Many of the world’s biggest corporations have engaged in mergers and alliances in recent years in an attempt to gain competitive advantage. Now, stock exchanges are doing the same. In Europe, Asia and the United States over the past few months, exchanges large and small have either proposed merging, announced alliances or held conversations with prospective partners. Exchanges are seeking to add capabilities they do not currently enjoy, to achieve economies of scale, and to fend off increasing pressure from electronic communications networks, or ECNs. ECNs allow trades to be matched on computers that interact with the NASDAQ National Market System, away from traditional exchanges. The scramble for partners raises a host of regulatory, financial and technical issues that have to be ironed out before consolidations can get into full swing, according to Wharton faculty members. In fact, some exchanges may see no reason to merge with others. Nonetheless, it is clear that partnerships among many exchanges, in some form or another, will increase in years to come. "The entire structure of the equity markets is changing radically, and all of the exchanges are ‘in play’, as people like to say," says finance professor
"They’re all trying to get order flow," says Kenneth A. Kavajecz, assistant finance professor. "Volume is what makes an exchange work, and they’re trying to gather as much volume as they can."
Finance professor Richard Herring agrees. "The driving force is the fundamental economic proposition that the liquidity of any market is proportionate to its size. So there are enormous economic pressures to put together bigger and bigger markets. The pressures are especially evident in Europe where there is, for the first time, the possibility of thinking about Euroland, the 11 countries that have adopted the euro as a common currency, as a truly single, integrated market."
The London Stock Exchange and the Deutsche Borse in Frankfurt announced plans on May 3 to merge and form a new exchange called iX. In a joint venture with NASDAQ announced the same day, iX said it would set up a separate market for so-called new-economy stocks. Meanwhile, Tradepoint, a British electronic stock market controlled by investment banks, has begun talks with the Swiss Exchange about creating a market for European blue chips.
But the prospects of partnerships are occurring all over the globe. NASDAQ and the Stock Exchange of Hong Kong have entered a co-listing agreement. Just last week, shares of Microsoft, Applied Materials and five other NASDAQ stocks began trading on the Hong Kong bourse. For its part, the New York Stock Exchange has also dipped its toe in the water, holding talks with markets in Canada and Latin America about alliances. The Big Board has also held discussions about trading shared listings with Euronext, which unites the Amsterdam, Brussels and Paris exchanges.
Eric K. Clemons, professor of operations and information management, says the urge to merge in Europe is driven, in part, by practicality. "If a company’s business crosses borders, it’s just easier if the stock is traded in one place rather than among three or four different exchanges," he says. "It’s easier for investors. It consolidates liquidity. It’s also probably easier for securities firms to deal with one set of interfaces to one exchange, rather than multiple interfaces with multiple systems."
In addition, exchanges are feeling competition from ECNs. "Much of what the exchanges have historically done can now conceivably be done much more efficiently and at much lower cost with the technology offered by ECNs," Herring says. "The economic motive for people to trade on ECNs is simple — they’re cheaper. They are a very major threat to exchanges. For their part, exchanges argue that ECNs are a threat to the integrity of markets because they’re not as transparent."
While a wave of consolidation is expected to take place in years to come, some exchanges may decide they have no need to forge links with others, says Kavajecz. "Some have argued that because country barriers have been erased and the regulatory structure is in some sense uniform in Europe due to the European Union, we will see a strong consolidation," Kavajecz says. "However, that premise is built on this notion that all exchanges are providing the same service. To the extent that some exchanges are providing a different service than others, there’s no reason to expect them to consolidate." As a result, some exchanges may remain niche players, specializing in small trades or trades in large blocks of stock.
Indeed, the very structure of an exchange may be a factor in determining the type of merger partner it will seek, since certain market structures lend themselves to one type of trade versus another, Kavajecz explains. ECNs are pure limit-order markets in which there are no dedicated specialists to provide liquidity. In the case of NASDAQ, there are designated market makers but only in a collective sense; if a NASDAQ market maker does not want to supply liquidity on one side of the market, he can make his quote so unfavorable that he is out of the market for that stock. However, the specialists on the Big Board do not have that option, since they are required to be present to maintain an orderly market.
"So here are three different structures that have their own benefits and costs, and each exchange realizes that each of the other structures has benefits and costs," says Kavajecz. "I think exchanges are trying to position themselves to take advantage of the benefits they just don’t have."
As an example, Kavajecz points to a plan announced in March by Archipelago, an ECN, and the Pacific Stock Exchange to create the first fully electronic national exchange for stocks listed on the New York exchange, NASDAQ and the American Stock Exchange. "The ECNs are growing very fast, so the Pacific exchange, I think, would like to access Archipelago’s order flow, while Archipelago would like to access the consolidated quotes that the Pacific exchange is part of."
Another example, says Clemons, involves the talks between Tradepoint and the Swiss exchange. "Tradepoint so far has not been able to make a go of it in practice. If you want to sell an instrument, you probably want to sell it now. If you take it to an illiquid exchange and it doesn’t trade and sits there two or three days, that’s probably because everybody was trying to buy when you were trying to buy, and trying to sell when you were trying to sell. In theory, you get a better price in the ECN because there are fewer intermediaries, but that’s only true if you execute. If not, you pay a significant penalty – the opportunity cost. But if the ECN is liquid, you get a better price and better execution. So what I’m guessing is that if Tradepoint, which has a lovely design, merges with an exchange, they may be able to pick up liquidity in one fell swoop."
In general, Blume says, mergers will probably hurt some brokerage firms but help investors. "Brokerage firms, as a whole, will probably make less money, although some won’t, and individual investors will pay less in commission costs because when you have more buyers and sellers coming together, the difference between the prices at which people offer to buy and sell a stock [the spread] becomes narrower," Blume says. "In years to come, individuals will be able to go directly to the markets, bypassing the traditional role of the brokerage firms. Brokerage firms will still have a role, but not a major role. Clearing processes will still have to go on, but as they become harmonized across countries, that process will be very cheap."
The changes in the equity markets have drawn the attention of regulators. In a speech in Australia in May, Arthur Levitt, chairman of the U.S. Securities and Exchange Commission, said he was concerned about the effects consolidations may have, including a lack of innovation. Meanwhile, a team of experts headed by former U.S. Federal Reserve Chairman Paul Volcker is working to develop a common set of accounting and financial reporting standards to allow companies to list on any exchange in the world.
Indeed, Clemons says one major impediment to mergers is the existence of different regulatory regimes and differences in the behavior of market participants. "What constitutes insider trading in the U.S. is very different from what constitutes insider trading in Hong Kong. One of the most serious impediments the New York exchange has in seeking any kind of merger partner is that it’s the best-regulated market in the world. Not all companies elsewhere want to disclose what they pay their chairmen."
Herring notes that there has been some movement by non-U.S. companies to get closer to adopting U.S.-style financial reporting standards. "Some German corporations [such as DaimlerChrysler] are a striking example of this. The amount of liquidity available in U.S. markets is so great that corporations with very opaque traditions and serious reservations about disclosing much financial information have found it worthwhile to adopt U.S.-like accounting and reporting standards."
Despite the obstacles, Wharton scholars say exchange partnerships are here to stay. "When Chrysler and DaimlerBenz merged, something interesting happened," Blume notes. "The company created a share that could be traded in either Germany or the U.S. You could buy it in Deutsche marks in Germany and sell the same share on the New York Stock Exchange. Thus, the barrier between European and American markets is vanishing. I expect that, over time, there will be an increasing number of shares that could be so traded. This requires harmonization of the [stock] clearing process. Because of this, local markets are no longer protected. The result will be new alliances, new mergers, all across the world."
