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Exchange wars

Published in Automated Trader Magazine Issue 31 Q4 2013

Securities and derivatives exchanges around the world are facing severe headwinds, or depending on your viewpoint, "opportunities"...

Adam Cox talks to senior exchange executives and a range of industry players in this "six-part story" to examine some of the burning issues. Regulatory changes are encouraging new lines of business and new business models, merger and acquisition activity is dominating the headlines, venues are scrambling to come up with products they hope might catch fire.

So Automated Trader decided to take stock of some of the forces which are redefining the trading venue landscape. We've spoken to top executives, analysts and market participants to provide a snapshot of some of the main themes.

Part 1: Pump up the volume

It's been a long time coming, but the market finally has something to cheer about in terms of volumes. Ultra-low interest rates, a post-crisis hangover, investor skittishness and a variety of other factors had all conspired to keep volumes slack. But that seems to be changing.

"For the first time since 2008, the value of share trading of WFE stock exchanges increased sharply (+23%) in the first half of 2013," the World Federation of Exchanges said in its latest report. Yes, there have been other positive growth rates since the Lehman Brothers bankruptcy (for instance, a 5% gain in the first half of 2011), but by comparison those were anemic.

Exchange overview
Source: World Federation of Exchanges

For exchanges around the world, this couldn't come at a better time. A lot of the credit goes to the Asia-Pacific region, where, as the WFE noted, the value of share trading jumped 52% in the first half of 2013. Japan notched up a staggering 111% growth rate while China turned in a mouth-watering 54% gain.

Arnaud Giblat, an analyst who covers the exchange sector for UBS, said there is a correlation between economies, market activity and turnover velocity. In a research paper, he predicted European exchange volumes would keep rising into 2015, based on the relationship he identified between trading and economic trends.

"Overall I showed that there is a decent correlation between activity levels and economic growth," Arnaud told Automated Trader.

Arnaud prefers to focus on turnover velocity - the number of times the market capitalisation trades itself - as opposed to pure volume because it gives a better indication of the underlying trend.

He views volume trends from a cyclical perspective and he suggested a recovery may be underway. He said volumes are currently well below the mid-cycle level. He also said 2007/8 volumes were abnormally high and the 2012 decline looked primarily cyclical.

Among the firms most likely to benefit from an uptick in volumes across asset classes were: Deutsche Börse, BME, Tullett, ICAP and LSE in that order, he said in a recent report.

The only real cloud on the horizon had been the threat of a financial transaction tax (FTT), which several analysts had estimated could make a modest dent in volumes once it was clear what form the tax might take. But a major legal blow to the EU's FTT ambitions emerged in September, making even that threat now look like a side-issue.

So is it time for trading firms to break out the champagne? No one is doing that just yet, but there is little question the mood has lifted considerably from the doldrums of 2011-2012.

Arnaus Giblat, UBS

Arnaud Giblat, UBS

Indeed, from an exchange perspective, many believe the additional requirements from the European Market Infrastructure Regulation (EMIR) are actually helpful. "EMIR is not a problem," Arnaud said, "EMIR is an opportunity for OTC clearing. In a nutshell, that's how I'd summarise EMIR."

Still, one regulatory area of focus continues to threaten the exchanges: either via the review of the Markets in Financial Instruments Directive (MiFID), legislation from the European Parliament or attempts to keep the FTT idea alive, the EU has looked at various ways to rein in high frequency trading. Arnaud said industry figures suggest at least 40% of volumes are high frequency trading.

"So at first glance it looks like it could be terrible. Now, the question is, if you take away high frequency trading activity, do you subtract those volumes from existing volumes, or do you put a multiplier on it, because of the virtuous circle everybody talks about? Or actually, do you say, well, you know what, high frequency traders counter the natural flow and there's no virtuous circle, and it's probably the other way around?"

Arnaud said the only real-life example to consider was EBS, the spot FX platform. "They changed the rules there, they increased the tick size, they slowed the platform down so basically they made it harder for high frequency traders to trade. ICAP say that over 30% of volumes were high-frequency trading, so when they did that your expectation was for volumes to drop quite significantly, and they haven't."

