the member states. The Commission also conducted a thorough analysis of the industry, focusing on possible barriers to competition and on likely economic gains from the removal of barriers. While some critics have argued that the two objectives may be contradictory (as market integration and consolidation might be inconsistent with a higher level of competition) it should be noted that the purpose of public action in this field is not to establish a specific market structure or a specific degree of concentration, which is left to market forces to determine according to cost-efficiency expectations, but instead to ensure that the legal and economic environments allow appropriate cost-efficiency levels (market integration) and to make sure that such provision of services will remain contestable. More recently, in July 2006, the Commission dropped plans for a framework directive, and instead called on the market participants to voluntarily commit themselves to achieving the required transparency, interoperability and free access conditions by adopting an industry code of conduct. The call was met with a prompt response, and by the beginning of November the members of the three main industry associations – the Federation of European Securities Exchanges, the European Association of Central Counterparty Clearing Houses and the European Central Securities Depositories Association – had signed such a code of conduct. The measures detailed in the Code of Conduct address three main issues that are critical to contestability in the post-trade market, such as (1) transparency of prices and services (to be implemented by the end of 2006); (2) access and interoperability (by mid-2007); and (3) unbundling of services and accounting separation (by 1 January 2008). A monitoring mechanism, which relies on external auditors that report to an ad hoc committee chaired by the Commission, will be set up to ensure that all the measures are implemented properly and on time. While the scope of the Code will initially be limited to cash equities, it is expected that subsequently it will gradually be extended to include other financial instruments, such as bonds and derivatives. The adoption of the Code of Conduct by the industry in response to objectives set by public authorities is an important step in the direction of resorting to modern forms of cooperation between public and private stakeholders in line with the principles of better regulation adopted by the European authorities, including the possibility of resorting to soft-law alternatives to regulation, as is also recognised in the 2003 Interinstitutional Agreement on better lawmaking.38,39 The Code of Conduct is an innovative tool to promote integration. On the one hand, being a form of self-regulation, it is voluntary and non-binding for its signatories. On the other hand, it benefits from the active support of the European Commission, and the fact that the Commission will chair the monitoring committee adds particular strength to its implementation process. It also has the advantage of being a pragmatic approach to addressing those issues that are likely to be

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solved more quickly by the private sector (in line with the Community’s obligation to legislate only where necessary), while at the same time it leaves open the possibility of a final assessment of the need for a directive on the issues outside the scope of the Code of Conduct (and/or on those areas where the implementation of the Code of Conduct may possibly be unsatisfactory or ineffective).

ECB initiatives on the regulatory and operational side The interest of central banks in financial markets infrastructures is well recognised both in economic theory and in most cases in their legal and statutory responsibilities in the fields of financial stability and monetary policy.40 The nature of their involvement has changed over time, encompassing various roles, such as regulatory, supervisory and/or operational, historically a field in which central banks have been very active. As far as securities infrastructures are concerned, in many jurisdictions central banks share their responsibilities with securities markets regulators or, where necessary, with banking supervisors. In Europe, as far back as 2001, the European System of Central Banks (ESCB) and the Committee of European Securities Regulators (CESR) agreed to work together in order to adapt the CPSS-Iosco Recommendations to the EU context. The result of this joint project was a report entitled ‘Standards for securities clearing and settlement in the European Union’, adopted by the Governing Council of the ECB and the CESR in October 2004. One of the major innovations of the Standards compared to the Recommendation is the design of a coordination framework for the conduct of oversight by the different EU competent authorities (Standard 18). The finalisation and implementation of the Standards has been delayed somewhat by the uncertainty over the precise line of action that the Commission would take, and, in particular, whether the possible directive would address issues covered by the Standards. However, recent developments with regard to the Commission’s strategy for action have made it clear that implementing the Standards would be a necessary measure to complement and support the adoption of the Code of Conduct by directly addressing the need for systemic risk containment, and indirectly supporting the objectives of interoperability, access, transparency and efficiency.41 There are also new developments on the operational side, as in July 2007 the Eurosystem announced its intention to evaluate opportunities to provide efficient settlement services for securities transactions in central bank money, leading to the processing of both securities and cash settlements on a single platform through common procedures. The implementation of the upgraded infrastructure would complement and allow for full exploitation of some of the benefits that will be introduced with the wholesale payment system Target2, which will go live in 2007. For this reason the possible facility is named ‘Target2-Securities’ (ECB 2006c). The Eurosystem would thus be in a position to deliver to the market such benefits, allowing harmonised settlement of all securities transactions (at least) in euros in central bank money. Such a facility would not compete with the service provided by CSDs and, in principle, would instead be a service provided to CSDs, and would allow for competition among CSDs in providing the single entry point to the settlement facility. The Eurosystem does not intend to set up an infrastructure for centralising the depository or notary function, nor to interfere with the custody function (which would be left to the various intermediaries active in this segment), but only to provide a facility for equal settlement of domestic and cross-border transactions in central bank money (thus eliminating

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completely the settlement agent risk that is currently high in certain market segments). The Eurosystem has started an intense phase of market consultation to test and further refine the idea, and a comprehensive feasibility study will have to be prepared before the Governing Council of the ECB will take a decision on whether or not to pursue the project any further (a decision is expected in early 2007).

Synergies between public initiatives The European experience shows that overcoming the barriers to market integration in the posttrade industry is no easy task, and, in order to be successful, effort is required from all the interested parties, each in its specific field of action and competence. The private sector needs to address the various conflicts of interest and make an effort to achieve harmonisation and foster market efficiency by favouring the conditions for the establishment of a competitive environment (for example enhanced transparency and ensuring the proper exercise of access rights to market infrastructures). The dismantling of some barriers in the private sector, and the adoption of the Code of Conduct, are positive examples of the ability of private players to pursue public interests through appropriate coordination. For its part, the public sector needs to speed up the completion of the removal of the legal and tax barriers. Central banks have traditionally played an important role in the direct provision of clearing and settlement services (and many continue to do so), and it is not impossible that an operational role (such as may be adopted if the Target2-Securities project comes to fruition) may complement the other initiatives, delivering an adequate technical solution at a swifter pace than any the industry could be expected to provide, while at the same time avoiding entering necessarily into competition with private infrastructures. In addition to coordination between private and public initiatives, it is also important that coordination among the initiatives of the various authorities is ensured, as this allows synergies to be exploited and mutually reinforces the effectiveness of different public actions (Exhibit 6.11 provides an overview of the relation between the public policy objectives and the various possible measures). Potential synergies may be found in all the three areas of safety, technical efficiency and economic efficiency. First, in the area of financial stability and systemic risk containment, the need for a harmonised oversight framework is more pressing in an integrated post-trade environment than in a fragmented one, as fragmented, non-harmonised and uncoordinated oversight would endanger the level playing field among market participants (with regulatory arbitrage as the potential market response).42 Furthermore, the lack of coincidence between, on the one hand, the impact of malfunctioning in terms of financial stability for the whole integrated market and, on the other hand, the partial approach of national authorities to risks and risk containment may weaken the oversight and supervisory function: national authorities may have no access, or limited access, to important information concerning major risks originating in or spreading to other parts of the internal market. The coordination mechanisms that will be introduced with the implementation of ESCB-CESR Standard 18 would ensure that the relevant authorities are in the best possible position to meet their responsibilities. Having the coordination mechanism in the form of a standard, rather than embodied in legal provisions, would have the advantage of allowing its dynamic adaptation to market evolution.

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Secondly, the various ESCB-CESR standards support the achievement of increased technical efficiency and interoperability (see, for instance, Standards 2, 3 and 15). Thirdly, the ESCB-CESR Standards also promote increased economic efficiency by requiring the adoption of some transparent practices, encompassing not only obligations and risks (Standard 1), but also prices and fees (Standard 17) as well as access conditions (Standard 14), which are necessary to allow free and informed choice by infrastructure participants. These measures are aimed primarily at containing accepted risks and ensuring that they are appropriately understood and managed, but also contribute indirectly to maintaining contestability in the industry (for example unbundling is encouraged by Standards 5, 9 and 10). Thus the ESCB-CESR Standards can be seen as complementary to the Code of Conduct proposed by the Commission and adopted by the industry, as the two measures both contribute to integration, but with the different objectives of fostering, respectively, financial stability and market efficiency. Finally, the Target2-Securities project not only aims to be fully compliant with the requirements of the Code of Conduct but also has the potential to help the industry become compliant with the requirements of the Code. First, it will play a fundamental role in dismantling some of the technical barriers to market integration, such as differences in business hours, and

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achieving interoperability through the establishment of a common platform for settlement. Secondly, it will adopt the highest transparency rules, thus setting an industry benchmark for compliance with the Code of Conduct. Thirdly, Target2-Securities may help in unbundling settlement services from other added-value services since settlement services will be de facto segregated on a dedicated platform.

Conclusions This chapter has analysed the main challenges facing authorities and market participants in the field of securities post-trade infrastructure stemming from market pressure to serve the needs of integrated financial markets, taking due account of risk, safety and efficiency concerns. The chapter has traced developments in the European post-trade industry following the adoption of the euro as a single currency in 13 member states of the European Union, and has reviewed the most recent initiatives taken by private and public authorities to promote further integration in the industry. The chapter has also reviewed and summarised the main lessons learned from the European experience, which could be useful for other sovereign states that are currently considering or have already taken steps to create a monetary union adopting a single currency. These lessons are that progress towards integration in the securities market infrastructure may be slowed down by a number of concurrent causes, such as vested interests, and the presence of technical, legal and fiscal barriers, and that appropriate positive actions need to be taken to support an adequate pace of adaptation of the infrastructure environment for the needs of integrated financial markets. Furthermore, it is of key importance that the mix of actions by public and private sectors (be they of a regulatory, self-regulatory, supervisory or operational nature) are coordinated in order to exploit synergies and mutually reinforce their ability to achieve the desired objectives.

1 The views expressed in this paper are those of the authors and do not necessarily reflect the views of the ECB or the Eurosystem. 2 For a detailed analysis of the causes, patterns, consequences and policy implications of consolidation see Group of Ten (2001) report on consolidation in the financial sector. 3 See, for instance, ECB (2003), in which, in a comparison of the money, bond and equity markets, it is concluded that equity markets may be the least integrated of the three, or ECB (2006a), in which it is shown that the degree of integration of financial market segments correlates with the degree of integration of the underlying infrastructure. 4 For example, unions are planned among states in the Caribbean, in West Africa, in East Africa and among the Arab States of the Gulf. 5 A detailed overview of the industry is provided in Deutsche Börse Group (2005). 6 In some countries where securities dematerialisation is not legally feasible, a process that achieves similar results is that of immobilisation, which is the placement of physical certificates for securities and financial instruments in a CSD so that subsequent transfers can be made by book entry. 7 Eurobonds are deposited into both ICSDs upon issue and distributed to the securities’ underwriters, initial investors or their intermediaries by book-entry according to their membership of either ICSD (the Eurobond market is the only EU market in which more than one CSD exists for the same issue of securities). 8 In some markets the notary function is performed by a separate entity, the registrar. In these markets, the CSD in which the securities are settled interacts with the registrar for reconciliation purposes. 9 Netting may take several forms with varying degrees of legal enforceability in the event of default.

