How you perceive the likely $10 billion merger in the works between the New York Stock Exchange (NYSE) and Deutsche Börse (DB) might well depend on whether you are a glass half-empty or glass half-full type of person. The former would argue that, especially where the NYSE is concerned, this is merely the best effort that can be made by two aging organizations struggling to remain relevant in a high-tech financial world that finds them gradually less essential. The latter, however, would argue that the proposal is a strategic bet by two important organizations that want to stay one step ahead of an increasingly global, interconnected and uniform financial market. The combined organizations would make up the world’s largest exchange.
In truth, of course, it is a little of both.
Since the 1970s, the U.S. Securities and Exchange Commission (SEC) has been working systematically to increase competition for the New York Stock Exchange in an effort to make trading more efficient and transparent, and less expensive for investors. Since the 1980s, and particularly since the late 1990s, technology has worked overwhelmingly in the SEC’s favor. In a more interconnected world, the barriers to entry for new trading platforms are extremely low, and it is easier than ever for disparate trading platforms, markets and even investment bank trading desks to pool information about transactions and prices.
Just as the SEC intended, spreads — the difference between the bid and ask prices on a stock, where market makers or specialists make their money — have dwindled to “pennies,” says Marshall Blume, a professor emeritus of finance at Wharton who co-authored Revolution on Wall Street: The Rise and Decline of the New York Stock Exchange with Wharton colleague Jeremy Siegel. “Exchanges earn a small margin on lots of volume,” Blume notes. In this world of slim margins, it is a lot easier for lean upstart trading platforms to turn a profit. They are not bogged down by cumbersome outdated technology, or the infrastructure that comes with providing all the additional services and oversight that the exchanges do.
If the legacy exchanges are losing market share, which they inevitably have as more competition has sprung up, it becomes harder to get those necessary large volumes. The NYSE trades about 27% of the volume of U.S. equities, down from 90% 15 years ago, according to Fortune. Moreover, according to Larry Tabb, CEO of the TABB Group, a financial research and consulting firm in New York, if the NYSE is handling a shrinking portion of the trading of its own stocks, it risks losing the “clout to attract quality listings,” which is arguably one of the strongest attractions the exchange has going for it.
To compete with the upstarts and survive, Tabb says, exchanges need to combine to diversify their geography, regain sizable market share in their trading businesses and create economies of scale that will lower their costs. Moreover, they need to diversify their offerings beyond equity trading. The NYSE is no stranger to mergers, having combined in 2007 with Euronext (a pan-European stock exchange based in Amsterdam, with subsidiaries in Belgium, France, the Netherlands, Portugal and the United Kingdom). Reports suggest that the combined NYSE-DB entity would save more than $400 million in costs annually.
Both NYSE and DB have products and services beyond trading, some distinct and some overlapping. They presumably want to partner to consolidate common services, cut costs and take advantage of the combined customer base to give each of their businesses a bigger audience. Bruce Weber, a professor of information management and management science and operations at the London Business School, points out that listings and settlement and clearance, while perhaps not as sexy as high-tech trading platforms, provide good cash flow.
“Listings are still valuable. And a NYSE listing is still a sign of a blue-chip company that’s stable and well managed,” he says. On the other hand, “the NYSE outsourced its settlement and clearing operations years ago. If they had it to do over, I’m betting they’d like to undo that.” DB brings to the table an in-house settlement and clearing business that reaches into several countries.
And of course, the NYSE has a powerful brand. To people all over the world, the exchange’s daily opening bell represents a liquid, well-regulated market that is as fair to the little guy as it is to the biggest institutions. Though the NYSE’s trading volume is smaller than it once was, it is nothing to sneeze at. “It also has its index, the NYSE composite, which is quite valuable,” adds Weber. In fact, the composite is increasingly lucrative, as exchange-traded funds (investment funds that are traded on stock exchanges); index funds and other new products are derived from it.
Searching for Common Ground
On balance, though, the business case for this merger is not overwhelming, according to Blume. “In terms of what the exchanges are getting out of this particular merger, I’m not sure.” Tabb, however, says the impetus for the proposed deal comes down to technology and trading volume. NYSE has its relatively new Unified Trading Platform (UTP), which operates in the U.S. and Europe, primarily with equities. DB has the Eurex platform, one of the biggest for trading derivatives.
By corralling the stock-trading volume from the New York, Frankfurt, Amsterdam, Brussels and Lisbon exchanges onto UTP and steering the companies’ combined derivatives activity to the Eurex, DB-NYSE would significantly shore up its market share in both trading arenas. A merged NYSE, Euronext and DB would reportedly have a combined annual trading volume of more than $20 trillion. Additionally, “a lot of derivatives trading happens in London and this will give Deutsche Börse a foothold in London,” via properties from earlier NYSE mergers, Tabb notes.
Beyond that, the two could streamline the listings services for these multiple exchanges, and apply DB’s clearing and settlement infrastructure across them and into new markets. These moves would likely provide small efficiencies and savings, along with the ability to lure new trading and listing customers with instant multinational reach, although the NYSE and DB would need an Asian partner to become truly global. Indeed, on Tuesday, the NYSE and the Tokyo Stock Exchange sealed an agreement to explore ways to open up trading between the companies’ markets, according to the The Wall Street Journal.