At the same time, even if draconian measures in the EU come to pass, some say HFT activity will still be prevalent.

"High frequency trading is not just one big bucket, right?" Arnaud said. "You've got a spread of different strategies, some being very nimble in terms of the targeted returns that they may want to make and others are arbitraging across venues, or arbitraging across asset classes, and with much more robust trading strategies. The institutions I've spoken to would suggest that half of the high frequency traders actually have quite robust types of returns."

In other words, they may be able to cope with change, and volumes won't suffer as a result.

The issues that most concern the HFT industry, he said, were the possibilities of an obligation to post continuous liquidity and a minimum fill-to-order ratio.

Part 2: M&A mania

The upswing in volumes may be welcome news - both for the exchanges themselves and for volume-starved market participants hoping to make money once volatility returns. But there are still plenty of reasons why the exchange map will continue to be redrawn over the coming years.

For a start, there may be a glut of platforms now.

"The Street is now realising that it can't afford to support every platform that comes along," CME Europe Chief Executive Robert Ray told Automated Trader.

"So you have X amount of MTFs out there right now, you're going to have Y amount at the end of next year," he said. "With exchanges, the drive to maximise opportunity and reduce costs for customers can make it more efficient in the end, and this would suggest that there could be more consolidation among the MTF marketplace."

Ray added: "I think that some form of further consolidation is probably on the cards, even though you're getting this proliferation of new entities. The Street just cannot afford them. They don't have the assets to be deploying more, which they used to. And with the gigantic amount of regulatory changes that are taking place, so many of the resources internally have to be dedicated to creating systems for that."

Interestingly enough, Ray's firm - the largest exchange group in the world - is one that appears least likely to make a big splash on the M&A front.

Phupinder Gill, chief executive of CME Group, has downplayed the possibility that his firm would engage in a big merger deal. "There's been a lot of consolidation over the past 10 years and personally on our side, unless there's a phenomenal opportunity that would present itself, we don't see much change from this point on," Gill said at an industry event recently.

He added that the ICE deal did not alter the environment radically for his group. "I think the competitive landscape does not change materially where CME Group is concerned," Gill said. "We used to watch two competitors, now we get to watch one."

There had been some talk that CME might want to snap up Deutsche Börse. But Johannes Thormann, global head of exchanges at HSBC Equity Research, said regulatory obstacles would stand in the way. "I don't believe CME can go for Deutsche Börse because the local regulator in the German state of Hesse would block it, if not the EU Commission," he said.

Thormann added: "The big houses really have the problem that they are big enough and it would be difficult to find something except for smaller bolt-on acquisitions probably. You have to keep in mind that in the emerging markets the exchanges are all heavily protected by the local regulator, because people want to develop the local market first before they even think about M&A with those other markets."

Ray suggested CME preferred the organic approach in any case.

"Our international strategy has always been organic growth. We've done well, very well with it. And as we push up the physical plant now here we expect to do well. I think if you were to summarise our view of the markets, we tend to take an extremely long-term view and we're not afraid to make the investments."

But not everyone has the size and muscle of the CME so mergers can appear more attractive to other players.

Even before the ICE-NYSE deal emerged at the end of 2012, the year had witnessed a huge merger in the form of Hong Kong Exchange's acquisition of the London Metal Exchange. That deal was clearly a play on the China growth story.

Then, the ICE-NYSE deal, announced in December, came as a bombshell. The significance of a relatively young firm such as ICE buying an age-tested giant such as NYSE was hardly lost on observers. But it also signalled more M&A activity because speculation immediately turned to what would happen to Euronext, the European securities bourse NYSE had acquired in 2006 when it became the first trans-Atlantic stock exchange group.

Thormann of HSBC said he couldn't see Euronext staying independent. "The logic is heavily against this," he said. One possible player, he suggested, was the London Stock Exchange Group, which has made a series of big acquisitions over the years such as Borsa Italiana, MTS, Turquoise and MillenniumIT. It also has come close to merging with other players twice in recent years, first with NASDAQ and then with TMX Group.

top ten exchanges

"I still believe that LSE could end up owning Euronext as well," Thormann said. He said the ICE-NYSE deal was, for all intents and purposes, really a domestic deal in his view so ditching Euronext only made sense.