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10 For a comprehensive description of CCP functions, their specific risks, concerns and relevance for financial stability, see ECB (2001). For a comprehensive discussion of the evolution of CCPs serving exchange-traded derivatives and a comparison of the European and US realities, see Russo et al. (2002). 11 Fleming and Garbade (2005). 12 Russo et al. (forthcoming b). 13 Kauko (2003) has suggested that this could be due to the pricing strategies of CSDs for the settlement of primary and secondary market transactions. 14 Carretta and Nicolini (2006). 15 Holthausen and Tapking (2004). 16 Russo et al. (2004) and Schmiedel and Schönenberger (2005). 17 These 12 key sets of standards are broadly accepted as representing minimum requirements for good practice. The CPSS reports (BIS 2001 and BIS 2004) are available on the website of the Bank for International Settlements. 18 In Europe, the European System of Central Banks (ESCB) and the Committee of European Securities Regulators (CESR) started a cooperation to adapt the CPSS-Iosco ‘Recommendations to the European environment’ (the socalled ESCB-CESR Standards; see ECB (2005)). 19 ECB (2005). 20 For a comparison of prudential and oversight requirements for securities settlement, see Russo et al. (forthcoming a). 21 Directive 98/26/EC of the European Parliament and the Council of 19 May 1998 on the settlement finality in payment and securities settlement systems (OJ L 166, 11 June 1998). 22 BIS (1992). 23 Securities creation is an accounting or bookkeeping activity within a CSD that results in the total value of holdings of a particular security recorded on participant accounts in the CSD exceeding the total value of the original issue of that security. 24 BIS (2005). 25 Ciampolini and Rohde (2000); ECB (2003); and ECB (2006b). 26 Schmiedel and Schönenberger (2005). 27 ECB (2006b). 28 As noted by Schmiedel and Schönenberger (2005), the terms ‘integration’ and ‘consolidation’ are often used as synonyms but they do not refer to the same thing: consolidation refers to an increase in the degree of industry concentration. Thus, consolidation is a form of integration, and may speed up or facilitate the rationalisation and integration of the industry. The paper contains an in-depth discussion of the securities infrastructure integration models and related policy issues. 29 Please note that, in Exhibit 6.8, the number of eligible links includes four links to non-euro-area CSDs up to 2002. The series for the number of eligible securities settlement systems and the number of independent alliances and mergers contains some degree of approximation and should be regarded as trends as it was constructed by combining data from ECB press releases on eligible securities settlement systems (including non-euro-area countries up to 2002) and public announcements concerning alliances and mergers among CSDs. 30 An analysis of the various stages of securities infrastructure market integration in Europe is also provided in Kazarian (2006). 31 For a comprehensive review of recent literature in this field, see Annex I to European Commission (2006) or Schmiedel and Schönenberger (2005). 32 Giovannini et al. (2007). 33 The authors carry out an in-depth analysis of the conflicting interests surrounding the integration process in the European post-trade interests, summarise the current debate on the preferable form that integration should take, and describe the rationale and guiding principle of public intervention. 34 Schmiedel and Schönenberger (2005). 35 The Treaty on European Union (EU Treaty), often referred to as the ‘Maastricht Treaty’, was signed on 7 February 1992 and entered into force on 1 November 1993. This Treaty has subsequently been amended by the ‘Treaty of Amsterdam’, which was signed in Amsterdam on 2 October 1997 and entered into force on 1 May 1999, and most recently by the ‘Treaty of Nice’, which was signed on 26 February 2001 and entered into force on 1 February 2003. For a historical overview of the process leading to the introduction of the euro, and a description of the legal, institutional and organisational aspects of the ECB see Scheller (2004).

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36 The progress made is monitored by the Clearing and Settlement Advisory and Monitoring Expert Group (CESAME), which advises the European Commission in this field. 37 Rietveld (2006). 38 For a discussion on the diversification of the EU’s regulatory instruments and in particular on the use of instruments alternative or complementary to traditional ‘command-and-control’ legislation, see Senden (2005). 39 See European Parliament, European Council and European Commission Interinstitutional Agreement on better lawmaking (Official Journal of the European Union, 2003/C 321/01). The Agreement envisages two forms of soft-law: co-regulation and self-regulation. Co-regulation means a ‘mechanism whereby a Community legislative act entrusts the attainment of the objectives defined by the legislative authority to partners which are recognized in the field, such as economic operators, the social partners and non-government organizations or associations’, and may be used on the basis of criteria defined in a legislative act that serves as a basis for the co-regulation. By contrast, self-regulation is defined as ‘the possibility for economic operators, the social partners, non-government organizations or associations to adopt amongst themselves and for themselves common guidelines at European level (particularly codes of practice or sectoral agreements’. The Agreement further specifies that ‘self-regulation is a voluntary initiative, and it does not imply that the Institutions have adopted any particular stance (. . .)’.The Commission will notify the European Parliament on self-regulatory practices, which it regards as satisfying certain criteria specified in the Agreement, such as sectoral and geographical cover, attainment of the EC Treaty objectives and compatibility with its provisions, and value-added of the commitments given. It is foreseen that the Commission will nonetheless consider the possibility of putting forward a proposal for a legislative Act, in particular on the request of the competent legislative authority or in the event of a failure to observe the above (self-regulatory) practices. 40 For the case of the Eurosystem see ECB (2002). 41 The swift adoption per se of the ESCB-CESR Standards would in itself be an important step towards creating a level playing field in the securities clearing and settlement infrastructure, as they would facilitate the harmonisation of the currently different supervisory and oversight practices in member states. It should be noted that the CPSS-Iosco Recommendations were issued in 2001. Six years have passed since then, and in the meantime they have already been used by EU overseers and securities regulators to assess national infrastructures. Today, the risk of a nonharmonised use of the CPSS-Iosco Recommendations, with all the resulting technical inconsistencies and level playing field problems, is already a reality. Thus, the implementation of the ESCB-CESR Standards will be instrumental in creating a level playing field. 42 The Fiscal Compliance expert group (Fisco), chaired by the European Commission, advises the Commission on the removal of fiscal compliance barriers to the clearing and settlement of cross-border securities transactions within the EU. The Legal Certainty Group analyses issues of legal uncertainty relating to the integration of EU securities clearing and settlement systems, and advises the Commission accordingly. The Group is chaired by the Commission, is composed of around 30 legal experts drawn from academia and the public and private sectors, and its membership is personal, rather than representative. T2S is an acronym for the Eurosystem’s Target2-Securities project.

References BIS (Bank for International Settlements) (1992), ‘Delivery versus payment in securities settlement systems’, Report prepared by the Committee on Payment and Settlement Systems (CPSS) of the central banks of the Group of Ten countries, September. BIS (Bank for International Settlements) (2001), ‘Recommendations for securities settlement systems’, CPSS Publications No. 46, November. BIS (Bank for International Settlements) (2004), ‘Recommendations for central counterparties’, CPSS Publications No. 64, November. BIS (Bank for International Settlements) (2005), ‘Central bank oversight of payment and settlement systems’, CPSS Publications No. 68, May. Carretta, A. and G. Nicolini (2006), ‘L’integrazione dei mercati mobiliari europei e i collegamenti tra borse valori: cross-listing, cross-membership and cross-trading’, Bancaria No. 9. Ciampolini, M. and B. Rohde (2000), ‘Money market integration: a market perspective’, Paper prepared for the ECB Conference on ‘The operational framework of the Eurosystem and financial markets’, Frankfurt am Main, 5–6 May.

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Deutsche Börse Group (2005), ‘The European post-trade market, an introduction’, Deutsche Börse Group white paper. ECB (European Central Bank) (2001), ‘Consolidation in central counterparty clearing in the euro area’, ECB Monthly Bulletin, August. ECB (European Central Bank) (2002), ‘The role of the Eurosystem in payment and clearing systems’, ECB Monthly Bulletin, April. ECB (European Central Bank) (2003), ‘The integration of Europe’s financial markets’, ECB Monthly Bulletin, October. ECB (European Central Bank) (2005), ‘The ESCB-CESR Standards for securities clearing and settlement in the European Union’, ECB Monthly Bulletin, April. ECB (European Central Bank) (2006a), ‘The Eurosystem is evaluating opportunities to provide settlement services for securities’, Press release. Available at www.ecb.int/press/pr/date/2006/hmt1. ECB (European Central Bank) (2006b), ‘Indicators of financial integration in the euro area,’ September, available at www.ecb.int. ECB (European Central Bank) (2006c), Target2-Securities Brochure, available at www.ecb.int. European Commission (2004), ‘Communication from the Commission to the Council and the European Parliament – clearing and settlement in the European Union – the way forward’, COM/2004/0312 final. Available at http://europa.eu.int/rapid/pressreleases. European Commission (2006), Draft working document on post-trading. Available at http://ec.europa.eu/internal_ market/financialmarkets/docs/clearing/draft/draft_en.pdf, May. Fleming, M. J. and K. D. Garbade (2005), ‘Explaining settlement fails’, Current Issues in Economics and Finance, 11(9), Federal Reserve Bank of New York, New York. Giovannini, A., J. Berrigan and D. Russo (2007), ‘Post-trading services in the European securities markets’, in Freixas, X., P. Hartmann and C. Mayer (eds) Financial Markets and Institutions: A European Perspective, Oxford University Press, Oxford. Giovannini Group (2003), ‘Second report on EU clearing and settlement arrangements’, Discussion paper, European Commission, Brussels. Group of Ten (2001), ‘Report on consolidation in the financial sector’, Group of Ten, January. Available at www.bis.org, www.ifm.org and www.oecd.org. Holthausen, C. and J. Tapking (2004), ‘Raising rival’s costs in the securities settlement industry’, ECB Working Paper Series, July, Frankfurt am Main. Kazarian, E. (2006), ‘Integration of the securities market infrastructure in the European Union: policy and regulatory issues’, IMF Working Paper No. 241, Washington DC. Kauko, K. (2003), ‘Interlinking securities settlement systems: a strategic commitment?’, Bank of Finland Discussion Papers No. 26, Helsineki. Rietveld, M. (2006), ‘Giovannini: a SPEED report’, SPEED, 1(1), London, 31–5. Russo, D., T. L. Hart and A. Schönenberger (2002), ‘The evolution of clearing and central counterparty services for exchange-traded derivatives in the United States and Europe: a comparison,’ ECB Occasional Paper Series No. 5, September, Frankfurt am Main. Russo, D., T. L. Hart, M. C. Malaguti and C. Papathanassiou (2004), ‘Governance of securities clearing and settlement systems,’ ECB Occasional Paper Series No. 21, October, Frankfurt am Main. Russo, D., S. Rosati, C. Papathanassiou and G. Caviglia (forthcoming a), ‘Prudential and oversight requirements for securities settlement: a comparison of ESCB-CESR standards with other regulatory regimes’, ECB Occasional Paper Series, Frankfurt am Main. Russo, D., S. Rosati, D. Chan and F. Fontan (forthcoming b), ‘The custody industry’, ECB Occasional Paper Series, Frankfurt am Main. Scheller, H. K. (2004), ‘The European Central Bank, history, role and functions’. Available at www.ecb.int. Schmiedel, H. and A. Schönenberger (2005), ‘Integration of securities market infrastructures in the euro area’, ECB Occasional Paper Series No. 33, July, Frankfurt am Main. Schulze, N. and D. Baur (2006), ‘Economic impact study of clearing and settlement’, Annex II to the Draft working document on post-trading, European Commission, Brussels. Senden, L. A. J. (2005), ‘Soft law, self-regulation and co-regulation in European Law: where do they meet?’, Electronic Journal of Comparative Law, 9(1), www.ejcl.org.

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Chapter 7

US securities regulation in a world of global exchanges1 Reena Aggarwal Georgetown University Allen Ferrell Harvard Law School Jonathan Katz formerly of US Securities and Exchange Commission

Introduction There has been a dramatic change in the organisational structure of exchanges as they have converted into ‘for-profit’ entities, and this has often been accompanied by a public listing of shares on the exchange itself and cross-border exchange mergers. These changes have been driven by technological and competitive forces. In 1993, the Stockholm Stock Exchange became the first exchange to demutualise. It was followed by a wave of other exchanges, including the Helsinki Stock Exchange in 1995, the National Stock Exchange of India (created as a demutualised exchange in 1995), the Copenhagen Exchange in 1996, the Amsterdam Exchange in 1997, the Australian Exchange in 1998, the Toronto, Hong Kong and London Stock Exchanges in 2000, Nasdaq in 2000, the Bombay Stock Exchange in 2005 and the New York Stock Exchange (NYSE) in 2006. The stock exchanges of Brazil, Sri Lanka, Pakistan, the Philippines and South Africa have announced plans to demutualise and list their shares. At the same time, the largest derivatives exchanges, such as the Chicago Mercantile Exchange, the London International Financial Futures and Options Exchange (Liffe), the Chicago Board of Trade and Eurex are either already publicly listed or are part of publicly listed parent companies – and others, including the New York Mercantile Exchange, have demutualised (in 2006) and gone public. The clear trend towards exchange demutualisation and listing can be seen in Exhibit 7.1, based on the World Federation of Exchanges’ 2001–06 annual surveys of its membership, charting the number of demutualised and listed exchanges. The National Association of Dealers (NASD) restructured Nasdaq in 2000 by conducting a private placement and issuing warrants. On 1 July 2002 shares of Nasdaq started trading on the over-the-counter Bulletin Board and eventually migrated to the Nasdaq Stock Market in February 2005 after issuing shares in a secondary offering. Nasdaq acquired the BRUT ECN in 2004 and in 2005 acquired the INET ECN (owned by Instinet) for US$935m. Nasdaq expects

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savings of US$100m per year from synergies in technology, clearing, corporate overheads and market data products. Both Nasdaq and the NYSE plan to enter the options business and increase the scope of the products that trade on their markets. Regional exchanges, such as the Boston Stock Exchange and the Philadelphia Stock Exchange, are also transforming themselves by launching new trading platforms and forming joint ventures/strategic alliances with large firms, such as Citigroup, Credit Suisse, Fidelity, Citigroup, Morgan Stanley and UBS. This trend is likely to continue in the future. The new organisational structure of exchanges has raised several regulatory issues. Exchanges have traditionally been self-regulatory organisations (SROs) that have regulatory responsibilities for their members. Such SROs set listing standards for companies that list and trade on the exchange, set the trading rules and conduct surveillance of market operations, and periodically inspect member firm operations. Typically all of these functions are subject to the oversight of the securities commission of the country. In some countries exchanges also have the authority to license and discipline member firms and their employees. This tension between the exchange’s role as an SRO and a for-profit making entity has been a cause for concern among regulators and market participants. As discussed by Fleckner (2006), a demutualised exchange wears two different hats, that of the player and referee. He argues that the concern is not that exchanges will systematically under- or over-regulate because in the long run exchanges are concerned about their integrity and reputation. Instead, as discussed in several papers, the concern is that for-profit publicly traded exchanges will be lenient in regulating themselves and use their regulatory powers to gain an unfair advantage over competitors.2 The incentives of the owners of demutualised exchanges are discussed by Ferrell (2006). He argues that there are two potential sources of distortion in the owners’ incentives. The first is related to the market power of existing exchanges that have already captured a significant