“There is pressure from regulators for more over-the-counter products to become listed and traded on exchanges,” Weber says. The combined company might be able to make a stronger grab for those new trading markets than either exchange could on its own. “They’ll emphasize the value of new equity options and other synthesized products based on their listing power, and the NYSE and Dax composites. And they’ll emphasize the settlement and clearing, which is boring, but good business and which Deutsche Börse does well,” he adds. “They’ll keep the stock trading business, which has become commoditized, in the background.”
One factor that is halting enthusiasm for this pairing, however, is that right now, the operations can only be consolidated and combined to a point. The numerous exchanges and trading platforms of the merged entities would still operate in different countries with their own regulating agencies, and rules and guidelines that can be out of sync with one another.
“You need common ground [in terms of regulations], and right now all these places are too far apart,” notes Saikat Chaudhuri, a Wharton management professor. He says that regulators tried, but ultimately failed, to create some common standards in the wake of the recent financial meltdown. And he points out that having to maintain dual headquarters and multiple listings and deal books to address incompatible standards will cut into savings, at least in the short term.
“You have to ask, to what extent is the existing set-up inhibiting global growth? If people feel it is, then they will find a common ground,” according to Chaudhuri. “This could be a bet on a future where there is more uniformity…. If companies and their products are integrated globally, then it makes sense to integrate stock exchanges globally. This is mirroring in the financial world what is going on elsewhere.”
Bye-bye to the Bell?
Tabb and others observe that the trends that make this merger and other exchange pairings necessary — namely the migration of trading away from exchanges — also make one wonder whether we need exchanges at all. Beyond the proposed NYSE-DB pact, the London Stock Exchange is looking to buy Toronto Stock Exchange parent TMX Group. A merger between Singapore’s exchange and the Australian Securities Exchange is awaiting regulatory approval.
One argument in their favor is that the more trading happens away from the exchanges, the more fractured, less transparent and less efficient it is. “Market makers don’t like transparency; institutional investors do,” Blume says. “It reduces costs for one and profits for the other.”
Without the rules and standards that exchanges have developed over time in reaction to abuses — and lacking someone at the exchanges whose job it is to keep an eye on daily trading activity — it could be that much easier for rogue traders to engage in illegal activities, and for legitimate traders to use techniques that are technically legal but still undermine the markets, particularly for small investors, experts note.
At the very least, it would mean that the order an investor put in to a broker to buy or sell 100 shares of Coca-Cola would probably never leave the brokerage house, and an investor might pay a few cents more or earn a few cents less per share than he or she would if the order went to an exchange.
But Tabb says that amounts to small potatoes. In a world with an increasing amount of easily available information and competition, spreads have narrowed to a fraction of what they used to be, and trading commissions are smaller, too. “When I worked for the company that also executed my trades, I would always get the worst trade of the day [as a small investor] and it cost me $200 [in trading fees],” he notes. “Now it costs $8 and the order gets filled in less than a second, at more or less what you see on the screen. So does it hurt that your order isn’t being filled at the exchange and might cost you a penny or so more? Probably not.”
Eric Clemons, a professor of operations and information management at Wharton, takes the opposite view, arguing that those pennies add up. “Say there is a stock that is five cents less than it should be. The efficient market hypothesis says that it will revert to the correct price, but it won’t happen instantaneously.” In the meantime, a high-frequency trader at an investment bank might exploit the pricing error by “stepping in and harvesting a few pennies.” But that could amount to a few pennies on thousands of shares. “It looks like free money, and no one cares because it’s dimes,” he says. “But it’s money being taken out of the market, away from serious, long-term investors, and it adds up to enormous amounts for the investment banks.”
Nasdaq — which last month was rumored to be exploring a rival bid for the NYSE — has put practices in place to stop this so-called front-running on its trading system. At the Big Board, though, this is where specialists come in. “The specialists’ job is to say that this price is too low and no one is willing to trade at it. He or she makes sure that just because the market is too thin, the small investor won’t get under-rewarded or overcharged,” Clemons notes. “This is not a function that a Goldman Sachs or a high-frequency trader wants to perform.”
According to Clemons, that does not mean there must be a physical trading floor, however. The NYSE’s iconic trading floor, probably the last one still standing at a major exchange, “has no advantage and is even a little inappropriate.”
Tabb concurs. When trades happen in nanoseconds, “it’s hard for humans to interact that quickly,” he points out. “The trading floor does 1% of total U.S. equity volumes. So it’s basically a nice studio set for [CNBC anchor] Maria Bartiromo.”
Some even joke that the NYSE would get better value out of its desirable Wall Street address by converting itself into condominiums. Still, with DB owning the majority of the proposed entity, the pact clearly amounts to a German takeover of an American icon. Closing down the NYSE would be a major, albeit mostly symbolic, hit to America’s and New York’s financial might.
“People come to ring the bell; Maria [Bartiromo] and Bob [Pisani, who reports for CNBC from the trading floor] hang out. It gives [the NYSE] a lot of visibility. Maybe it’s not cost effective operationally, but it’s very effective from a marketing and branding standpoint,” Tabb notes.
In the end, Weber says, the merger comes down to this: “Deutsche Börse is getting 60% of the proposed company and the NYSE 40% because the deal is driven by weakness on NYSE’s side and business on the Deutsche Börse’s side. DB has an ideal footprint and business, and NYSE has the brand.”