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Big Bang Marches On

Author: Benn Steil, Senior Fellow and Director of International Economics
October 23, 2006
Financial News


20-year anniversaries are a good time to look back and recount the happy narrative that led us to our present state of bliss and perfection. They are also a good time to contemplate how primitive we will look when the next one rolls around.

The London Stock Exchange of 1986 was focused on modernizing its market structure. Today’s LSE and its continental counterparts are wholly pre-occupied with mating dances, and have taken their eye off the bread and butter business of market structure development. No longer operating as broker co-operatives, one would have expected them to be far more aggressive in their efforts to out-internalize their members. The irony of so-called “Direct Market Access” (DMA) for the buy-side being provided indirectly by the sell-side has been lost on the exchanges, who continue to ignore the vast profit potential of providing hedge funds with true DMA. At twice their current charges, the exchanges could still undercut broker middlemen. When a few years back I suggested as much to a European exchange exec he called me a “terrorist.” (I was, of course, offended. The polite term is “insurgent.”)

It’s not just the locusts being cold-shouldered by exchanges, but the blockheads. I refer, of course, to the traditional buyside, who have made Liquidnet’s block trading platform the most successful market structure innovation since 1969, when Instinet first introduced the continuous electronic order-matching architecture—an architecture which dominates the exchange world nearly 4 decades on. Trade sizes on Liquidnet are, on average, 100 times larger than those on exchange order books. More recent non-exchange offerings like Pipeline and the broker-bankrolled BIDS are also attacking the block trading space. The exchanges, though, remain convinced that Fukuyama’s End of History thesis, while having been shown to be bunk in the world of politics, somehow applies to their Cold War trading architecture. But just in case they’re wrong, EU and US regulators are doing their best to stop innovation. MiFID and Reg NMS will in 2007 elevate pre-trade transparency, the single greatest flaw in today’s exchange systems, to the status of sainthood in the Church of Best Execution, all the while continuing to bless soft-commission fleecing of fundholders. Go figure.

2007 is shaping up to be the Year of the Plumber. Whether Euronext ultimately opts for an American or German dowry, clearing and settlement is set to take centre stage in the battle to beat down trading costs. Market pressure is pulling against vertical integration in the cash markets, but towards it in derivatives.

As stock exchange consolidation progresses, it becomes ever more important to users that the trading system market remain contestable, which requires that new competitors have access to the plumbing. When Deutsche Börse bought Clearstream in 2002, they made access to the system verboten for competitors, thus ensuring continued monopoly in German share trading. The glorious 2004 price war between Euronext and LSE for Dutch equity trading, on the other hand, was only made possible by shared access to the London Clearinghouse. Thus if Euronext merges with DB, market pressures for dismantling the German silo will be considerable. And if Euronext opts for New York, pressure for linking, and eventually integrating, LCH with DTCC will also emerge as shareholders focus on maximizing transatlantic synergies. This will require an unprecedented level of transatlantic regulatory co-operation, as legal and regulatory barriers to EU and US plumbing consolidation are even greater than those within the EU.

On the derivatives side, market pressures currently weigh in the opposite direction. ICE’s purchase of NYBOT was first and foremost a move to free ICE of its clearing dependence on LCH. Euronext’s Liffe derivatives arm has never been satisfied with LCH’s support on product development, and no doubt would welcome a vertical alternative as well. Yet since derivative products can be replicated by other exchanges, there is much less market concern about silos for derivatives, in contrast with stock.

Jurisdiction shopping among market participants is surely set to grow in line with the proliferation of cross-border electronic trading links. Exchanges are no longer defined by geographic home, but rather by legal home. The efforts of the NYSE and Nasdaq to acquire European exchanges should properly be seen as efforts to acquire European jurisdictions, thus freeing their struggling listings businesses from the clutches of the American Congress. The combined effect of Sarbanes-Oxley and repeated congressional capital markets sanctions campaigns against Chinese and Russian companies has been devastating for US exchanges, which now face a much harder sell with foreign—and, increasingly, domestic—companies shopping for a public listing. The political battle launched by Nymex against fellow American exchange ICE, over the latter’s use of a UK regulatory domicile for US-traded oil futures, presages many such conflicts to come. Both the SEC and CFTC have raised their level of cooperation with their European counterparts—not out of a newfound American love of multilateralism, but rather a sense of realpolitik over the migratory capacity of the securities markets.

The FX spot market is a latecomer to centralized clearing, owing to the powerful interest of the biggest FX banks—Deutsche Bank supreme among them—in blocking the dismantling of bilateral credit relationships with clients. But the benefits of centralized clearing—elimination of counterparty risk, transaction cost savings through netting by novation, and post-trade anonymity—are so overwhelming as to make it inevitable. The success of the LSE’s SETS platform owes everything to the launch of centralized clearing in 2001. The recently announced joint venture between Reuters and CME to produce a centrally cleared FX spot market is the most compelling sign yet that post-trade plumbing has surpassed trading systems as the driver of exchange competitiveness.

The Big Bangs to come will be far more buy-side driven than those of the past. Two forces are at work here. First, brokers no longer control the supply side of the industry, the exchanges. Second, brokers are losing control of the demand side, which is increasingly dominated by hedge funds who are much less dependent on soft-commission services than their long-only traditional counterparts. And not only are hedge funds driving change from below—hedge fund FX volumes should surpass interbank volumes by 2010—but they have replaced brokers as the largest and most vocal owners of exchanges. So if you want to imagine how much change we’re in for over the next 20 years, ask yourself—do today’s exchanges look anything like what a hedge fund would design?

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