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portion of trading volume in a particular security. Competitors will sometimes need quotation data from the incumbent exchange in order to generate prices on their own venue and thereby compete. The second potential source of distortion arises from possible externalities related to order exposure and to price discovery.3 The use of market power and regulatory authority for competitive advantage is not a new phenomenon. Historically, it was not uncommon for not-for-profit exchanges to adopt rules designed to prevent competition from other exchanges.4 Even recent regulatory initiatives, such as Reg. NMS, that are designed to promote inter-market competition have tended to focus only on price improvement. Established exchanges have asserted a form of commercial proprietary ownership in order flows submitted to them. Thus, it should retain order flow even in the face of a superior bid/offer on another trading platform, if it matched the best available price on a competing market. Under Reg. NMS, if an exchange matches the best bid or offer price, it has no obligation to transfer the trade to the exchange that had the best price first (‘price time priority’). At the same time that exchanges have themselves become public companies, there have also been major changes in the disclosure and governance requirements of public companies, which may be influencing a company’s decision on where and whether to go public. Many of these changes in the US have been prompted by the Sarbanes-Oxley legislation, new exchange regulations and changes mandated by the US Securities and Exchange Commission (SEC). The new requirements have impacted the capital raising process globally and the choice of listing venue. These developments have in turn intensified competition among exchanges, and may lead to a wave of cross-border consolidations by exchanges and other trading platforms. The likely emergence of ‘global’ exchanges that are the product of these cross-border mergers raises the pressing question of how these global exchanges are going to be regulated. This issue has been brought powerfully to the fore as a result of the pending NYSE-Euronext merger. Will one country’s regulator regulate these global exchanges? Will each subsidiary market be regulated separately by a nominal home nation regulator applying different standards? Will national regulators develop coordinated regulatory systems based upon shared mutual principles of regulation and mutual deference to coequal regulators? What is the regulatory regime of companies, often multinational enterprises, that list on these global exchanges? How is the resolution of these regulatory issues impacting the organisational structure of cross-border exchanges? Based on the changing nature of financial exchanges, the US SEC has proposed new corporate governance, transparency, oversight and ownership rules for SROs5 and issued a concept release examining the efficacy of SROs.6 The concept release states: the advent of for-profit, shareholder-owned SROs has introduced potential new conflicts of interest and issues of regulatory incentives. In addition, recent failings or perceived failings with respect to SROs fulfilling their self-regulatory obligations have sparked public debate as to the efficacy of the SRO system in general. This chapter is organised as follows. In the next section, we describe the competitive environment facing exchanges. This is followed by a discussion of the governance of exchanges, and an analysis of the regulation of global exchanges, with special reference to the pending NYSE-

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Euronext merger. Finally, we provide our conclusions and some suggestions for resolving the regulatory impediments to the emergence of truly global exchanges.

The competitive environment Beginning in the 1980s, traditional stock exchanges have faced increasing national and global competition for both order flow and listings from a number of directions. This competition has come from established stock exchanges that were revitalised by the transition from trading floorbased exchanges to electronic systems, the creation of alternative trading platforms possessing unique trading features that carved out market niches or offered faster execution or lower transaction costs, and the numerous stock exchanges that were created around the world following the demise of the communist economic system in the late 1980s and early 1990s. This increase in competing markets was made possible primarily by the dramatic decrease in the fixed costs associated with establishing a securities market. Advances in computing capacity and telecommunications efficiency made ‘virtual trading floors’ a reality. An exchange today is often a network of servers with telecommunication linkages to broker-dealers, investment banks and other market participants. In the US, these electronic markets are called electronic communication networks (ECNs) or alternative trading systems (ATSs). Also promoting competition and reducing costs were significant regulatory initiatives that reduced or eliminated the self-regulatory obligation of new competitors (Reg. ATS for ECNs in the US) or permitted greater regulatory flexibility in accepting listings (such as the Alternative Investment Market (AIM) in London and the original Nasdaq Bulletin Board experiment in the US). New regulations, such as Reg. 144A and Reg. S in the US, enabled institutional investors to invest globally and in unlisted securities and made it easier for US companies to offer securities globally. The adoption of the EU’s Markets in Financial Instruments Directive (MiFID) has caused a consortium of seven large investment banks – Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS – to announce that they will form a new company that will develop a pan-European equity trading platform that will compete with the European exchanges. A spokesperson for the consortium explained: ‘We are responding to the MiFID legislation by creating an integrated pan-European trading platform where equities can be traded more cost effectively, obtaining significant liquidity with greater efficiency for each and every participant in the equity markets.’ Under Reg. ATS, ATSs had the option to register as an exchange or as a broker-dealer.7 Registration as a broker-dealer eliminated the statutory obligation to become an SRO, with the attendant cost burden. In the new environment, ATSs formed alliances with exchanges in order to combine the regulatory status of the exchange with the trading platforms of ECNs. The ECN benefited as it did not have to build regulatory costs into its business model and the exchange benefited from the transaction and market data fee revenues generated by the ATSs. ECNs started executing and reporting trades through particular exchanges and sharing in data revenues. The interest of the traditional exchanges in the US in establishing such alliances or outright mergers with ECNs has only increased as a result of Reg. NMS, which confers a regulatory benefit on exchanges that have automated access to their quotations. Paradoxically, some ECNs claim that Reg. NMS, and the SEC’s previous order-handling rules, have adversely affected their business model by requiring them to provide non-members with access to their quotes.

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Another deregulatory initiative that encouraged global competition was the relaxation in the US of disclosure and listing obligations on foreign companies interested in listing. As of the end of 2005, 453 foreign private issuers from 47 countries were listed on the NYSE, representing more than 37 per cent of total NYSE market value.8 Following the enactment of the SarbanesOxley Act, however, this trend abruptly shifted. While there has not been a wave of delistings, there has been a drop in new listings. Instead, markets in Europe and Asia have become popular alternatives for new listings. Due to this enhanced ability by companies to issue securities globally and the freedom of investors to invest globally, competition is no longer confined to a country’s boundaries. Differences in a country’s regulatory regime are therefore part of the competitive landscape. Exchanges in different countries operate under the regulatory regime of their own country and these regulations can differ considerably. For example, firms listed on US stock exchanges must comply with the exchange’s listing requirements and with US SEC disclosure regulations, as well as the internal control requirements of Sarbanes-Oxley. There is some evidence to suggest that this has deterred some foreign firms from listing in the US and has hampered intitial public offerings (IPO) activities in the US.9 By going public and listing on a foreign market the stocks in these firms can trade in foreign markets and even on ECNs, while still gaining access to US institutional investors via Reg. 144A private offerings. The ability of institutions to invest globally has diminished the traditional liquidity advantages of the US markets. The freedom of institutional capital to trade on competing markets, the rise of sophisticated ECNs, the elimination of SRO trading rules that prohibited member trading on other platforms, and the adoption of regulations that require firms to trade for clients at the best price, regardless of the market, have reduced the ability of a single stock exchange to dominate trading in its own listings. Even if a stock is listed on an exchange, considerable trading activity can occur on other trading venues. For example, the NYSE trades less than 80 per cent of the volume in its listed stocks while the American Stock Exchange (Amex) handles 21 per cent of the volume for Amexlisted stocks. More than 50 per cent of Nasdaq volume is accounted for by automated order-driven systems such as SuperMontage and the ECNs rather than the traditional market-makers. In this highly competitive environment, stock exchanges have responded by developing multiple trading platforms or acquiring trading facilities that are operated by entities other than the SRO charged with regulating the market. For example, the Pacific Stock Exchange formed PCX Equities, which became the first for-profit stock exchange in the US in May 2000. It then entered into an agreement with the ECN Archipelago to provide the Arca-Ex trading platform to trade its equities. Similarly, the day-to-day operations of the Boston Options Exchange (BOX) are managed by the Boston Options Exchange Group LLC. This group is itself owned by the Boston Stock Exchange, Inc., the Montreal Exchange, Inc. and a group of broker-dealers including Interactive Brokers, Credit Suisse, UBS, Citigroup, JP Morgan Chase and Morgan Stanley.10 The regulatory and SRO tasks are managed by the Boston Stock Exchange via a wholly-owned subsidiary, BOX-R LLC, which is responsible for the surveillance operations and other regulatory responsibilities. The new competitive environment has led to innovation and reduced costs. However, there are concerns that this has placed undue strains on the regulatory structure. These issues have included the concern that trading might move to markets with lower regulatory requirements, that there might be inconsistent rules across markets and that exchanges may reduce the rigour

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of their regulatory oversight in order to gain market share. There is also the concern that exchanges may be ‘too soft in regulating themselves and too severe in regulating competitors’.11 For example, the SEC in its concept release, and in an earlier concept release, discussed the possibility of regulatory arbitrage, whereby, for example, an exchange might reduce its market surveillance function to attract trading volume, or lower listing requirements to attract companies. While these concerns were theoretical, there has in fact been an instance where an SRO failed to pursue a member firm’s misconduct and the SEC order imposing sanctions indicated that this may have been possibly because the firm was a critical component of the SRO’s business model to generate market data revenue vital to the SRO.12 Some of the competitive pressures have led exchanges to demutualise and this exchange structure has led to further competition. The recently announced merger of the NYSE and Euronext and Nasdaq’s acquisition of a large stake in the London Stock Exchange (LSE) could mark the start of a new wave of consolidation involving mergers, acquisitions and alliances across national borders, resulting in the rise of global exchanges. The global movement of traditional stock exchanges to for-profit businesses has exacerbated these pressures. A for-profit stock exchange, burdened with expensive regulatory duties, and competing with trading platforms that have lower regulatory burdens or no regulatory duties must grow its business to be successful. As with any business, profit growth may come from increased revenues or reduced costs. For a stock exchange, revenue growth must come from increased trading volume, by adding new listings or by acquiring other exchanges or trading platforms.13 Cost reduction may come from a reduction in regulatory burdens or through economies of scale, such as the consolidation of separate market surveillance units and operating acquired trading platforms on existing surplus IT capacity. This emerging business dynamic may be driving a variety of fundamental changes in global regulation.

Governance of exchanges Self-regulatory function Regulation of capital markets around the world often relies on the principle of self-regulation. The concept of self-regulation reflects the historical reality that stock exchanges in the US, England and other nations operated successfully before there was any direct governmental oversight. They were organised as membership organisations that established membership requirements, minimum standards for companies to list on the exchange, capital adequacy standards and minimum commission rates for member firms, trading rules and disciplinary procedures in the case of violations by members. In the US these principles were codified by Federal law. The Securities Exchange Act of 1934, which created the SEC, required all stock exchanges in the US to register with the SEC. SEC approval of the registration required a determination that the exchange is organised and has the capacity to carry out the purposes of the Act and to comply and enforce compliance by its members with the Act.14 The dual regulation by governmental body and industry organisation has continued within the US and the principle has been exported to other countries, in greater or lesser degree. Hence, even though a securities commission normally has the ultimate responsibility for regulating exchanges and their participants, exchanges can play an important role in regulating the markets.

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Exchanges are considered closer to the marketplace and serve as SROs. SROs are on the front line and are able to benefit from the expertise of industry professionals. As a private organisation, an SRO is able to directly raise funds from the industry, and is not subject to governmental restrictions on the number of employees it may hire or on the salaries it can pay. Also, an SRO is not subject to election year changes in policy, revolving-door leadership and staff turnover. This results in a greater degree of regulatory stability and the benefits resulting from retention of experienced and talented staff. This model of regulation reduces the resources required for direct regulation by a securities commission. While the history of self-regulation in the US is long, it is not without controversy and scandal. The fundamental conflict created by an organisation of competitors policing itself is not just a recent by-product of the transition to for-profit exchanges. Almost immediately after its creation, the SEC was confronted with a scandal at the NYSE, which raised questions as to the efficacy of industry self-regulation. In 1937, Richard Whitney, the President of the NYSE, was found to have misappropriated large sums from the NYSE ‘widows and orphans’ fund to save his own brokerage firm. In a pattern that would be repeated several times, this scandal provided the SEC with the leverage needed to require the NYSE to reorganise itself and strengthen the independence of its Board of Directors. Similarly, scandals at Amex in the late 1950s, at the NASD in the mid-1990s and, most recently, at the NYSE provided the impetus for the SEC to prod the industry dramatically to reorganise exchange governance as a solution to collusive industry activities that undermined the integrity of the exchange. Policy-makers have long looked to a strong corporate governance structure to balance the inherent conflicts within an SRO. In the US, Congress specified in the 1934 Act that a registered exchange ‘assure a fair representation of its members in the selection of its directors and . . . provide that one or more directors shall be representative of issuers and investors and not be associated with a member of the exchange, broker or dealer’.15 The recent attention to SRO governance as a response to changes in exchange structure, market competition, weaknesses in SRO regulatory programmes and the most recent cycle of scandals continues this tradition. In 2003, William Donaldson, the Chairman of the SEC (and formerly a President of the NYSE), noted that the SROs ‘play a critical role in our securities markets as standard setters for listed companies, operators of trading markets and front-line regulators of securities markets’, and asked the SROs to review their own governance practices.16 This review made sense, particularly in a period when the exchanges were requiring enhanced governance standards of firms listed on them.