Also, it's not as profitable as the derivatives business. "The cash trading business is never as profitable as the derivatives part of the business," Thormann said.

While the market was still digesting the implications of ICE-NYSE, which had been clearing its various regulatory hurdles, along came another mega-merger: BATS and Direct Edge, which announced plans in August to combine in an all-stock deal. In doing so, they had the chance to knock NYSE and NASDAQ off the perch of the world stock markets.

So, after all of this frenetic activity, what's next?

Steve Engdahl, a senior vice president of product strategy at enterprise data management company GoldenSource, had some thoughts. While he may not be privy to the discussions among senior exchange executives and investment bankers who might be structuring mergers, he has a view as to what drives profitability among exchanges and hence what could lead to future deals.

"How do you make the economics of an exchange work? And one way to really make it work - and there's a lot of exchanges with really bullet-proof systems that can handle much higher volumes than they're processing today - is how can we get as much scale as we can in our primary business line of managing and making markets available?" Engdahl said. "So mergers are a real driver for that."

While the market waits to see what will happen with Euronext, and whether BATS-Direct Edge will satisfy competition concerns, there is still plenty of gossip as to what other deals might be in the offing. One of the most talked about concerns is central Europe.

The Warsaw Stock Exchange, which for years had been in a fierce stand-off with the Vienna bourse over which could lay claim to being the gateway to central Europe, entered talks with its Vienna counterpart earlier this year. The talks are officially about cooperation, but people in the market generally suspect they could be about something more significant. At time of writing, all sides were keeping quiet but there's been no end of speculation as to whether a merger is on the cards.

Taking a counterview, Olivier Vonet, senior vice president of business development at Etrali Trading Solutions, felt that given the already fairly consolidated industry, further mergers may prove difficult as recently experienced by the multiple merger attempts turned down by regulators since 2008. But in the same breath he added: who predicted that ICE would make a successful bid for NYSE five years ago?

There is, of course, the question of what the mergers mean in real terms for the trading community. There appears to be a schism.

"For a trader, of course, choice is nice because it probably increases the chances of arbitrage," Thormann said. "For a lot of my clients, the investors, I have a lot of people who would love to see all those choices being massively restricted and then going back to, in the extreme, the old French model of a centralised order book, where you have 100% liquidity in one instrument in one order book."

Part 3: Model behaviour

While question marks hang over who may merge with whom, it's clear that exchange groups have been adopting a new, vertical approach to their business models in order to take advantage of the regulatory push that is driving trading into the exchange-listed arena.

The implications of this are several-fold. For a start, it means exchanges have begun competing for business in pre- and post-trade services such as collateral management - a huge area in and of itself.

"If you look on the exchange map I saw five years ago, there were far less silo models whereas even the LSE is now becoming more and more a full-scale silo model," Thormann said. "Because, if you own the whole value chain, you can influence and optimise all the processes in a much better way than if two independent parties need to do bilateral legal negotiation."

That's one reason why the NYSE-ICE deal makes so much sense. "Of course in terms of the vertical approach, you can trade nearly every asset class on the market of the new group, on the other hand it also is coming to the point where they have trading and clearing within the group and don't rely on third-party services except for US options trading."

In other words, the race is on for each exchange to create its own universe. That raises the question of how open each firm wants to make the borders of its universe.

"Deutsche Börse currently has very little openness whereas the LSE is probably the other extreme. LSE say they want to cooperate with everybody, but we'll see how the complexity of this business pans out," Thormann added, noting that headaches can ensue from the myriad deals.

MillenniumIT, the technology group founded in Sri Lanka in 1996 and bought by LSE Group in 2009, has its own strategic goals but it also knows that integration with the other parts of LSE is a major part of the overall strategy.

"The opportunities are there to do much more automation around market infrastructure," MillenniumIT CEO Mack Gill told Automated Trader. "To increase automation, to increase flow, to increase the use of standards on the platforms that we're using, that's a big part of the play," Gill said, adding that was one of the main attractions for his joining the group.

