In the twists and turns of the world’s capital markets, the stock exchange is a potent landmark. Nowadays most trading is electronic, but the prevailing market archetype is still the exchange floor. It’s a romantic notion that in many places, including Wall Street, actually exists. Increasingly this model is under pressure from new stock trading paradigms.
This fall’s market correction highlighted the restless and evolving role of markets. As prices cascaded up and down from Hong Kong to New York to London, there lurked the constant pressure of small competitors preying on stray liquidity. This is the fight for volume, the age old dance of major money centers competing against smaller, regional ones. But strike ‘regional’.
‘It doesn’t make a difference if a stock is listed in New York or Reykjavik,’ says Mark Edwards, principal of Plexus Group, a Los Angeles firm advising institutional investors on trading. ‘Electronic space disentangles you from geography.’
For Everett Howe, vice president of corporate IR at the Gillette Company, this new environment prompted a review of the company’s stock listings. As a result, it recently delisted from the London Stock Exchange. ‘With electronic trading, investors can deal in any market around the world. Today there’s less of a need to be listed on regional exchanges,’ says Howe. The extra costs and ‘administrative burden’ of a London listing also swayed Gillette.
As exchanges around the world strive to attract business, innovation, technology and service are driving the competition. And as in any competitive environment, costs are being driven down. ‘Unless trading volume stays at the same rate or continues to grow, the US might not be able to maintain multiple exchanges,’ says one stock exchange executive. ‘I predict a shake-out.’
Like small market centers in continental Europe, regional US exchanges are battling hard to stay out of the consolidation derby. ‘The regionals are doing what they’re supposed to: they’re providing an alternative marketplace so investors can choose where to do business,’ says the Boston Stock Exchange. ‘We play a competitive role in attracting more order flow away from the primary markets, using technology, innovation, and new services to attract business.’
Often price pressure comes from mutant upstarts. For example, a new ‘black box’ trading system called Optimark has regulatory approval and is planning to start up in the spring. The UK’s Tradepoint is seeking SEC approval to admit US investors and expects the go-ahead by year end. The advantage of such systems – like Instinet’s Crossing Network – is that institutions can trade large blocks without moving the market.
Broken Pieces
The NYSE has vehemently campaigned against Optimark and other ECNs (electronic crossing networks). Recently it has resisted SEC pressure to open the US intermarket trading system (ITS) to such players.
‘We are seeing the growth of fragmented markets, and the NYSE feels its franchise is embattled,’ notes Edwards at Plexus. But others are more gung-ho. ‘Competition is good for this business just like any business,’ notes the BSE. ‘However we are cautious about the idea that just anybody could declare themselves an ECN and hook into a system that’s been in existence over 20 years.’
Paradoxically, the only way these fragmented markets can work is by integrating, Edwards explains. ‘The same thing is happening all over the world: small bourses are going to end up consolidating. They’re already taking large steps in that direction with so much cross-market trading.’ It seems one of the lessons of technology is integration. So there may be more exchanges, and alternatives to them, but connectivity means consolidation is inevitable.
The most amazing trend leading up to the millennium is the convergence of the two main market models. Programs like the BSE’s competing specialist initiative add a tinge of the dealer market to the traditional auction market. More significantly, London’s introduction of order-driven trading is a bid to reverse the flow of listings to New York’s auction market.
In many ways, these changes auger well for listed companies and investors. A market maker system like Nasdaq’s or London’s promotes liquidity in hard-to-trade issues, but transparency suffers. Auction markets, on the other hand, are highly transparent but do little to drum up interest in illiquid stocks. A combination of the two clearly has its advantages.
In the short term, though, the going is getting tough. Since trading spreads have been squeezed under new rules imposed on Nasdaq, so have broker-dealer profit margins. That has meant some major players are ceasing to make markets in many stocks, typically the small, hard-to-trade issues. Merrill Lynch, for one, in September dropped about 350 – or 40 percent – of the Nasdaq stocks it traded.
While market forces are driving such developments, the arbiter of change may turn out to be regulators. In the US, the SEC has been gathering comments on a ‘concept release’ covering a wide range of issues, from the regulation of ECNs to the national exchanges and foreign market activities. Issues like transparency and access, regional and national boundaries, disintermediation and cost of capital are sure to play roles in regulatory mapmaking, in the US and abroad.
On the bright side, experts believe that the same competitive pressures driving down the cost of trading are reducing the costs of listing for companies, and even pushing down the cost of capital. And while US markets still seem to provide the best combination of liquidity and transparency in the world, exchanges elsewhere are learning from the US example.