For-profit structure With this history, it is understandable that, when the migration to for-profit exchanges accelerated, regulators looked to reform of governance as a solution to the inherent conflict between a business objective of maximising exchange profits and a legal duty to perform expensive regulatory oversight functions. The SRO role of exchanges has created concerns due to the fact that exchanges have demutualised and become publicly traded companies. Demutualisation has resulted in the separation of the right to trade on an exchange from the ownership rights of an exchange. Historically exchanges were organised as mutual, non-profit organisations owned by members,

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but the new structure means a new constituency, in the form of shareholders, that will naturally be interested in promoting business interests. For a long time the NYSE argued that a wellregulated market is a hallmark of the franchise and therefore demutualisation does not create any conflicts, but rather aligns the SRO regulatory obligations with the exchange’s commercial interests. At the same time, Nasdaq has for several years publicly identified the competitive disparity between an SRO, burdened with regulatory expenses, and an ECN, operating free of SRO obligations.17 Due to regulators and market participants being concerned with the actual or perceived conflicts of interest and the possibility that SROs might put their commercial interests ahead of their regulatory responsibilities, they have insisted upon structural and governance changes as a condition to becoming a for-profit exchange.18 In the US, the two primary exchanges, the NYSE and Nasdaq, have both adopted structures in which the self-regulatory functions are in separate subsidiaries, with separate boards. The performance of regulatory functions is governed by a contractual agreement between the for-profit exchange and the regulatory unit. Limits on member ownership have been adopted and procedures for dealing with exchange ‘self-listings’ have been put into place. At the NYSE, the Board is now comprised exclusively of independent directors. A separate advisory board of industry representatives has been created to periodically meet with the Board to ensure sufficient industry input into exchange policy. But this advisory board has no voting authority and the actual Board is required to meet periodically without participation from the advisory board. While the NASD structure does not require an exclusively independent board, it is required that the number of non-industry directors equals or exceeds the combined number of member-representative directors and industry directors.19 This conflict is evident in the demutualisation process of several exchanges globally. For example, on 1 November 2001 the Tokyo Stock Exchange demutualised and changed its name to the Tokyo Stock Exchange, Inc. However, its planned listing has been postponed due to delays that are partially due to disagreements between the exchange and the Financial Services Agency (FSA) over the exchange’s management structure as a listed entity. The regulator had demanded that the exchange separate its regulatory division from the stock trading-related division. When the SEC issued a concept release in 2004 to discuss possible new approaches to selfregulation, two of the four identified objectives pertained to SRO governance and the protection of funding for regulatory functions: • the inherent conflicts of interest between SRO regulatory operations and members, market operations, issuers and shareholders; . . . • the funding SROs have available for regulatory operations and the manner in which SROs allocate revenue to regulatory operations.20

Separation of market operations and regulatory functions In order to address the conflicts of interest issues associated with the organisational structure of exchanges, US exchanges will be required, in the SEC’s proposed governance rules, to separate market operations and commercial interests from regulatory functions.21 This separation can either take place at the functional level or the organisational level. Self-regulation is based on

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the premise that regulation works best when it is close to market activity. However, it has also been felt that regulatory activities need to be isolated from market activities. The merger between the NYSE and Archipelago Holdings, Inc. resulted in the NYSE Group, Inc., a publicly traded holding company. This company is the owner of the New York Stock Exchange LLC, a company that succeeds the NYSE. To avoid conflicts of interest, the NYSE Group has created a not-for-profit corporation, NYSE Regulation, Inc., with the New York Stock Exchange LLC as the sole equity member of NYSE Regulation. This new corporation performs all the SRO regulatory responsibilities currently conducted by the NYSE, as well as the regulatory responsibilities of NYSE/Arca which is also an SRO, and will be funded from two sources. First, NYSE Regulation has contractual relationships with the two SROs, the NYSE and the Archipelago marketplaces, in which NYSE Regulation agrees to regulate these markets, and thereby fulfil their SRO responsibilities in exchange for various fees. In addition, NYSE Regulation is the recipient of regulatory fees imposed on the membership of the NYSE and Archipelago markets. The NYSE believes: This organisational structure preserves and extends the separation yet pervasive communication between business and regulatory activities achieved under the NYSE’s previous governance architecture that was comprehensively reformed in 2003. It also seeks to insulate NYSE Regulation from the additional crosscurrents created by public ownership.22 The CEO of NYSE Regulation has primary responsibility for the regulatory oversight of NYSE Group and its exchange subsidiaries, and reports to the NYSE Regulation Board of Directors. NYSE Regulation includes divisions such as Market Surveillance, Member Firm Regulation, Enforcement and Listed Company Compliance among others. The Board consists of five directors with no affiliation to the NYSE Group Board nor any listed company or member organisation; three directors who are also NYSE Group directors; and one management director who serves as the CEO of NYSE Regulation. NYSE Group’s CEO does not have a seat on the NYSE Regulation Board.

Board and committee structure Listed exchanges have higher governance standards than those applicable to listed companies on the exchange. This reflects the unusual combination of conflicting objectives of an exchange compared to an ordinary company. While an ordinary company has a legal responsibility only to its shareholders to make a profit, an exchange has a regulatory function, an obligation to member firms and to listed companies, as well as a duty to maximise profits and shareholder value. These responsibilities are compounded by the higher standards for public companies’ boards adopted following the enactment of Sarbanes-Oxley. Under the new regulations adopted in 2003, all listed companies must have a board that is composed of majority independent directors. This is applicable to exchanges also. In addition, key board committees, including the nominating, audit and regulatory oversight committees, must be composed solely of independent directors. Other exchanges around the world have also adopted, often in response to exchange demutualisation, governance requirements focused on board and committee structure. For

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instance, the Toronto Stock Exchange must have on its Board of fifteen, seven independent directors. The Hong Kong Exchange Board must have a majority of directors that are ‘public interest’ directors.

Limitations on ownership and voting Exchanges are also required to limit ownership and voting by broker-dealers. Historically exchanges were member-owned organisations but demutualisation has raised the concern that a member’s self-interest could compromise the self-regulatory function if a member controls a significant stake in its regulator. For example, an exchange might not diligently monitor a member’s trading if the member is a controlling shareholder. The SEC has proposed that no one broker-dealer may own more than 20 per cent of an exchange in which it is a member. Many exchanges around the world have ownership limits, often capping ownership by a single entity at 5 per cent. For instance, the Singapore and Philippine Stock Exchanges cap ownership by a single entity, absent a regulatory waiver, at 5 per cent.

Listing of affiliated securities Listing of securities issued by an exchange or its affiliate on its own market creates new potential conflicts of interest. Conflicts regarding ‘self-listings’ raise concerns as to an exchange’s ‘ability to independently and effectively enforce its own or the Commission’s rules against itself or an affiliated entity, and thus comply with its statutory obligations’. If the security of the exchange or its affiliate is not in full compliance with the rules of the exchange there might be the possibility that such issues would be ignored. Securities of competitors might be listed, and therefore regulated, by the exchange, which might also cause conflicts of interest. In the US, under listing rules, the securities of exchanges and affiliates can trade; hence self-listings are allowed. However, the SEC has put additional safeguards in place in the form of proposed Regulation AL. The exchange’s Regulatory Oversight Committee must certify that the securities satisfy the SRO’s listing criteria before the securities can be listed. The exchange is also required to file a quarterly report with the SEC summarising monitoring of the affiliated security’s compliance with listing rules and surveillance of trading. This report must be approved by the Regulatory Oversight Committee. In addition, an annual report prepared by a third party will need to be filed.23 Many countries, concerned with potential conflicts of interest, require that self-listed exchanges be supervised by a governmental regulator rather than by the exchange itself. This is true, for example, of the Australian Stock Exchange, the Hong Kong Stock Exchange, the Singapore Exchange and the Stockholm Stock Exchange.

Regulation of global exchanges: the pending NYSE-Euronext merger Cross-country mergers between exchanges are following close on the heels of the organisational transformation of exchanges. Indeed, demutualisation coupled with a public listing is often undertaken with an eye towards future mergers, as a merger of a non-profit, membership-owned exchange with a for-profit, shareholder-owned exchange can be extraordinarily difficult if not

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impossible. These cross-border mergers have several potential benefits: cost savings; increased liquidity; reducing the transaction costs of purchasing foreign securities; and diversification of the exchange’s business into new product areas. The CEO of the NYSE has stated that the NYSE considers the proposed merger of the NYSE with Euronext to be a partial solution to the migration of new listings away from New York to other markets, in particular the LSE. The most dramatic example of a cross-border merger is the proposed merger of Euronext and the NYSE Group. Euronext itself is the result of a series of mergers of numerous European exchanges. The merger of the NYSE Group and Euronext will be consummated by combining their businesses into a new holding company structure. Under the terms of the merger agreement, as detailed in the NYSE-Euronext’s Form S-4 registration statement, Euronext NV and the NYSE Group will be distinct corporate entities both being owned by a US holding company named NYSE-Euronext. Euronext NV will not register as a US securities market and, therefore, will not be an SRO under the Exchange Act of 1934. Rather, Euronext NV itself will own subsidiaries consisting of the various Euronext markets: the Paris, Brussels, Amsterdam and Lisbon exchanges, and Euronext UK (the holding company for Liffe, which is a market for financial and commodity derivatives). In addition, Euronext NV will own 51 per cent of MTS, an electronic trading platform for European fixed-income securities. These various Euronext markets are currently regulated, and will continue to be so regulated, by the various European national governments in which these exchanges operate as well as pursuant to the European Union directives in the financial services area. The most important of these directives is MiFID, which eliminated national rules requiring concentration of trading on designated national exchanges and imposes new transparency and best execution requirements on market participants. The NYSE Group, on the other hand, will own the New York Stock Exchange Market and NYSE/Arca, which runs the Archipelago market, as subsidiaries. Both the New York Stock Exchange Market and NYSE/Arca will continue to be exchanges registered with the SEC. Their regulatory responsibilities as a result of being registered exchanges and SROs will continue to be performed by NYSE Regulation, a separate subsidiary with its own board of directors. The operations and funding of NYSE Regulation are expected to be unaffected by the proposed merger. The organisational structure of NYSE-Euronext is summarised in Exhibit 7.2, which is drawn from the NYSE-Euronext Form S-4 registration statement. There has been a great deal of concern throughout Europe that the Euronext markets, and the companies listed and traded on them, will potentially be subject to US securities law, in particular the requirements of the Sarbanes-Oxley Act, as a result of the merger. The stakes are high. If the Euronext markets had to register as an exchange with the SEC, this would create a whole host of new and extensive obligations for these markets. The Euronext markets, for one, would have to submit to the SEC their rules and rule changes for approval, ensure compliance by their members with the myriad provisions of the Exchange Act, and comply with SRO governance requirements. Registered US exchanges also have to comply with Reg. NMS, which includes the so-called trade-through rule. The trade-through rule prohibits trades that occur at prices inferior to quotations that are immediately accessible through automatic execution. Moreover, if the Euronext markets were registered exchanges then any firm listed on a Euronext market would have to register its securities with the SEC, as a result of section 12 of the Exchange Act, and thereafter comply with the reporting requirements of the Exchange Act.