It can be simplified as easily as just looking at pre- to post-trade. "And I think - not to beat a dead horse - but there's so much legacy out there. There are great opportunities for simplification and modernisation in terms of the platform environment and the connectivity environment in the industry."

Part 4: The fight for future revenues

To sum up the story so far, we have a world where volumes are finally starting to pick up, exchanges are jockeying to see who might buy whom, regulation is pushing the bigger groups to adopt vertical models and take control of as much of the trade lifecycle as they possibly can, and a number of prominent companies have been looking to leverage their technology investments…

So where are some of the main competitive battle lines being drawn? They tend to fall into two distinct categories: technology and products.

On the product side, Ray of CME Europe is about to launch his group's new London-based derivatives exchange, starting with FX contracts. He said that when he arrived five years ago, there were 14 people in the office. Now there are more than 160 and another 100 in Belfast.

The CME's bet is that it can leverage its Globex infrastructure, central counterparty clearing and build on what it's been able to do in the US and then expand into other asset classes.

"Nearly 25% of electronic trading volume now comes from outside the US. I think by pushing more here, I don't even question in my mind that it won't work," he said.

He says CME Europe is "recreating the curve, listing monthlies going out two years for starters" and then it plans to push those out further.

Ray also argues that CME has a cost-efficient argument. "What the real key for all this was there we're taking the Globex infrastructure and we're leveraging that up and providing scalability. So when firms talk about, 'Oh it would cost me too much to connect to these guys and I can't really afford it', for us it's a turnkey solution. Most of them are already connected. So it's basically just another exchange on Globex with products."

Whatever success CME Europe does or does not have with FX contracts, a lot of the market's attention has been on the swap side. Interest rate swaps are the largest market in the world and the futurisation of swaps has taken the market by storm due to the more lenient margin requirements that exchange-listed futures enjoy versus OTC contracts.

CME Europe can expect plenty of competition (see our profile on GMEX in this issue). Arnaud said the big question in terms of swap futures is whether Europe will follow in the footsteps of the US and give a margining advantage rule to exchange-traded products.

"The general plan is to harmonise regulation across continents. Whether that gets done or not, it's a hard call to make. But if it does go that way, then you should expect some futurisation to happen," he said.

In general, Arnaud expects futurisation. He noted a buy-side survey UBS carried out. The outcome was a range of between 20% and 30% of interest rate swaps could be standardised in the longer term," he said.

Thormann said he believes the bulk of trading will be a full-blown move onto exchanges, rather than via Swap Execution Facilities (SEFs).

"Bespoke products will remain off exchange. But my general feeling is that at least half of the market is made up of me-too products, which could also be traded on exchange, and there is little bespoke-ness in the product."

And yet hardly a week goes by these days when another firm does not announce its application to become a SEF.

Then there is the sale of technology. While CME is spreading its wings using Globex, groups such as the LSE and NASDAQ have been selling their operational prowess to others.

MillenniumIT is known as one of the fastest systems and it has successfully sold its technology to venues all over the world, including ICAP, the London Metal Exchange and a host of emerging market exchanges.

Gill said that while the company's name is historically in equities, it's looking increasingly at derivatives markets and other asset classes. He described two main thrusts. "One is extending the equity story - especially in emerging markets and into newer alternative exchanges," he said, noting a recent sale in Argentina. "There's that story and in the core developed markets we're looking at cross-asset opportunities."

He added: "Basically Millennium Exchange as a product is actually engineered to be multi-asset class by definition. So that's what we're looking to utilise. We're not going to move away from our core market with equities, but when we look at the market, we see a lot of current opportunities with other asset classes."

A lot of Millennium Exchange's attraction has been its speed, although other exchanges have been making inroads too. Last year, SIX said it got down to speeds of 37 microseconds for processing. Eurex has a new platform that is much faster than before. But there are no independent bodies which compare exchanges on a level playing field.

Gill said speed is important but it's hardly the whole story.

