New York, London, Paris, Frankfurt… all the traditional stock exchanges are changing. Faced with a single, unified global marketplace of international investors and issuers, they have no choice but to expand their reach across national borders. Competition among exchanges is fierce. They strike alliances, upgrade their trading systems and reorganize their governance structures to stay competitive.
The only thing that hasn’t changed much is the language of trading. A New York Stock Exchange floor broker from 1901 wouldn’t need much time to adapt to the language of 2001, though he might have a tough time thinking in decimals and entering cap orders electronically. London and Paris are different matters. Any old traders would be shocked to learn that his contemporary equivalent sits in front of a screen all day. Even a trader from 1981 would be surprised.
As many exchanges have shown, technology has broken down the need for a single, centralized trading floor. Around the world the majority of buyers and sellers never meet face-to-face, despite the fortunes they may trade daily. Whereas technology on the trading floor originally served to support order routing, trade settlement and clearing, it has now come to dominate the exchanges’ core function: matching supply and demand.
Few exchanges today embody the image of a crowded, messy hall filled with excitable, screaming men waving paper slips. Today most exchanges look like high-tech offices, though traders can be just as excitable as ever.
Electronica evolution
In the 1990s the transition from open outcry to electronic trading accelerated and many exchanges worldwide converted to electronic platforms or announced plans to do so. Today most of the European exchanges are fully electronic networks linked to one another.
‘Getting access to foreign investors via the home exchange is quite easy,’ announces Stefan Seip, head of market policy at Deutsche Borse AG. ‘For example, the German issuers who are traded on the Frankfurt exchange can be accessed by virtually all European countries via the Deutsche Borse network. So it’s quite easy to trade on the Deutsche Borse from London as well as from Paris, Amsterdam, Milan and everywhere else.’
The benefits of linking exchanges are evident: cost reduction, transparency of trading activity, improvement of order collection and distribution. There is also the opportunity to win market share from rival exchanges, or lose it, as the case may be.
For some exchanges, linking to others is more necessity than choice. Consider the Australian Stock Exchange which is thousands of miles away from other major markets. Without the electronic links, the ASX would have greatly reduced participation. Today Australia boasts an exchange that is 100 percent electronic with costs that have been driven down by 50-60 percent.
Of course electronic trading also reduces the age-old advantage exchange members have enjoyed as privileged users of the trading floor. Most floors have now been replaced by a network of screens that all participants – domestic and international – monitor equally. Members have not lost their advantages altogether, though they can no longer get away with fees quite as high.
Two strong defenders of the open outcry trading floor are the NYSE and the American Stock Exchange. They point out that while alternative trading systems have been vocal adversaries, their own market shares in the trading of NYSE and Amex-listed stocks have hardly declined. The alternative systems have succeeded in taking far more market share from the Nasdaq (more on this next month).
‘We have been hearing for a couple of decades that there will be no need for stock exchange floors, but our business does not bear that out,’ announces the Amex’s senior vice president of corporate communications, Bob Rendine. Both the Amex and the NYSE have expanded their trading floors in 2000. ‘I don’t think one can make a generalization about floor-based trading diminishing. I think the market will dictate which direction that will take.’
As most of the traditional exchanges replaced their open outcry auctions with computers, the NYSE has never taken an either/or position. Instead it has looked for ways to mesh the two formats and demonstrate they are not mutually exclusive.
‘The main thing that public issuers need to know is that our business is undergoing a revolution in terms of the impact of technology and globalism,’ announces an NYSE spokesman. ‘And this is resulting in some revolutionary changes; the net effect is that we can offer our customers new choices in how they access the liquidity and the information that we have on our market.’
For example, the NYSE is currently rolling out a series of initiatives under the umbrella of Network NYSE, which proposes to give investors and brokers virtual access to the trading floor. One product, called MarketTrac, allows users to travel through a simulated three-dimensional trading floor and access stock information as if they were physically there. This includes limit orders, quotes, news, transactions, and everything else the floor brokers have. Traders then execute their orders through a high-speed connection.
This scenario, akin to a sci-fi novel, is a good example of how traditional exchanges are changing their models as needed. Today they not only face competition from one another, they also face competition from purely automated trading systems.
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Capital search.
Technology has changed not only how issues are traded, but also how the stock exchanges themselves are organized, governed and financed. The old exchange model, which dates back to the 18th and 19th centuries, was a member-owned, non-profit firm where the members alone performed all trades and profited handsomely from their strategic location. This model grew naturally throughout the decades and was well suited to the traditional trading environment.
As technologies opened up the trading floors to participation by outsiders, the member-owned model became suspect. Insiders began scrutinizing the cost of membership versus its benefits, while outsiders began demanding access to the equities markets without having to own the venues on which those equities trade.
During the 1990s, as the world’s exchanges joined the race to modernize, their limitations for raising capital became undeniable. As member-owned organizations, they struggled with the enormous challenge of building state-of-the-art systems and maintaining a good level of technological competitiveness.