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In addition, any firm listed on a registered exchange would have to comply with Sarbanes-Oxley, including the burdensome internal control provisions of section 404. Finally, the trade-through rule of Reg. NMS applies to securities listed on registered exchanges. Even if the Euronext markets did not have to register with the SEC as an exchange, a firm listed on Euronext could nonetheless be required, again pursuant to section 12 of the Exchange Act, to register its equity securities, and subject the company to periodic disclosure rules, with the SEC if there are more than 500 owners of record of the company’s equity securities worldwide, and if 300 of those investors being in the US, and if the company has more than US$10m in assets. A company with registered securities, in turn, is subject to various regulations pursuant to the Exchange Act of 1934, including Sarbanes-Oxley obligations. However, the application of US securities law to the Euronext markets or its listed companies is highly unlikely. The SEC has provided assurance that the NYSE-Euronext merger will not automatically result in US securities law being imposed on foreign markets and firms. The SEC staff issued a 16 June 2006 fact sheet explaining that a ‘non-US exchange would only become subject to US securities laws if that exchange is operating within the US, not merely because it is affiliated with a US exchange’. Moreover, the SEC staff went on to state that ‘joint ownership of a US exchange and a non-US exchange would not result in automatic application of US securities regulation to the listing or trading activities of the non-US exchange’. More specifically, companies listed and traded on the Euronext market can avoid having to register, and thereby largely escape US securities law, by relying on Rule 12g3–2(b) of the Exchange Act.24 Rule 12g3–2(b) provides an exemption from the registration requirements of

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the Exchange Act and, perhaps most importantly, from the provisions of Sarbanes-Oxley. NonUS companies that are (1) not listed on a registered exchange; (2) have not made a public offering in the US; and (3) have fewer than 300 US resident investors at the time of application for a Rule 12g3–2(b) exemption, can avoid having to register their securities and comply with SarbanesOxley if they merely provide the SEC copies of the reports that they are required to file in their home country. It is important to note that, even if a company has more than 300 US resident investors, the company can still enjoy a Rule 12g3–2(b) exemption from registration so long as at the time of the company’s application for an exemption, which might have occurred years earlier, the number of US resident investors did not exceed 300. The Rule 12g3–2(b) exemption for foreign companies is easy to obtain and maintain assuming these requirements are satisfied. As pointed out above, the availability of Rule 12g3–2(b) is conditional on a company’s security not being listed on a registered exchange. This fact has important implications for how a cross-border exchange, such as that between the NYSE and Euronext, can be structured. If Euronext and the NYSE had created a common trading platform that constituted the new merged exchange (with the Euronext, NYSE and Archipelago markets no longer having an independent existence with separate trading platforms), then it would make avoiding US registration and Sarbanes-Oxley requirements far more difficult, if not entirely impossible. This is due to the fact that a common trading platform would practically ensure that some non-trivial percentage of the trading would be deemed to occur in the US, thereby triggering the requirement to register the exchange with the SEC. If the surviving exchange had to register with the SEC, then the previously Euronext-listed firms would become firms listed on a registered exchange. Rule 12g32(b) would therefore no longer be available. The necessity of Euronext NV, or any of its subsidiaries, avoiding having to register as a US exchange has very important implications for the organisational structure of cross-border exchanges. NYSE-Euronext cannot create a common trading platform that would replace the NYSE, Archipelago and Euronext markets as this would render NYSE-Euronext itself an exchange that would have to register with the SEC. As a result, all the firms currently listed on a Euronext market would be companies listed on a registered exchange for US securities regulation purposes. Forcing cross-border exchanges to be effectuated by creating a holding company, which in turn owns subsidiaries that are the pre-existing exchanges, may well limit the ability of these mergers to fully realise cost savings and maximise liquidity. This is in sharp contrast to the mergers that resulted in Euronext. While companies can still list on the Paris, Amsterdam, Lisbon and Brussels markets, these markets do not have separate trading platforms. These four markets share a common trading platform. Besides the SEC’s public statements and Rule 12g3–2(b), there is a second line of defence against the application of US law to the Euronext market and its listed companies. In the NYSEEuronext merger agreement, there is a specific provision that would trigger a break-up of the merger in the event that there is a US law that imposes new regulatory burdens on a substantial proportion of non-US companies listed on one of the Euronext markets solely because ‘the securities of such non-issuers are listed on a Euronext market; and such Euronext market is owned . . . by NYSE Euronext’. Interestingly, this provision explicitly states that, if the non-US firm can avoid the regulatory burden in question by complying with Rule 12g3–2(b), then a break-up of the merger will not be triggered. While the Euronext market and its listed companies will be spared the requirement to register

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with the SEC, and all the obligations that registration creates, Euronext-listed firms will not entirely escape US law. Foreign issuers could be subject, for instance, to potential liability pursuant to the anti-fraud provisions of the Exchange Act even if they do not have registered securities, so long as they have US resident investors. But this exposure is neither due to, nor will be aggravated by, the fact that an exchange merger has occurred. There is another regulatory concern surrounding the NYSE-Euronext merger. An important motivation for the merger is the NYSE’s attempt to enter the lucrative derivatives business. It is sometimes claimed that there are economies of scope in operating an equity market in conjunction with a derivatives market, such as the ability to offer investors the option of purchasing a covered call (which involves going long the stock while writing a put option on it). Euronext NV will have as a subsidiary Euronext UK, which owns the Liffe market – a derivatives market. One possible concern is whether the Liffe market would continue to be regulated by the UK’s FSA or would the Commodity Futures Trading Commission (CFTC) attempt to assert jurisdiction at some point?25 The CFTC has permitted foreign derivatives markets to place trading terminals in the US through the issuance of no-action letters. Perhaps most notably, the CFTC has recently permitted the InterContinental Exchange to place trading terminals in the US despite being regulated by the FSA. However, whether the CFTC will continue its liberal policy of issuing noaction exemptions from US regulation, especially in the light of lobbying by domestic derivatives exchanges that wish to shut down this form of competition, is not entirely predictable.

Conclusions The rapid transition of securities exchanges from member-owned entities to publicly owned forprofit companies has highlighted and amplified many of the inherent, and long-standing, conflicts in having a private organisation perform arguably governmental regulatory functions. The solutions adopted to minimise conflict between a profitable business model and unprofitable regulatory responsibilities have resulted in governance structures that promote independence of board members, at the potential expense of the member firms and the investors in the stock exchange. This result creates interesting paradoxes. Historically, one of the rationales for selfregulation was the belief that industry involvement improves the quality and effectiveness of regulation, as members are ‘closer to the market’. However, the proposed structures emphasise policy-making by independent board members, no longer ‘closer to the market’, with industry participation limited, in the NYSE structure, to an advisory role. Similarly, the separation of regulatory functions from market operations, with separate boards setting policy, reduces the ability of the for-profit market entity to maximise shareholder value, as the regulatory entity will control the key decisions on the cost of regulatory operations. In effect this results in for-profit stock exchanges being out of step with the Sarbanes-Oxley goal of increased shareholder control by realigning board of director interests with shareholder interests. A second emerging trend, globalisation of stock exchanges beyond the authority of a single national regulator, creates a difficult regulatory problem. Should a regulator that has accepted the principle that a stock exchange may be a for-profit entity restrict potentially advantageous acquisitions in another country merely because it lacks the authority to directly regulate the

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acquired component? Or must the regulator look to alternative creative approaches to fulfilling its regulatory duties. It can be argued that regulatory policy rarely leads but more often follows market innovations. As such, the challenge for regulators will be to develop regulatory programmes that respond to globalised markets. There is in fact support for the argument that national regulators are moving in that direction through increased coordination among national regulators and convergence of regulatory programmes along mutually acceptable principles.26 Iosco, the international organisation of securities regulators, has vigorously promoted both greater cooperation and the development of commonly acceptable regulatory principles. The Iosco ‘multilateral memorandum of understanding’, providing for free exchange of information among regulators conducting investigations, is one example of the trend towards mutual coordination of market oversight functions. The development of International Financial Reporting Standards (IFRS) in Europe and the expectation that, if it becomes widely adopted and consistently interpreted in multiple countries, it will become a de facto global standard suggests that there is movement towards global regulatory standards, enforced nationally. Another example is the deference accorded by the US SEC to home-country disclosure standards for foreign companies, when conflicts exist with US disclosure. The NYSE-Euronext transaction has clearly been structured to avoid provoking a premature and restrictive regulatory response to globalised markets. However, it is reasonable to assume that the current NYSE-Euronext structure is not final and is likely to evolve. A for-profit company must strive to control costs as well as grow revenue. Consolidation of both markets onto common IT platforms is one obvious way to reduce costs and it may well be the first step to full consolidation.27 If it passes regulatory muster, one can envision a proposal to merge market surveillance functions of the NYSE and Euronext, as it would both reduce costs and presumably improve the effectiveness of market surveillance. If acceptable, it seems reasonable that a plan to fully merge both markets could be developed, with a mutual agreement by the relevant home country governmental regulators to jointly perform regulatory functions. Admittedly, this is pure speculation. But the events of the 1990s and this century have demonstrated the speed of market innovation and one must assume that, in a for-profit environment, the imperative to innovate will only accelerate.

1 This paper was completed while Reena Aggarwal was a visiting professor at MIT’s Sloan School of Management. Allen Ferrell is grateful to the John M. Olin Center in Law, Economics and Business at Harvard Law School for financial support. Reena Aggarwal gratefully acknowledges research support from the Stallkamp Fellowship and the Capital Markets Research Center at Georgetown University. 2 See Aggarwal, R. (2002), ‘Demutualization and corporate governance of stock exchanges’, Journal of Applied Corporate Finance, 15(1): 105–13; Aggarwal, R. and S. Dahiya (2006), ‘Demutualization and public offerings of financial exchanges’, Journal of Applied Corporate Finance, 18(3): 96–106; Bradley, C. (2001), ‘Demutualization of financial exchanges: business as usual?’, North Western Journal of International Law & Business, 21(23); Fleckner, A. M. (2006), ‘Stock exchanges at the crossroads’, Fordham Law Review, 74: 2541–620; Karmel, R. S. (2003), ‘Demutualization of exchanges as a strategy for capital market regulatory reform, in Focus on capital: new approaches to developing Latin American capital markets, (eds Kenroy Dowers and Pietro Masci), Inter-America Development Bank, Washington, DC; Karmel, R. S. (2002), ‘Turning seats into shares: causes and implications of demutualization of stock and futures exchanges’, Hastings Law Journal, 53; Lee, R. (2003), ‘Changing market structures, demutualization and the future of securities trading’, Brookings-Wharton Papers on Financial Services

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3 4

5 6 7 8 9

10 11 12

No. 283 (eds Robert E. Litan and Richard Herring); Lee, R. (2003), ‘The future of securities exchanges’, BrookingsWharton Papers on Financial Services No. 283 (eds Robert E. Litan and Richard Herring); Licht, A. N. (2001) ‘Stock exchange mobility, unilateral recognition and the privatization of securities regulation’, Virginia Journal of International Law, 41; Macey, J. R. and M. O’Hara (2005), ‘From markets to venues: securities regulation in an evolving world’, Stanford Law Review, 58. For details, see Ferrell, A. (2006) ‘Demutualization and exchange owners’ incentives’, Working Paper, Harvard Law School. At one time NYSE rule 390 required member firms to execute transactions in an NYSE listed company only through the NYSE or another exchange. Another former NYSE rule required a supermajority vote of all shareholders before a company could delist from the NYSE, preventing NYSE listed companies from delisting and listing on another exchange. SEC, Release No. 34-50699, File No. S7-39-04. SEC, Release No. 34-50700, File No. S7-40-04, Concept Release Concerning Self-regulation. See US SEC Regulation ATS, 17 CFR 242.300, et seq. Comment letter dated 10 March 2006 of Mary Yeager, Assistant Secretary, NYSE, to Nancy Morris, Secretary, SEC. Available at www.sec.gov/rules/proposed/s71205/myeager031006.pdf. Charles Niemeier, a member of the Public Accounting Oversight Board (PCAOB), offers a slightly different interpretation of this trend. He suggests that the statistics do not support an exodus from the US markets and that a key competitive advantage in foreign listing arises from the substantially lower underwriting fees charged outside the US; see www.pcaob.org/News_and_Events/Events/2006/Speech/09-30_Niemeier.aspx. See www.bostonoptions.com/ove/ope.php. Fleckner (2006), ‘Stock exchanges at the crossroads’, op cit. See www.sec.gov/litigation/investreport/34-51163.htm: It is also possible that the business interests of the Nasdaq InterMarket, which had the goal of increasing its market share of Tape B trades, may have contributed to a failure by InterMarket personnel to appreciate the implications of the trading pattern they observed.

13 The SEC Concept Release Concerning Self-regulation identified several revenue sources for trading systems: regulatory fees, transaction fees, listing fees, market data fees and various minor miscellaneous fees. 14 Securities Exchange Act, 17 USC 78(f). 15 Ibid., 17 USC 78(f)(b)(3). 16 SEC, Release No. 34-50699, File No. S7-39-04. 17 In 2002, Nasdaq highlighted this problem: Moreover, Nasdaq continues to pay virtually all costs involved in regulating trading in Nasdaq securities, even though a significant portion of that trading does not take place on Nasdaq. Nasdaq cannot long sustain a business model where it subsidizes the regulatory costs of its competitors. Available at www.sec.gov/news/extra/mktstr-invites/nasdaq102902.htm. 18 These issues have been discussed in several papers, including: Aggarwal, R. (2002), ‘Demutualization and corporate governance of stock exchanges’, op. cit.; Fleckner, A. M. (2006), ‘Stock exchanges at the crossroads,’ op. cit.; Karmel, R. S. (2002), ‘Turning seats into shares’, op. cit.; Licht, A. N. (2001), ‘Stock exchange mobility, unilateral recognition and the privatization of securities regulation’, op. cit.; Steil, B. (2002), ‘Changes in the ownership and governance of securities exchanges: causes and consequences’, Brookings-Wharton Papers on Financial Services. 19 SEC Release No. 34-53128, 13 January 2006: Order Approving Application of The Nasdaq Stock Market LLC for Registration as a National Securities Exchange. 20 See www.sec.gov/rules/concept/34-50700.htm#III. 21 Nasdaq continues to perform some market surveillance functions within the exchange subsidiary. 22 See www.nyse.com/about/nyseviewpoint/1097788616359.html. 23 For details, see www.sec.gov/rules/proposed/34-50699.htm. 24 The SEC proposed significant amendments to this rule in 2006 and announced that it would consider adoption of the proposal at a public meeting on 13 December 2006. 25 See Karmel, R. (2006), ‘The once and future New York Stock Exchange’, Working Paper, Brooklyn Law School.