"Today, it's table stakes," he said. "You have to have a certain level of latency to be relevant so that's something that we provide for our clients and you know we've been pushing the envelope in the market."

He also cast doubt on some claims he has seen from various vendors. "You have to be careful about what vendors might say about the potential in any given test scenario. I mean you could do any number of things in a laboratory and there are a whole bunch of people trying to get bragging rights around tweaking something, or adding a new element or networking aspect. But what you need to look at is actual performance - public performance of a trading environment."

Gill added: "This is a very interesting time to be talking about exchanges, given everything that's been going on. So you have to look at the track record of what a trading venue can bring to the market in terms of its technology but also in terms of its operating capabilities and its operating know-how."

He says he rests his case on LSE and Turquoise performance. "But the other aspect to it is not just about latency. It's much more about quality and performance and uptime."

The London Stock Exchange

The LSE atrium in London

Finally, GoldenSource, the enterprise management specialist group, pointed to another area that gets little attention: reference data.

"What we've been working on is a different concept and picture of how you make the economics of an exchange work," Engdahl said.

"And that is looking around the different businesses of the exchange it is in, the different types of products and services it offers, and we've actually stumbled into a pocket, we're actually working with a number of exchanges worldwide who on their own are stumbling into this pocket of additional profitable lines of business."

The pocket, which potentially could provide replacement revenues for any declining fees on the trading side, is based on making the most of reference data.

"All of the exchanges have a data feed business, many of them have really excelled in the real-time and low-latency depth of book and time and sales and real-time information," Engdahl said.

"But what they're finding is that there's another piece of it that is equally important and that's on the reference data side; things like listing information that helps their customers do analysis looking for trading opportunities, for optimising portfolios and so forth."

Company announcements, corporate actions and various other bits of data are collected as a matter of course by exchanges.

But the value comes in structuring the data and making it possible to slice and dice.

"So each financial institution doesn't have to do as much work to transform it into the way they want to see it within their applications. It's a step down that data supply chain on the reference data side, and exchanges are seeing that they can mine existing customer relationships and build for an existing product they have but offer a greater level of service and generate significant additional revenue off of that," Engdahl said.

To put it in perspective, he said some feeds had perhaps 20 attributes whereas GoldenSource was seeing a move to include as many as 200 attributes for those providers that can gather the right information.

But what customer could ever want 200 attributes on reference data?

"That's where customisation is pretty important," Engdahl said. "I don't think there are really many use cases for a single department within an institution who want all 200 fields, but having a menu of 200 to choose from and picking the 50, 70 or whatever it is that I want for my purposes…" That, he said, becomes a more attractive proposition.

Saheed Awan

Saheed Awan, Euroclear

Part 5: Collateral damage?

Talk to any exchange executive and often the first thing you'll hear is how they want to make things easier for the customer. Okay, they're talking their book. But there is something to what they say. A huge new area of competition is in how to help their clients make the most out of collateral. Many exchanges are competing in this area, and also a few non-exchange players. It comes down to this: how can a trading client do more with what he has?

"We had this race for speed, but nearly every platform is in the microsecond area - speed is not the differentiator any more between two markets," HSBC's Thormann said. "It's probably nice but not a necessity anymore because all the markets operate at high speed. The thing now is risk management tools, where you have to see how much of a netting effect and better usage of collateral is possible."

"The change in the industry in the last three years, for all the investment banks, is optimised inventory management," he said.

Saheed Awan is global head of collateral management at Euroclear. He speaks about the current market environment as if a sea-change is underway.

Banks have undergone a period of massive deleveraging, during which they have shed enormous amounts from their balance sheet.

"Banks got rid of so much junk-grade assets from their balance sheets. And yet, in order to carry on trading, they need good usable assets, as well as a perfect global view of their enterprise-wide assets. They are asking themselves, 'Okay, this is what I'm now left with, how can I leverage these assets after all the sales I've made to carry on trading?'"

That's where collateral management comes in, and it's a business that exchanges have been keen to tap into.

"Collateral management can be encapsulated by a very simple definition - it concerns maximising a firm's funding capacity and minimising the margin of risk-weighted assets," Awan said.