Today every major financial exchange is at least considering demutualization, and several have taken steps towards becoming publicly traded companies themselves. The Swedish and Australian exchanges, for instance, are public entities. All but two or three Western European exchanges are joint-stock companies. Vienna is 50 percent owned by its issuers, for example, while Copenhagen and Iceland expect to float their shares in 2001 and other European exchanges, each at its own pace, are following suit.
Gregor Pozniak, the Federation of European Stock Exchanges’ deputy secretary general, summarizes: ‘Where we have had a history of government ownership [of national stock exchanges], government ownership is now down to 40 percent. It has sold to banks, to issuers and to institutions.’
What does this mean for public issuers? Well for one, a profit-oriented exchange, financed fully or in part by equity sales to outsiders, has the potential to be better funded and more efficient than its traditional counterparts. This is a lesson that all the world’s exchanges are coming to accept. The smaller exchanges, in particular, are beginning to see opportunity to raise capital and compete.
Also, open governance impacts the trading floor insofar as the owners stipulate who can and cannot trade. As the circle of ownership gets wider there is a democratizing effect on participation. The more traders there are, the more price spreads and trading costs fall.
Team work
Another impact of globalization comes in the form of alliances among stock exchanges. In Europe, the Paris, Brussels and Amsterdam exchanges allied to form Euronext. The London and Frankfurt exchanges had been negotiating their joint operation, called iX, with Milan, Madrid and Nasdaq before talks broke down. Meanwhile the NYSE has been talking about possible partners all around the world including the Tokyo Stock Exchange, the Stock Exchange of Hong Kong, the Australian Stock Exchange, the Toronto Stock Exchange, Mexico’s Bolsa Mexicana de Valores, Bolsa de Valores de Sao Paulo in Brazil and Euronext. Obviously stock exchange partnerships are a hot topic.
Deutsche Borse’s Seip sums up the benefits for publicly traded companies: ‘Multinational exchanges provide access to multinational investors, which is a good thing and would help the issuers raise capital across borders.’
While international partnerships are undoubtedly good for issuers, Gregor Pozniak says the most important reason for exchange alliances is to satisfy the investment firms. ‘They and their customers want to invest in a bevy of markets around the world. Linking up to ten different European markets is extremely complicated because your IT people have to learn ten different computers; your traders have to look into ten different trading systems, ten different settlement systems, ten different clearing systems, ten different sets of trading rules, and so on.’
Seip agrees. ‘It’s certainly not possible to have a guy sitting there at the trading desk and trading on all the exchanges at the same time. You need to have your Frankfurt Stock Exchange trading desk and your Paris Stock Exchange trading desk and all the others. The big houses have them all but it’s still expensive.’
Seip says that in recent years the big international trading firms have become more pressing in their demands as both stakeholders and clients of the exchanges. For them to relinquish their privileged positions on the exchange floors, they have demanded their needs be met in other areas. Exchange alliances are the natural solution.
Middleman out
One might wonder where floor broker stands in all this. For a few exchanges, he still stands on the trading floor. The NYSE is a good example of what CEO Richard Grasso calls a ‘high-tech/high-touch’ system. Of all the major exchanges, New York has done some of the most aggressive spending on technology, yet it continues to employ open outcry trading on the floor. The argument that modern exchanges must become disintermediated (essentially, getting rid of their middlemen) is clearly contested in New York.
NYSE floor specialists only participate in an average 26 percent of the market trading volume. Therefore the amount of volume in which natural public buyers meets natural public sellers is 74 percent. ‘These are both important numbers,’ claims Howard Eisen, special limited partner of Spear Leeds & Kellogg, ‘as they show that the specialists stay out of the way and let the public trade directly most of the time. However they also demonstrate that when additional liquidity is required, the specialists utilize their capital.’
Eisen says he believes in disintermediation, though it has its limits. ‘I believe that we should all be striving for the most efficient way to trade and that is without middlemen. However, having said that, the fact is that you’d need a specialist or some form of liquidity provider to make sure that there’s consistent price stability under any circumstances.’
Eisen points to electronic communications networks (ECNs) as examples of pure disintermediation. While they are in many ways efficient, their lack of market makers disrupts the flow of trading. ‘There are no third parties adding liquidity there. If there’s a buyer there’s a buyer, if there’s a seller there’s a seller, and if not, the trade doesn’t occur. And the result of that lack of liquidity is, of course, a tremendous amount of volatility.’
Today the European exchanges more closely resemble ECNs than they do traditional exchanges. The NYSE, with its high-tech/high-touch system, may claim they have done themselves a disservice by becoming too automated. If the true test is uninterrupted trading, that claim is untrue. Does pure disintermediation represent the most effective stock exchange model? We’ll pick up the discussion in next month’s article.
