The Perennial Profit Challenge: 2013 Roadmap for World Exchanges

Posted on December 16, 2012. Filed under: Exchanges, Practitioners, Regulations, Securities and Exchange Commission, Technology | Tags: , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , |

Edgar Perez and Sir Richard Branson

Edgar Perez and Sir Richard Branson

Financial exchanges play a vital role in economic development as one of the primary tools for the allocation of capital in both developed economies and emerging ones. The indices created using the platforms provided by global exchanges are used by the financial services industry and the government as barometers of economic health and a predictor of national financial well-being.

However, the exchanges model has changed dramatically over the past decade starting with demutualization. The first wave began with the Stockholm Stock Exchange (STO) in 1993 and included the Bombay Stock Exchange (BSE) in 1995 and Borsa Italiana (BVME) in 1997. Demutualization was followed by a second stage in which a number of exchanges became publicly traded and profit-seeking companies listed on their own platform, with the Australian Securities Exchange (ASX) being the first to follow this model in 1998. Such restructurings are still taking place in exchanges all over the world.

Exchanges have come under increasing regulatory attention. In the US, for instance, the Securities and Exchange Commission is expanding an enforcement probe into a broader look at how exchanges develop new products, communicate with investors and provide incentives to trade; this was sparked partly by an SEC probe into trading order types apparently benefiting high-speed traders, whose activity comprises more than half of all stock-trading volume.

As companies exercise more flexibility in seeking to raise capital outside their national boundaries, the environment has become even more competitive for exchanges. Furthermore, they are hugely capital intensive (mostly due to the IT infrastructure required for increasingly high frequency trading), reason why some exchanges are looking to grow through acquisitions in order to enjoy greater economies of scale.

While these challenges are common to exchanges worldwide, the impact on their bottom lines has been rather diverse. For instance, the Philippines Stock Exchange (PSE) doubled its profit in the first nine months of 2012 compared to last year. While the exchange benefited tremendously from the favorable economic environment and sky-high optimism in the country, there were a number of reforms implemented by the PSE, including the rollout of a new trading system, extension of trading hours and implementation of multiple regulatory and governance enhancements.

London Stock Exchange (LSE) reported a profit for the first half of the year nearly unchanged from last year as strong performance in information services helped offset weak capital markets. The exchange highlighted the benefits of its increasingly diversified international group and the growth from its Information, Post Trade and Technology businesses; the exchange reported a 66 percent increase in Information Services revenue, while Capital Markets revenue dropped 19 percent.

On the other side of the spectrum, NYSE Euronext, the operator of the New York Stock Exchange and other stock exchanges, announced that its third-quarter profit fell 46 percent, which the company attributed to reduced average daily trading volumes, primarily related to its derivatives business. It said its results last year were helped by the extreme volatility of the markets in Europe and the United States due to debt concerns. Certainly, volatility has declined considerably since then, reaching multi-year lows in August 2012.

Exchanges are responding to this increasing competition in a number of ways. Negotiating mergers has been the first option considered by a number of companies, only to be derailed in some cases by regulators or rebuffed by targets. NYSE Euronext face resistance from European regulators on its proposed combination with Deutsche Boerse; ASX’s agreement with Singapore Exchange (SGX) fell through as well; LSE dropped its bid for Toronto Stock Exchange (TSX) after its owners spurned them in favor of the bid from a group of Canadian banks and pensions. However, that doesn’t mean that exchanges will not attempt to find combinations that don’t run afoul of regulations, just because mergers almost in all cases strive to provide an avenue to widen their business model and to exploit economies of scale, economies of network, cross selling opportunities and trading hours; for instance in Asia, Tokyo and Hong Kong shortened their midday halt to one hour last year, while Singapore scrapped its lunch break altogether, joining Australia, South Korea and India on the list of exchanges that have uninterrupted trading days.

Second, developing cutting edge-edge technology and its further commercialization is paving the way to extract additional profits from investments already paid. For instance, LSE leveraged its IT investments with the adoption of an outsourced managed services model that allowed the exchange to run other exchanges, such as the Johannesburg Stock Exchange, using its own platform. Building a major technology franchise through outsourcing was vital for the LSE if it was to continue to compete with the likes of NYSE Euronext and Nasdaq OMX, which had extended their brand and influence in several emerging markets through major technology deals.

Finally, exchanges are standing up to the challenge of diversifying their business model. Exchanges that were primarily focused on cash trading decided to integrate services such as the trading of derivative financial instruments markets. As it was the case for LSE, information services delivered in machine-readable format are providing growth opportunities for exchanges worldwide; RapiData, company acquired by Nasdaq OMX, enabled the company to deliver U.S. government and other economic news directly from the source to customers interested in receiving information in an electronic feed, giving them instant access to events that are incorporated into algorithmic trading systems. The perennial appetite of high-frequency and algorithmic trading firms for faster access to trading data is also encouraging exchanges to provide colocation services that bring all participants equal access to their matching engines. Ultimately, exchanges will be forced to explore all upstream and downstream opportunities in the production chain of the exchange industry, from the above mentioned information services upstream to the integration of clearing and settlement services downstream.

Revenues at exchanges will need to evolve from its reliance on volume-dependent fees and commissions for a range of activities (including trading, listing, clearing, settlement, depository, custody and nominee services) to uncorrelated income sources that might not have existed just a few years ago; the infrastructure they have, the data they manage and proximity to their matching engine are all key assets that need to be fully exploited if exchanges are to succeed in 2013 and beyond.

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