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26 SEC Chairman Christopher Cox spoke on this subject and stated: The way for each of us, as national regulators, to maintain robust investor protections while building healthy international markets is first, to adopt strong regulatory regimes at home that are cost-justified; and second, to cooperate with our fellow securities regulators abroad to implement agreed-upon regulatory objectives on a global level. Available at www.sec.gov/news/speech/2006/spch111606cc.htm. 27 In a speech on 20 June 2006, SEC Commissioner Annette Nazareth, a former Director of Market Regulation at the SEC, suggested that this next step would be likely. Available at www.sec.gov/news/speech/2006/spch062006aln.htm.

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Chapter 8

MiFID and its effect on exchanges Simon Bennett Capco

Introduction: genesis and background History, ISD The Markets in Financial Instruments Directive (MiFID) is the latest in a series of legislative changes that have been introduced by the European Union and a continuation in a process that has been going on for a decade or more. EU member states are committed to creating a more effective and integrated financial services market that will deliver ‘the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion’.1 Few could argue that the fundamental objectives of a single market will be of benefit to both investors and financial services firms within Europe. These objectives can be summarised as: • To allow European retail customers to have access to a wider range of cost-effective services and financial products. • To give firms the opportunity to access markets in other member states within a common framework and to carry out cross-border business effectively and on a level competitive playing field. • To reduce the costs of doing cross-border financial services business within Europe. • To improve the accessibility of capital and enhance its allocation across the whole of the EU. MiFID is designed as a continuation of the groundwork laid out in the original Investment Services Directive (ISD), which was put in place by the EU more than a decade ago on 1 January 1996. As such MiFID can be considered as ‘ISD2’. The key facet of the original ISD was to create the concept of a Europe-wide regulatory ‘passport’ whereby a financial services firm approved and licensed in one member state could undertake deals cross-border with pan-European clients without having to obtain national regulatory licences.

FSAP 43 directives, objectives The ambition of the European Commission to create an integrated market has been embodied in the Financial Services Action Plan (FSAP), which was endorsed by the European Council in

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Lisbon in March 2000. The FSAP sets the overall direction and is effectively a framework for a host of other legislation. Some of this legislation pre-dates FSAP, including the original ISD. The FSAP has the goal of ‘creating the most effective and integrated financial services market in the world’, an ambitious objective for a region that partly shares a single currency and that is far from homogeneous in terms of financial markets, regulation or tax treatments. MiFID is one of more than 40 directives imposed by the EU on the financial services industry in the current decade. Unfortunately, no cost-benefit analysis was conducted pre-MiFID and hence genuine questions remain in respect of the true cost and net benefit to the industry and to the end-investor. Introduced in January 1996, the ISD introduced the European Passport, allowing firms to carry out a wide range of investment business across member states, opened up membership of exchanges in others, and reduced local regulatory barriers. As part of the FSAP, ISD was reviewed, resulting in ISD2, the original name for MiFID. MiFID was formally adopted by the EU Council in April 2004.

40+ exchanges Much, though not all, of MiFID focuses on equity products and hence exchange-traded activity, particularly in respect of client order handling. In terms of context, it is useful to picture the EU exchange landscape, which is more complex than the handful of major markets (see Exhibit 8.1).

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Furthermore, it is worthy of note that not all equity executions are in fact executed on-exchange – this remains the case even in so-called ‘concentration rules’ countries such as France, Spain and Italy, where it is estimated that 30 per cent of flow by value is executed over the counter.2

Moving target At the time of going to press, MiFID remains a moving target in terms of its definitive terms and scope, and hence a precise impact assessment cannot yet be developed. Consultation at the implementation level on a pan-EU basis is being driven by the Committee of European Securities Regulators (CESR) and successful transposition of the Directive into national law was due to be completed by all countries in January 2007. Indicators are that the majority of EEA states may not have met this deadline. Various industry-wide published MiFID milestones have been missed over the past four years and there remains the possibility – although not the probability – that dates could move yet again. More likely it will be an asymmetric implementation, with implementations running at different times within different national jurisdictions. This gap risk is discussed further on p. 158. Thus it is advisable to maintain an active watch on market-wide MiFID developments, which are highlighted in the trade press and, increasingly, in the national press.

What is MiFID? Objectives MiFID aims to increase the transparency of European financial markets and to ensure the protection of the interests of the investor; in particular the retail investor. At the same time the Directive aims to increase efficiency by allowing investment firms to benefit from opportunities that arise from their right to conduct business in other states based upon their existing homemarket authorisation. Once implemented in the law and market practice of member states, MiFID is intended to deliver the following: • Increased transparency on the depth of liquidity across all trading venues, including trades in regulated markets, multilateral trading facilities (MTFs) and internalised trades. • Enhanced protection for the retail investors covering the whole spectrum of investment services, from the provision of advice through to the execution of orders where specific obligations exist regarding how the order is handled and best execution achieved. • Greater competition between regulated markets and MTFs, and removal of barriers to investment firms connecting with the trading venues in other states. • Greater emphasis on, and clarity in, the obligation for investment firms to take specific action to avoid any conflicts of interest. • Increased levels of disclosure to the retail investors, including greater transparency in relation to charges and fees.

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Scope of MiFID Countries MiFID applies to the 25 member countries of the EU, plus the three additional states that comprise the European Economic Area (EEA), namely Iceland, Norway and Liechtenstein. In addition, there are the two new accession states of Bulgaria and Romania. Clients MiFID classifies clients of the financial services industry as eligible counterparties, professional clients and retail clients. Such a distinction will be familiar to those readers who have been exposed to the UK regulatory regime. Eligible counterparties are other market professionals, such as competitors, to whom a different duty of care is required in terms of transaction management and order handling. Professional clients include institutional investors whose funds under management are beyond a prescribed size. The retail clients segments, therefore, comprise all clients that are not classified as either counterparties or professionals. A word of caution in respect of client classification needs to be expressed at this juncture: the boundaries between client segments under MiFID will not be identical to those boundaries previously established nationally, and certain EU countries do not currently make any such distinction. Products MiFID has a defined product scope in respect of specific financial instruments. The product scope is summarised in Exhibit 8.2. Markets MiFID addresses several types of market, including stock exchanges, MTFs and systematic internalisers (SIs). An MTF is defined as an ‘organised trading system’ within the Directive and various MTFs exist in the European financial markets. MTFs active today include, inter alia, VirtX, EuroMTS, TradeWeb and Equiduct. SIs are market-makers in transferable securities and other in-scope MiFID products. In particular, these firms, such as the larger investment banks, create a market internally via their own balance sheet. ‘Systematic’ refers to the organised and ongoing process of client order management; indeed, larger broker-dealers and investment banks have developed, and continue to develop, sophisticated trading technology investments to facilitate such internalisation of client order flow. In the UK, a special type of firm – the retail service provider – exists to funnel client orders from smaller stockbrokers and take them to market. Whether such firms will be considered SI businesses from a MiFID perspective is currently unclear. MiFID, therefore, explicitly seeks to regulate those trading venues that may not have been considered as such in the past. Certainly, the legacy approach of a recognised bourse and its attendant physical infrastructure as a meeting place is outmoded and the ascendancy of electronic, internet-based virtual marketplaces applies no less to financial services products than to any other economic good. Indeed, the dematerialised and information-centric nature of financial services products makes them ideal candidates for virtual, electronic markets. The challenge of cross-border regulation of a market domiciled outside the EU member states, on behalf of customers domiciled inside the EEA, will be increasingly complex in a web-enabled world.

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Finally, MiFID does, of course, cover regulated markets, such as existing recognised investment exchanges and bourses. National regulators will, under MiFID, be expected to treat each market equally and this has important consequences for certain country ‘concentration rules’, the impact of which is described on p. 149.

Key articles With 73 articles in the original Directive (‘Level 1’) and almost as many in the form of ‘Level 2’ clarifications, there is a significant amount for investment firms to take on board. The good news, however, is that the number of articles that will have significant material impact focus on a relatively small collection of key provisions. The majority of the key impacts are highlighted in the overview in Exhibit 8.3. In total the current directives, draft regulations and explanatory notes comprise hundreds of pages of material. The language style used does not appear to be practitioner-driven and translating the European Council text into simple business English is far from an easy task.

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Timetable MiFID implementation follows the Lamfalussy process, which has four discrete layers, as presented in Exhibit 8.4, which starts with EU directives issued by the European Council. It then progresses into more detailed technical guidance before embracing the regulatory bodies in member states for the conduct of business rules. Finally the legislation becomes law and practice in the markets of the member states. Moving the regulations into national law is known as ‘transposition’, underneath which exists a series of national regulatory rule books, such as the FSA Conduct of Business (CoB) principles in the UK.

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Notwithstanding past changes (slippage) to various published implementation dates, the current 2007 timetable milestones – from a UK perspective – are as follows: • January 2007: amended national legislation to transpose MiFID into UK law. • January–June 2007: detailed consultation with particular focus on national rulebooks via CESR and also intra-domicile at the regulator level. • Third quarter 2007: publication of revised rulebook, such as CoB, and key principles. • 1 November 2007: implementation date for new rulebooks, effective date for national legal change and start date of MiFID measures that apply directly (that is become law automatically).

National and trade association responses Nationally, individual securities regulators work with their memberships to consult and refine detailed MiFID rules (known as ‘Level 3’) prior to incorporating these changes into final draft rulebooks which should be published in the first quarter of 2007. Regulatory views are aggregated via the CESR, the expert body leading the creation of MiFID implementation measures. A raft of interested parties are involved nationally and also on a pan-European level in lobbying, responding to consultation papers and preparing specific proposals. These are too numerous to mention here in full, however ISITC, SIIA/FISD, CESR, FESE, APCIMS, ESF and many others are publicly involved in the consult-iterate-publish-approve cycles. Individual firms are well advised to channel their comments and inputs via the relevant trade association.

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It appears that the majority of industry response effort is directed out of the City of London; hardly a surprise given the standing of London as the pre-eminent EU financial centre. But also a matter of concern in that other major centres may be insufficiently aware and hence ill prepared come 1 November 2007. Activity is somewhat visible in Frankfurt but less so in Paris, Madrid or Milan, for example.

Potential scope expansion Although the scope of MiFID has significant focus on Europe’s equity exchanges, partly as a result of the elimination of concentration rules, the Directive also explicitly includes fixedincome instruments, which are transferable securities after all, over-the-counter (OTC) derivatives and collective investment schemes, such as UCITS III. The Directive does not, however, focus on order-handling, pre-trade price transparency or on-exchange transactions. As such the principally OTC nature of European bond markets – and in particular the nature of price transparency as a result – became a hotly debated topic during the latter half of 2006. How this debate will play out, and whether the benchmarking type of approach becomes a best execution requirement for the fixed-income asset class, is a key area of concern and certainly one to watch. The investor, who is being protected, could reasonably ask why the focus is skewed towards one asset class when investors clearly use financial institutions too. The explosion in the use of derivatives is well known – not just for wholesale but retail too, such as UK contracts for difference (CFDs).

MiFID summarised Clearly MiFID has multiple facets and a complex implementation process, across 28 participant states. The degree of impact to financial services firms, their clients and, above all, their marketplaces is the focus of the following section. MiFID has widely supported aims and objectives, such as investor protection and panEuropean market harmonisation. However its drafting, time to implementation, revision cycle and complexity lead many industry commentators to question its cost-benefit. Above all, MiFID is expected to impose a material compliance cost on the 2,000+ firms involved in the EEA, and we would expect those firms to want to pass those costs onto their clients – ultimately the endinvestor. Whether such costs are a fair price to pay for the possibility of added protection and/or improved access to execution liquidity is a moot point at the time of writing. MiFID is, on this level, a mandatory compliance-driven programme of change for 2007. It also represents, for certain firms or their suppliers, an opportunity to develop new products and services and hence increase the top line. Much is made by the vendor community of the opportunity (revenue growth) story, but as we shall see, while the opportunities do indeed exist, they remain possibilities and far from definite. Compliance costs, on the other hand, are very real and hence the balance between firm costs and opaque revenue possibilities makes MiFID an issue for the business (and the industry) as a whole to address. MiFID is not solely a matter for the compliance officer.