Neil Stewart
Black Boxes & Penny Markets
Innovation is rife north of the 49th parallel. Jeff Cossette reconnoiters from Montreal
In their struggle to stay afloat amid the global wave of technological change, Canadian stock exchanges are rapidly adapting. Underlying the process is a determination to boost their relevance in an increasingly networked world.
Meanwhile, technology has also engendered a generation of start-ups thirsty for capital. Take Quebec. Looking to channel money into a growing brood of high-tech fledglings, local financials heavyweights are considering a penny stock market. A government-sponsored committee is expected to report early next year.
Observers haven’t failed to notice the likes of Montreal animation software designers Softimage and Discrete Logic listing on Nasdaq while other promising local companies go to junior markets elsewhere in Canada. Perhaps the penny market’s most rosy-cheeked cheerleader is Quebec’s venture capital community. For them, another route to going public means another exit mechanism to cash out.
Links with other markets make sense, and getting the Montreal Exchange on side may prove critical. While the ME has relaxed listing rules for high-tech companies, Louis-Francois Hogue, vice president of Quebec City-based Aeterna Laboratories and penny market committee coordinator, warns that this process could backfire if taken too far. ‘You can’t lower listing requirements unduly and remain seen as a senior exchange,’ argues Hogue, a former ME director. ‘Many senior exchanges have benefited from a junior platform which can complement rather than compete.’
Niche Market
Launching a new market, even with the blessing of the ME, means addressing the twin issues of liquidity and investor confidence. Hogue is upbeat. ‘Every exchange develops a niche,’ says Hogue. ‘Maybe we can create a new exchange that focuses on the new economy. If you are a focused exchange, you get the investors.’
In Toronto, the country’s largest stock exchange is pondering new ways to attract institutional traders. To make big trades more efficient, the TSE is considering a ‘black box’ electronic network – matching orders in a call market. The idea is similar to Instinet’s Crossing Network.
Different Strokes
While it’s a dramatic departure from the TSE’s traditional open auction style, institutions like the idea because they can quietly trade large blocks with minimal movement in the bid and ask price.
On the other hand, selling the TSE’s own member brokers on the idea seems at first an uphill climb. Block trades done on the electronic exchange would see money managers name the broker that earns a commission on the deal.
‘This basically accelerates the shift toward an environment where brokers get paid for ideas rather than transaction skills,’ says Susan Crocker, TSE senior vice president for equities and derivatives markets. ‘In the end, clients will go where their needs are being met.’
Crocker suggests that the options for brokers are simple: they can either be part of a solution or watch while business goes to a non-exchange member. Still, like her counterparts in Quebec, Crocker has a lot of work ahead. The TSE expects to release a preliminary report in January.
While the TSE grapples to make big trades fair and efficient, strong standards appear urgently needed at a TSE subsidiary, the Canadian Dealing Network, which has eclipsed the Vancouver and Alberta markets as the hotspot for smaller, speculative firms. With 950 listings, and no listing standards, the OTC market’s lack of regulation was spotlighted in a recent Ontario Securities Commission report.
Among other failings, the Commission found some companies didn’t disclose material information while others simply used overly promotional and misleading language. In a bid to avoid the pitfalls of junior markets elsewhere, not to mention the ire of investors, the OSC is looking to crack the enforcement whip harder in the future.
Banding Together in Europe
David Fanning detects a new level of cooperation among Europe’s exchanges
If the recent experience and planned future of Europe’s stock exchanges were to be summed up, then ‘electronic trading’ and ‘cross-border linkage’ would seem to do the job. The picture is one of change, modernization and systemization.
As Dr Jean-Pierre Paelinck of the Federation of European Stock Exchanges says, Europe’s capital markets are on the move. ‘European markets encounter competition from all over the world,’ he warns. In his view, regional cooperation is the most effective way of meeting that challenge.
There is a strong feeling among some exchanges, however, that not everything that could have been done has been done. As one exchange director comments, ‘The European exchanges could have saved themselves an enormous amount of money if they had worked together more fully, for instance in developing common software and trading systems.’
Currently, there are around 9,500 companies with equity listed on the 17 FESE member exchanges, although some of those have multiple listings. Significantly, London accounts for around 32 percent of those listings while the rapidly-expanding Deutsche BÃœrse accounts for 24 percent. A measure of the German exchange’s rate of international growth is that 392 foreign companies began trading in Frankfurt during 1996 while 51 joined London. Foreign companies now represent more than 70 percent of the Deutsche BÃœrse’s listed equity stocks.
