When exchanges want to reduce their operating costs and diversify their revenue streams their first response is often to seek a merger with another exchange. However, by no means all such mergers ultimately pay off and other options are available.
“We expect exchanges will continue to consolidate, with the announced merger between the London Stock Exchange and Deutsche Börse simply being the latest in a long line,” said Octavio Marenzi, founder and chief executive of consultancy Opimas. “While the logic underpinning these mergers appears to be watertight, migrating to a combined platform can be fraught with difficulties.”
A handful of exchange mergers in the past have failed to live up to expectations as they dealt imperfectly with the technical and organisational difficulties of integrating their operations. Defensive acquisitions to retain market share also often lead to incumbents, frequently slow to adapt, making costly acquisitions in order to avoid running the risk of obsolescence. This was true of Nasdaq’s acquisition of Inet, and NYSE’s acquisition of Archipelago.
A recent report from Opimas suggested bourses should consider more creative strategies, which involve moving aggressively into areas occupied by banks and securities firms.
“In most industries, business strategies aimed at moving up and down the value chain are considered absolutely normal. However, vertical integration of exchanges has not come naturally,” explains Paris-based Marenzi, who previously worked at Celent and Oliver Wyman. “They have been extremely reluctant to trespass on sell-side firms’ territory and offer products and services that might compete with them.”
This hesitancy, he says, is understandable given that sell-side firms are exchanges’ core customers and there are risks in offending them. However, this deference has deeper roots. Exchanges will have to overcome their traditional deference to the sell-side – a legacy of the ownership structure when they were created – if they are to prosper, according to Marenzi.
“The current generation of senior exchange managers came of age in a market where banks and securities firms were not only the virtually exclusive users of the trading platforms, but actually owned the exchanges.”
Few member-owned exchanges remain. Those that were once operated on a semi-profitable basis for the benefit of the banks and broker-dealers that owned them are long gone.
Marenzi says a reluctance to alienate former members persists. Unfortunately for exchanges, the favour is not being returned. “Broker-dealers are constantly creating alternatives to exchanges in an attempt to reduce their dependence on them and shrink the fees that exchanges can charge.
“In the future we expect the boundaries between the sell side and exchanges to blur more and more, with exchanges increasingly performing functions that have historically been reserved for broker-dealers.”
For example, smart order routing, already provided by exchanges for US equities, is likely to become more common for derivatives exchanges. The same is true for European and Asian equities.
“There is no reason that exchanges should not offer more sophisticated orders, including algorithmic trading strategies,” he adds. “Programmed trades would be much easier for users to execute on an exchange than at a broker-dealer. Furthermore, exchanges could easily handle orders facilitating pairs trading, where one stock is sold at the same time as another is bought, without help from the sell-side.
Exchanges could also move into multi-asset trading strategies, combining, for example, FX trades with foreign equities with rising numbers of exchange mergers spanning asset classes. Marenzi also anticipates that exchanges will expand their less cyclical subscription-based services such as market data and push into territories currently occupied by sell-side firms and interdealer brokers.
Total revenues for exchanges globally are growing and expected to exceed $20bn in 2016. Marenzi expects exchanges will continue to flourish and form one of the few bright spots in capital markets. Profit margins for exchanges remain remarkably high with an average of approximately 60% for leading exchanges, according to Opimas.
However, it won’t be plain sailing for exchanges to hold onto their pricing power. “The sell side is experimenting with cheaper alternatives to trading,” Marenzi adds. “Leaner upstarts could take market share, and European regulators have ruled that fees for the fast-growing business of providing market data must be ‘reasonable’.”
“To diversify their product lines, exchanges must increasingly position themselves as alternatives to sell-side institutions. That is an uncomfortable activity for them, but considerable revenues are at stake.”