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MiFID impacts The national perspective At the national regulatory level, it is important to recognise the number of items competing for attention, resource and consideration. Across Europe, these include, besides MiFID, the Single European Payments Area, the Market Abuse Directive, UCITS III, the EU Savings Directive, the Transparency Directive (Issuer Information) and Basel II. Of these the Basel II regulations – concerning capital requirements for banks – is high on the agenda and MiFID is by no means the only game in town. Against this backdrop of change, and limited regulatory change resources across the industry, it is possible that (for certain countries) MiFID will be forced down the agenda. The consequence of such a scenario is likely to be an asymmetric implementation, with some countries being ready from a legal and rulebook perspective, and others not. Such a scenario, if it transpires, is likely to lead to regulatory arbitrage, whereby larger multinational firms will book business onto the balance sheet of a more lightly regulated (due to regulator delay) entity. Ironically, this scenario runs completely counter to the pan-European harmonisation objectives of MiFID. Given that MiFID enshrines the European Passport discussed above and the principle of ‘home’ and ‘host’ regulators, the regulation actually facilitates the migration of order flow to compliance-efficient entities for multinational players.

Conduct of Business Conduct of Business (CoB) refers to such core client management issues as conflicts of interest, client complaint-handling, client classification, suitability and appropriateness of investment advice, and, critically, best execution. Here national rulebooks are the key area of change. From an exchange or service provider perspective, including MTFs and possibly Retail Service Provider (RSPs), it is important to recognise the distinction between a market participant who is party to a client transaction, and a platform that facilitates a market transaction. Service providers will not bear the brunt of the CoB regulations, but their clients, the market-makers and members firms, will. The key market-wide issue arising from CoB changes is pre- and post-trade transparency, which is discussed on p. 151. Exchanges and other providers are expected to have to capture a wider range of order types and order conditions than is currently the case; however, a common European syntax for orderhandling at the attribute level would benefit the industry as a whole.

Competition, concentration and internalisation It is in the domain of market competition that the key impact of MiFID will be felt in terms of the exchange segment, which includes MTFs, electronic communication networks (ECNs), etc. MiFID explicitly forces certain European markets that have imposed ‘concentration rules’ under the original ISD to open their order flows to outside competition from other liquidity pools.

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Concentration rules – visible in France and Spain, for example – force all client orders to be routed through a specific national exchange and hence create a barrier to entry at the exchange level. These rules will disappear on 1 November 2007. Local member firms in impacted countries could, therefore, route their order flow to a different market immediately thereafter – assuming their technology permits this. While this (welcome) removal of competitive barriers is theoretically going to create a level playing field leading to exchange consolidation and the survival of efficient players, a note of caution is required. Why? Because the redirection of order flow, while consolidation plays out at the market infrastructure level, means a fragmentation of liquidity pools, where concentration is a positive for all concerned. New market entrants will not be able to create large liquidity pools overnight. The second caveat around exchange consolidation is to remember that it was already taking place across Europe – before any MiFID deadline. The advent of Euronext, the queue of buyers for the London Stock Exchange (LSE), the creation of VirtX and CHI-X, the merger of Euroclear and Crest, and the increasing use of ECNs in the fixed-income sphere all pre-date MiFID implementation and were not – primarily – catalysed or driven by MiFID positioning. Even the (at the time of writing) news of ‘Project Turquoise’ – a plan for seven large sell-side firms to form their own pan-European exchange – appears to be driven by the desire to reduce exchange fees from existing providers, such as the LSE, rather than strategic positioning ahead of MiFID deadlines. The transfer of shareholdings, and thereby governance, in demutualised exchanges from their original (mutual) owners to investors and arbitrageurs is also a key driver of European exchange consolidation; notwithstanding that the consolidation has a transatlantic dimension following recent bids by both Nasdaq and the NYSE for major European players. MiFID should, therefore, be seen as a secondary driver of change to market infrastructure and not a primary one. It is possible that, in its early days, the fragmentation of liquidity pools could result in poorer execution quality for clients than under the previous regime – again counter to the objectives of the Directive. The law of unintended consequences has a part to play in the MiFID story during 2007 and beyond.

Clearing and settlement In the clearing and settlement space, MiFID is also a secondary driver of change; however the Directive does have some key consequences for the post-trade domain. At the market infrastructure level, consolidation is already well under way among both clearing houses, such as the merger of LCH and Clearnet, and central securities depositories (CSDs), such as the Euroclear group spanning Crest in the UK, France and the Netherlands, and other national CSDs. The natural result of these ongoing moves would be to expect that we would be left with two European clearing houses (LCH/Clearnet and Eurex) and two European International CSDs (Euroclear and Clearstream). Both Eurex and Clearstream are owned by the Deutsche Börse Group, which has a so-called vertical model. The alternative, horizontal, model, which allows multiple exchanges to clear and settle on a single post-trade platform, is more flexible but requires more work for participants to achieve straight-through processing.

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MiFID has specific requirements in terms of client-reporting and record-keeping. This will be familiar to firms operating in mature securities markets, but will require potentially some technology investments and data management efforts for smaller players in Europe. In summary, the key requirements can be grouped into three categories. Each will be considered in turn.

Client data At the client-data level, the key issue is one of classifying clients into the three types discussed on p. 143 (that is eligible counterparties, professional clients and retail clients). Firms will need to review and reclassify their client databases, since the type of client has important consequences for order-handling under articles 19, 21 and 22 of the Directive. Furthermore, given the need to demonstrate ‘suitability and appropriateness’ (in risk terms) of each client transaction, the level of record-keeping and pre-order checks that would likely result will require a data management review, particularly, though not exclusively, in relation to complex products, such as OTC derivatives. Instrument data This piece of the puzzle is absolutely critical to understanding the post-MiFID landscape. Why? Because, above all, MiFID envisages a multi-market world where the same instrument is traded at multiple venues – whereas today firms can safely assume that an instrument identifier can be linked to a single exchange. This assumption underlies almost all significant order-routing technology platforms. In the future, instrument reference data will need to be able to take account of the ‘place of trade’, that is some kind of market identification code. Beyond the trading location, where is the place of listing, the location of the closing price and the source of the most recent quote? The 2,000+ financial services firms in Europe all have large instrument databases, usually resident across a series of technology platforms and linked to multiple market data providers, so the act of changing this critical foundation layer represents a very real task, in terms of both business process and technology. The task applies not only to firms themselves but also to all exchanges and relevant service providers. Moreover, the precise syntax to be used on a pan-European level to describe instruments in a post-MiFID world is still under debate – albeit via several knowledgeable trade associations. Until the detailed requirements are fixed, the technology and data management task cannot be initiated and this key dimension of MiFID is therefore likely to cause time pressure and resource strain for all participants in the second half of 2007. We should balance this warning, however. The well-known market data providers are in the business of designing services and content to meet client needs and it is therefore natural to assume that the market data community will offer some solutions in this space – at a price – before the second half of 2007. Reporting and record-keeping The final element of the clearing and settlement space touched by MiFID is reporting and recordkeeping. Transaction-reporting is a very important area of impact, although one or two minor items can be addressed first. Record-keeping elements of the Directive are not expected to require a change to business processes for financial services firms familiar with a seven-year retention policy (based on the statute of limitations in UK contract law).

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The client-reporting items in the Directive – both of transactions and of portfolios – bring some consistency to the European space, but may create flexibility issues for some firms since MiFID is prescriptive about client-reporting content and frequency. Where firms, and their clients, are comfortable with current arrangements, MiFID may force an unnecessary change. In the main, though, the Directive requires sensible reporting standards, such as reporting (confirming) a transaction to a client on or before close of business on T+1. This is far from onerous as an example. A much bigger issue is that of ‘transaction-reporting’. This currently comprises the end-ofbusiness-day reports of all firm-level activity made to the national regulator, usually, but not exclusively, via the national equity exchange. Exchanges act as points of aggregation and quality control, and as post offices for regulatory data aggregation. Exchanges also then resell this information to firms themselves and to market data providers. From a back-office perspective, the pre-MiFID transaction-reporting task requires the compilation of a series of daily files of information, per regulator (that is per market), followed by quality-checking and dispatch of these files, usually electronically, to the exchange or local regulator. In the post-MiFID domain, a single European transaction report becomes an opportunity. Why? Because reporting firms can decommission redundant technology, manage a single daily deadline and include all relevant instrument types. Moreover, firms can make this information available to the market ‘on a reasonable commercial basis’ (that is firms can sell this data and can use exchanges, or third parties, to facilitate this). This is a new source of revenue for the firm but a potential revenue loss for the exchange, directly as a result of MiFID regulations. The announcement in late 2006 of ‘Project Boat’, a transaction-reporting utility to be established by 10 or more large European investment banks, has been created explicitly to leverage this cost-benefit play from the firms’ perspective.

Transparency Pre-trade transparency is a key MiFID impact area – meaning the publication of open (limit) orders to the wider market – albeit with time protection for larger orders. Historically such orders were not required to be made public, certainly in terms of the role of the SI. Making such information available to the wider market, and how to disseminate such order- or quote-based data, is a key MiFID action item. Clearly, where firms already leverage an exchange order book, then outstanding orders are already in the semi-public domain, with the attendant anonymisation protection. When we turn to quote-driven markets, OTC fixed income markets, auction-driven processes (such as for new issues of French treasuries, for example) and especially SIs (which do not provide any live quotes from their book), the issue of publishing previously private information to the market as a whole is troublesome. In the first place, deciding which open orders to publish (MiFID refers to limit orders but there are many order types) is a key question. Secondly, which channel should be used to publish the data? Should a third-party market data provider broadcast facility be leveraged or is posting to a web page sufficient? Finally, there remains the risk that firms create dummy proprietary orders to publish to the market to confuse a true client scenario.

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Article 27, the obligation for investment firms to make firm public quotes, is the relevant section of MiFID. In particular, quotes will refer to ‘liquid shares’, expected to comprise approximately 500 of the major European equity issues ranked by market capitalisation. However, MiFID permits individual countries to additionally nominate a number of liquid shares, that is additional issues below the market cap threshold. Maintaining a live list of such instruments presents a serious challenge for the market. Furthermore, the dissemination of a large, additional volume of quote data around the market will have an impact on network bandwidth and this is another key consideration for the relevant players. Firms will have to make further investments not only in their quoting engines but also in new quote-comparison technology on this basis. Post-trade transparency is covered in the last section ‘Reporting and record-keeping’, in terms of both transaction-reporting to the market and also client-reporting.

Memberships and passports As mentioned earlier, in terms of the genesis of MiFID being derived from the ISD, the concept of the regulatory passport is a key tenet of the Directive. MiFID opens the door for domestic firms to expand into cross-border markets with minimal additional regulatory licence overhead. However, the reality of the 2,000+ exchange member firms across Europe having the management depth, capital base or desire to start conducting business outside their home country is questionable at best. One of the key drivers will be client behaviour, with a majority (more than 90 per cent) of retail portfolio assets being domestically invested at the time of writing. As exchanges consolidate, memberships will permit access to a wider order book in more instruments. The services that exchanges provide to facilitate seamless cross-border order flow will be the key determinant of market behaviour in this space. Today, notwithstanding the consolidation plays already evident, at the technical connectivity layer, multiple legacy systems remain and the reality for member firms is the need to maintain various inefficient channels to take client orders to the market and back. The most sophisticated European investment banks are already well versed in leveraging the passport concept; it enables them to reduce costs via remote exchange membership (typically from a central European trading floor, removing the need for duplicate infrastructure multidomestically) coupled with a single European balance sheet and market booking name against which clients and counterparts transact. A single balance sheet provides for cost of capital scale economies via the netting effect of a transaction hub.

Revenue sources At the firm level, client-driven revenues are already under pressure. According to Merrill Lynch estimates,3 equity commission rates have tumbled by approximately 50 per cent since mid 1998 and retail investors can ‘click-to-trade’ in multiple markets for approximately 20 per trade online. At the exchange and market provider level, MiFID will most certainly impact their datadriven and transaction revenues. On the data side, exchanges make a significant portion of their revenues from data publishing – in effect reselling the data created by their members, both pretrade (orders, quotes) and post-trade (transaction-reporting, market share statistics). MiFID

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explicitly permits member firms to sell this data to third parties and yet still meet their regulatory obligations (‘on a reasonable commercial basis’). Hence the data vendor role of the exchange is threatened and a revenue protection or defensive response is required. The feedback of the industry to CESR in early 2007 strongly suggests that an exclusive arrangement between a single firm and a single data publisher should not be sufficient to meet the requirement to publish data on a non-discriminatory basis; yet commercial behaviour would lead us to suppose that precisely such lock-in structures make the most economic sense for the data vendors or aggregators, and the large market players. How this tension between the good of the market as a whole and bilateral commercial arrangements plays out will be an interesting test of MiFID and its original objectives. Once again, the law of unintended consequences may create a scenario counter to the desired outcome.