Changing Environment
Regulatory, cooperative and technological initiatives are changing the ways exchanges operate and the environment for investors. The EU investment services directive – still not fully implemented in most member countries – gives authorized investment firms a ‘passport’ to participate in any European market. Exchanges will be obliged to admit such firms to remote membership.
Another factor is the Eurolist project, under which major companies already officially listed on one European stock exchange can use a simplified procedure to obtain listings at other European exchanges. While domestic financial reporting requirements and company structure legislation will continue to pose difficulties, there are growing signs that cross-border listings are on the increase and becoming easier to achieve.
In a parallel move, there is a speedily evolving process of integration taking hold among FESE member exchanges. There have been a handful of bilateral and regional linkages in recent months.
The fourth, and probably most evident, factor in the European exchanges’ development is the extent to which they have met the challenges posed by information technology. Electronic trading and settlement are now the order of the day and several European exchanges are having to invest substantial sums and considerable effort to meet the expectations of market makers and investors.
Developed by SBF-Paris Bourse, the NSC electronic package is rapidly making its mark on international trading systems. The NSC is already the designated trading system for many of the world’s largest exchanges, including those of Toronto, Brussels and Sao Paolo, as well as for the French futures market, the Matif.
Order-driven electronic trading is becoming the central focus of the London marketplace too, with the inauguration in October of the London Stock Exchange’s new trading system. Attempts to introduce computerized trading to the exchange have been going on for some years, and effectively led to the dismissal of the previous chief executive. The new system is initially being restricted to the shares of the top 100 companies but may be extended next year.
European market makers are attempting to emulate the success of Nasdaq, which is continuing to attract European companies to its automated market. Easdaq, the European Association of Securities Dealers Automated Quotation market, launched a year ago, has now attracted 17 companies to its trading lists and expects that figure to rise to 30 or 40 over the next six months.
To counter the threat posed by Easdaq and the success of London’s Alternative Investment Market, four of the continental European exchanges have created Euro.NM, a market network for the shares of the many newer, smaller, fast-growing and perhaps more risky companies anxious to have ready access to the capital markets.
Rising to Challenges
Uniting the Nouveau Marché in Paris, NMAX in Amsterdam, Euro.NM Belgium in Brussels and the Neuer Markt in Frankfurt, Euro.NM is establishing a common datafeed and launching a Euro.NM index. However, market makers point to a stubborn syndrome among investors: the reluctance to accept that the new markets are both appropriate for debutant companies and safe for investors. Turnover in Euro.NM stocks remains very low.
European exchanges face a number of daunting challenges in the years ahead, with perhaps the biggest of those coming from the globalization of financial business. Issuers carry on business in a host of foreign countries and quite often wish to issue securities abroad. Additionally, investors are seeking opportunities to maximize profit and spread risk. Foreign markets are attractive to many as a source of diversification.
While there are encouraging signs that Europe’s exchanges have begun to meet those conditions, there are continuing worries about the liquidity of several of the markets, especially those outside London, Frankfurt and Paris. The institutionalization of investment, with the unabated rise in the influence of mutual funds, pension funds, insurance companies and the like, increases block trading and raises questions of liquidity, while electronic trading is not designed to reduce that impact.
Further Changes
There are further changes ahead, as Europe gears up for the launch of the euro on January 1, 1999. ‘The European financial markets will be confronted with competition to a degree previously unknown,’ says Dr Werner Seifert, Deutsche BÃœrse’s chief executive officer. ‘The euro will lead to a sharp differentiation between national and international financial centers. A handful of international centers will attract the large market players. In the next 20 months it will be decided whether Paris or Frankfurt will grasp the opportunity to develop into the international financial center on the Continent,’ he believes.
Transparency Questions
Where does all this leave investor relations? The exchanges and their market makers point to the very real IR benefits to be derived from electronic trading, with buying and selling information generally being readily available worldwide within minutes of order execution.
There is a developing fly in this ointment, however. The probable introduction next year of anonymity into trading deals on London’s system will render the process less transparent than most issuers would like.
Adrian Rusling of European IR consultancy Kuhn Partners welcomes the greater amount of information that is now available but cautions that the data must be interpreted and understood. ‘In terms of shareholder identification, there is now a lot of information on mutual fund holdings, less so for pension fund and private client positions. But the information needs to be examined carefully, particularly where a fund is domiciled in one market but actually managed from another.’