The problem is that firms typically first use cash as collateral; which makes zero sense. It reduces their liquidity and means they can trade less. "But 80-90% of collateral selected for margin processing is cash. These firms are annoyingly giving away that liquidity for their margin calls," Awan said.

The goal, then, is to maximise the use of higher risk-weighted assets. The biggest consumers of that collateral end up being the clearing houses owned by the exchanges.

Awan pays credit to Deutsche Börse for creating what some argue to be the perfect model for exchanges: by going vertical, it offers clients the ability trade on the exchange, use its clearing house and then link into its settlement system. Other exchanges, he said, scoffed at the idea years ago but then ended up doing the same thing.

All of those clearing houses now owned by exchanges are important to Euroclear.

"LCH, CME's Clearing Europe, and ICE Clearing are key partners for us. Because of the new collateral requirements under the G20 agenda, the CCPs are going to be large receivers of collateral margin. Every time a firm conducts a clearable OTC swap transaction or even an exchange-traded derivative, it will need to post a different margin with the central clearinghouse," he said.

The exchanges themselves are competing for this collateral management business, as are some of the investment banks. But Euroclear reckons it has an edge because it is a neutral collateral management agent, not owned by an exchange or clearinghouse.

"Why should a competitor of Eurex give business to Eurex?" he asks. Similarly, why would an investment bank rely on another investment bank for its collateral management services?

Still, the exchange groups have their own argument for why collateral management business should come their way.

"So your ability to understand your margining requirements in a real time environment is a huge benefit to the industry both in terms of cost per trade and in terms of better risk management. The industry's looking to concentrate a lot more on exchange, CCP and CSD structures and you can't do that with technology or systems that are 20 or 30 years old."Gill of MillenniumIT said a big focus for his group is bringing to market a post-trade platform. He said it would be based on the same technology and same architecture the firm has at exchanges around the world. "We're looking to extend that out for a whole clearing, settlement, custody environment, and again, what's interesting about that is not only the ability to optimise and modernise… but also there's a huge focus on better collateral management, for example," he said.

Vonet at Etrali Trading Solutions suggests the exchanges will have a big incentive to fight for a piece of the collateral management pie. "Tighter integration and flexibility with the clearing business will enable exchanges to attract liquidity and volume through better risk management of collateral and mark to market collateral," he said.

Part 6: Ch-ch-ch-ch changes

Remember that statistic mentioned at the beginning of this article? The most spectacular volume growth these days is coming from Asia.

Beyond deals to purchase technology, the view is that local Asian bourses will remain wary of giving up any advantage to Western bourses who might want to come in and gain business. Nonetheless, Western firms are still looking east and that could be a new avenue for future deals.

Deutsche Börse, according to a Reuters report in September, is exploring plans to create a derivatives clearing house in Asia as a way to expand its post-trade processing services in emerging markets. Reuters cited two sources familiar with the matter, although Deutsche Börse declined to comment.

The move would form part of a strategic push to diversify. In February, Deutsche Börse Chief Executive Reto Francioni said the group would focus on growth in Asia and Latin America. Reuters reported that Deutsche Börse may partner with a local player in Asia, one of the sources familiar with Deutsche Börse's thinking said.

Whatever the region, whatever the technology or the product space, there seems little doubt competition will only become fiercer. The staid old days of monopolistic trading empires, each bourse having control of its fiefdom, are long gone.

Vonet is of the view that since the start of deregulation of the industry in the 1980s and the first appearance of competition through ECNs, the exchange eco-system has transformed, first through technology, demutualisation, and then from early 2000 with re-regulation.

Any evolution or change in business models in the new exchange landscape will centre on how to cope with drastic competition.

Single financial instruments are traded on multiple venues, but even across asset classes competition now tends to reach new highs as seen by the futurisation of swaps. Historically, where brokers and exchanges were partners they have now become competitors for the same liquidity, Vonet said, as brokers run quasi-exchanges in the form of crossing network, MTFs or dark pools.

Or, as David Bowie might say: Turn and face the strain.