Market trends Finally, it is important to recognise wider market trends shaping the European securities landscape. As has been stated above, while MiFID is a factor, it is a secondary driver of market change, at best. MiFID is a catalyst for a small number of very specific changes, which are nontrivial – certainly, but which are unlikely to be at the very top of the agenda. The more important drivers of a reshaped European securities market include the following.

The advent of algorithmic trading Larger sell-side firms have made very significant investments in black-box technology, which not only monitors market arbitrage opportunities and order book patterns in real time, but also generates orders without human intervention. The key impact here is the inexorable growth of market volumes (that is transaction volumes) but not turnover. In other words, the average value of each ticket is declining, while the volumes have risen. State-of-the-art technologies can generate thousands of orders per second and can create and dispatch an order in less than seven milliseconds. The impact on exchange capacity and latency is clear to see – requiring significant investment at the market infrastructure level. Spikes in trading volumes are a key driver of recent transaction-driven revenue growth for exchanges; and yet their users are publicly complaining about trading costs. This cost-per-trade pressure is the most critical determinant of the mergers and acquisitions (M&A) scenarios described shortly in ‘Market M&A, demutualisation’. Direct market access (DMA) offerings Alongside algorithmic trading, sell-side firms now offer DMA to both retail clients (click-totrade) and institutional investors (typically a sophisticated website). The removal of the human interface from vanilla order-handling has had the effect of removing a volume bottleneck and has also driven down commission revenues. The roles of the buy-side and the sell-side also become less differentiated when investors have direct exchange access. The historic model of leveraging (and paying for) the member firm’s access to a liquidity pool is being broken down. Certainly, how all players manage this issue of roles, cannibalised revenues and, above all, disintermediation is key.

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The retailisation of structured products and the advent of spread betting Retail clients are now well aware of a variety of offerings to gain exposure to the price behaviour of an underlying security or a basket thereof. Some examples would include CFDs and traded options or index futures. By leveraging such products, clients believe that they are avoiding the transaction costs associated with the exchange round trip and the accompanying settlement process. The seller who creates the product will normally leverage cash securities markets to hedge such exposures and lock in (in effect) their commission or spread. Spread betting, where underlying securities or indices are available as products, takes the same concept to a further level of a cash-settled virtual securities product. Not only do such products offer (in theory) lower transaction costs and a reduced hassle factor, they also have tax advantages. CFDs do not attract the 50 basis points transfer stamp cost in the UK, for example, and spread-betting (gambling) gains are usually free from capital gains taxes. Market M&A, demutualisation In an environment where demutualised exchanges can no longer count on their users (their exowners) to vote in favour of the status quo, the ability of potential consolidators to launch bids for European market infrastructure players has been a feature since around the time of the introduction of the single currency in 1998. A variety of transatlantic bids are on the table at the time of writing. The outcome of any successful M&A transaction is far more meaningful to the European securities industry than MiFID implementation. Asset allocation preferences Financial services activity is driven by the savings ratio and the switching of assets from one class into another – for example, the widely reported switching of UK pension fund assets from equities to fixed income. Similarly, the appetite of the investor for cross-border investment assets is expected to grow slowly over time and is a powerful hidden driver in terms of creating homogeneity in pan-European financial services. Tax harmonisation Notwithstanding any laudable aims to create a level playing field, it has been recognised that national governments in Europe have no visible appetite to deliver tax harmonisation. The explicit strategies behind the development of euro-zone locations such as Dublin and Luxembourg have been tax-driven (one capital gains-driven, and the other withholding taxdriven). Investors and market players will be attracted to such jurisdictions for obvious reasons – the tax landscape thereby skews the pan-European picture and makes investor outcomes dependent upon the domicile not only of the issuer but also of various participants in the investment value chain. Web 2.0 Finally we should consider the internet as a key catalyst for change in the European exchange landscape. Exchanges, as their history shows, were created as a meeting place, an information exchange and a mutual rule setter for an orderly market. The key meeting place and information

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dissemination aspects are clearly something that the internet is now capable of delivering, even for value transactions. The result of this threat is that exchanges’ core asset is probably their order book or quote management technology, coupled with the commercial value of their client base to the degree that clients promise not to take their business elsewhere. To summarise, various threats and opportunities exist in the European financial services marketplace, from an exchange perspective. None of these will be closer to an exchange CEO’s heart than the possibility of M&A activity, either as hunter or as somebody’s prey. These strategic drivers are – when taken individually, let alone collectively – more critical than MiFID to shaping the future landscape in terms of a level playing field for the investor community and also in terms of developing more efficient capital markets in the European time zone.

Responses – the exchange perspective Having understood MiFID in terms of its objectives, its content and its (potentially limited) impact – we can turn our attention to the spectrum of responses that exchanges will be considering as they prepare their business plans for 2007 and beyond.

Market consolidation As has been noted earlier, market consolidation is already clearly visible and such entities as Euronext, Nordex and the ongoing M&A activities are all harbingers of further consolidation to come. MiFID is an additional, secondary catalyst here. Balancing the need to achieve scale economies with retaining sufficient competition to protect investors might result in a situation where the current players coalesce into two equity trading blocks. Such a configuration would mirror what has already taken place on the settlement and clearing front, such as the Clearstream and Euroclear platforms. In a consolidation phase, market share and governance are all important and so the key response for exchanges and MTFs is to find a source of liquidity and order flow and a commercial means to lock in such market share.

Defensive or aggressive? Another aspect of the exchanges’ response to MiFID, and to other industry drivers, is the fundamental decision on whether to act defensively (that is via a mutual structure, relationship management and political lobbying) or whether to go on the offensive. The more aggressive stance would require developing new products, new services, new clients and new market segments. It is on the basis of such a stance – where the status quo is untenable – that the following suggested specific responses are based. Why is the status quo untenable? Because MiFID abolishes concentration rules, the final important order-routing entry barrier in European securities – and this important change creates de facto opportunities for competing exchanges and requires those markets that currently enjoy this protection to respond.

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Products and services What new products or services, at the exchange or third-party service provider level, does MiFID catalyse? Based on MiFID’s key tenets described earlier, the following shortlist has been suggested. First, MiFID creates, for the first time, the concept of pan-European, cross-asset class transaction-reporting. Assisting member firms to download, reformat, aggregate and qualitycheck, and then dispatch such data (at a price), is an obvious contender for a new service to the market. The launch of ‘Project Boat’ by a group of larger investment banks to precisely create such a service for themselves is fraught with governance and technology build risks – as history has shown. This initiative merely serves to validate the market demand for a new service and it should not, per se, prevent other players from trying to offer a better service at a more attractive price. Secondly, notwithstanding that MiFID’s original best execution approach appears to have been watered down into a more principles-based approach, the need for best execution market data is likely to be demanded by clients of market industry players. Detailed tick databases (that is detailed intraday price movement history), best execution modelling services and best execution price history datasets have a value that MiFID will spotlight. Thirdly, given that MiFID catalyses the concept of a product being available to transact across multiple liquidity pools and trading venues, an obvious service requirement is the ‘quote finder’ or ‘order router’ (that is a service that takes an order, hunts continually for the best price and size available, then advises the order manager or routes the order direct to the chosen market). The analogy here is a complex internet search engine that is capable of managing multiple dynamic inputs, secure enough to accommodate value transactions and able to offer different levels of sophistication to different classes of user. Taking this concept a step further, exchanges or similar providers could offer a ‘best execution’ product explicitly as a means to assist their clients to comply with the MiFID regulations. Such a product would imply that exchanges not only search their own order books but check other liquidity pools at the same time; meaning that certain orders would be routed to a competitor market. The advent of Reg. NMS in the US explicitly leverages this scenario: Reg. NMS requires the exchange to seek out best execution for an order it receives and not the member firm. MiFID, by contrast, places the onus firmly on the investment firm and therefore increases compliance complexity for participants. The US approach seeks to leverage the market infrastructure to achieve the same objective, namely best execution. The fourth potential service offering revolves around OTC products – and starting to offer price discovery mechanisms and order-matching services in this high-growth, high-margin segment. The OTC product space (that is complex derivatives) does tend to become commoditised as individual product markets mature and, once a degree of maturity and standardisation is reached, it is potentially suitable for an exchange-based service. The core benefit here is the opportunity to reduce the administration burden for wholesale users, whose back office issues in this space have led to public concerns being expressed by the regulators during 2006. Such a service requires genuine innovation on the part of the exchanges if they are to tap into this important product set. Competitors such as DTCC-DerivServ and Swapswire are examples of nascent services in this space.

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Fifthly, one extension to the current service exchanges provide is the growth in foreign (that is non-European issuers’) listings, where they seek to attract new issues to their order book, and hence reap the benefits of the resulting listing fees and transaction fees in the secondary market. Overseas listings are being attracted to Europe from North America, largely on the basis of a lighter-touch regulatory regime, and avoiding the Sarbanes-Oxley Act compliance burden. Other overseas issuers in the natural resources sector and also from the BRIC group are obvious targets for extending the existing product set to new clients. A sixth area of opportunity, where exchanges have on the whole been slow to react, is that of technology provision in terms of managing the in-house order management technology of member firms; in other words a bureau-based service. As discussed previously, the exchange has significant intellectual assets in respect of order management and order-handling and it is somewhat puzzling that this logical extension to existing clients has not been exploited. Larger firms – which could become competitors under the MiFID SI regime – invest significant technology budgets in their order management systems and such a prize is available to players who perhaps start to consider themselves as technology service providers rather than meeting place organisers. The competition in this space will come from the large market data providers, which increasingly offer software applications on top of their data-feeds, and new technologybased offerings such as Equiduct. One additional technology-based service that exchanges might consider, in a 28-country financial services marketplace post-MiFID, is a connectivity solution on a multi-market basis; in other words, a single connection to many pan-European markets leveraging bilateral exchange links. In today’s world, exchange connectivity is usually based on proprietary technology and hence redundant IT spend is rife, when considering the industry as a whole. The translation engine aspects coupled with an access point-based connection would have real value to market users, possibly in conjunction with a multinational telecoms provider. The final response to the market consolidation that is already under way, and the likely fragmentation of liquidity pools that MiFID is likely to engender, is to control (and hence drive revenues from) the clearing and settlement infrastructure that underpins the trade execution space. Such a strategy is often described as the ‘vertical model’ and is the business approach pursued by the Deutsche Börse Group via its ownership of Clearstream. The vertical approach has theoretical efficiency benefits for users, such as the need to enter data once, order flow, execution capture, and the fact that settlement instructions remain inside a single silo. Critics of the vertical model argue, however, that competition is stifled and barriers to entry result in supernormal profits for the infrastructure owner. To summarise, exchanges have a variety of new product or service opportunities, which are logical extensions of their skill sets and market standing. However, a creative and technologydriven multi-market vision will be the key to success in a landscape where governance and M&A activity represents significant pressure on incumbent exchange management teams. MiFID may be considered only a catalyst to some of these opportunities, but it does directly create certain opportunities too.

Conclusions MiFID, which remains a moving target, and has yet to be enacted and effective in either national law or national regulatory rulebooks, has a series of known (likely) impacts based on the ‘Level

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2’ measures published in 2006. These include pre- and post-trade transparency and reporting, and the elimination of concentration rules in several large European economies. However, MiFID is also likely to have unintended impacts too, in particular in two domains. These are the potential for the fragmentation of liquidity pools, thereby damaging execution quality, and the net costbenefit equation whereby end-investors will pay for the cost of compliance regardless of whether this cost is matched or bettered by the potential benefits of a more level playing field in European capital markets. Member firms and exchanges themselves have a variety of visible responses at their disposal. At the firm level, a minimum degree of change in order to comply will be required. Alternatively, the opportunities presented by the post-MiFID landscape could be leveraged, albeit subject to a variety of complex factors dependent upon competitor and client behaviour. At the exchange level, MiFID catalyses several specific new service ideas. However, larger issues remain at the centre of the agenda for exchanges, including governance, M&A activity, the resulting market consolidation and the extension of existing services to new client segments. One major area of concern is the risk of differing timelines for the national adoption of MiFID rules and the resulting potential for regulatory arbitrage: counter to the objectives that the European Commission’s FSAP sets out for MiFID. The pressure on national regulators to manage a large number of concurrent changes could result in MiFID taking a back seat in certain major markets. MiFID deserves to be understood and respected as a major change to the European regulatory landscape. However its scope, impact and the responses it will trigger across the financial market infrastructure are perhaps lower in scale than many commentators have so far suggested. Other more business-critical issues remain higher up the executive agenda for market participants. Above all, those involved should seek to influence their desired outcomes by contributing to the detailed consultation processes currently ongoing, and by engaging with their service providers who are well placed to solve industry problems on a market-wide commercial basis. Only by early 2008 will a clearer picture emerge of MiFID’s effects on the European financial services domain. Whether these effects are aligned with its original objectives remains to be seen.

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Presidency conclusions of the European Council Lisbon 23–24 March 2004. Capco Research. Gaulard, J.-H. (2005), ‘The future of the equities business’, Merrill Lynch, 24 June.

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