Paradise Lost
What is the future of foreign capital in Asia? David Lake offers an assessment
The days of cheap equity for Asian corporates are over. As one investment banker puts it, ‘The fool’s paradise Asian issuers have been living in has come to an end.’ The Asian currency crisis certainly took its toll on exchanges; and analysts across the region are predicting fewer IPOs at lower valuations.
‘As for foreign capital flows, the risks are going to be much higher for investors, especially since they have no way of knowing where currencies are going over the next two years,’ says Jim Grant, Singapore-based senior economist for Crédit Lyonnais Securities Asia. ‘There will be a decline in foreign involvement, but capital will return. Look at Latin America. Bankers and financial markets have short memories.’
For now, concerned that the Asian miracle may indeed be over, or at least in a period of hiatus, billions of dollars have flown from the region to markets in Latin America and Eastern Europe. This capital flight has forced companies to answer critical questions about the importance of foreign capital as investors re-think Asian weightings.
Asia has not taken this snubbing well. Market disappointment in the flight of foreign capital is evident in the words of Malaysian Prime Minister Mohamed Mahathir. Though most market participants write off his diatribes as intense paranoia, he has a receptive audience in the region.
Basically, Mahathir notes that Malaysia, like most other Asian capital markets, welcomed foreign investment. ‘But when the big funds use their massive weight to move shares up and down at will and make huge profits by manipulation, it is too much to expect us to welcome them,’ he notes, ‘especially when their profits result in massive losses for ourselves.’
Malaysia, along with Thailand, has been heavily damaged by the flight of foreign capital. As long ago as the end of August the KL Composite fell 8.3 percent during one day’s trading. It was the biggest drop in KLSE history and officials implemented trading limitations to stem short selling of the 100 stocks that compose the index and to reduce settlement periods. Foreign investors, who understood that the policies were aimed at them, voted with their feet.
‘You have to be a long-term investor to be talking Malaysia at this stage. The economic fundamentals are much worse in Malaysia than in Singapore,’ says Nick Bryan Brown, head of corporate finance at Peregrine for Singapore and Malaysia. ‘Due to strain on the banking system, the level of bad debt and investors’ perception of the way the economy is being handled, it will take some time before the market turns around. We feel both the currency and market are headed down even further.’
The role of foreign capital in the future development of Asia stock markets is reaching a new phase. For many years exchanges like those in Jakarta and Manila have been fueled largely by foreign investment volumes. On some days as much as 80 percent of the volume was generated by foreigners. While it is difficult to judge the total size of foreign involvement in Asian markets, it could be in the 30-50 percent range. The good news is that this changing dynamic is seeing greater involvement from locals in the development of the capital market.
In the aftermath of the Asian market crises foreign investors are re-evaluating asset allocation parameters. While this re-thinking is going on in institutional investor and fund management boardrooms worldwide, it is interesting to consider the diminishing strength of local exchanges since the markets’ peak in 1994.
For the most part, the battle for investor attention has clearly shifted in favor of the exchanges in Greater China. Of course, any calculation of Asian market capitalizations is impossible right now: by the time you’ve done the sums, the figures are already out of date. But some of the wider trends have been evident since the 1994 peak.
Since then, Hong Kong’s share has risen to 38 percent. Taiwan is next with 23 percent. Singapore, which has long vied for Hong Kong’s position as the financial center of Asia, saw its share of market cap decline from 15 percent to 10 percent in this period. One reason has been Singapore’s treatment of foreign investors, who are irritated by a market structure that has pushed them to pay a premium for a select group of blue chip issues. Investors must purchase so-called ‘foreign shares’ when buying into companies deemed to be of national strategic importance. A lack of US dollar denominated foreign shares has pushed up the price of some companies. In one case, the premium surpassed the 100 percent mark.
Still, some believe Singapore could rebound and Hong Kong could be headed for a fall. ‘Singapore blue chips are attractive whatever the foreign share premium to the local share market is,’ concludes Hong Chye Quah, a research analyst with Merrill Lynch. ‘We sense the government is considering moves to make Singapore much more competitive.’
‘Hong Kong may be dominant short-term and should remain so for as long as China does not get its act together in promoting Shanghai,’ says Grant. ‘You can’t have the magnitude of recent change and hope everything stays the same. Don’t count Singapore out. It has made headway and is in a position to come back against Hong Kong.’
For now, the Asian miracle may have run out of steam and turned off many foreign participants. As volatility increases in the years ahead, both Asia’s stock exchanges and their listed companies will have to pay more heed to what their investors want in the future.
