Brokers vs. Exchanges

The U.S. pattern of stock-exchange consolidation, which has recently spawned a flurry of new investments by market participants in alternative or smaller trading venues, is repeating itself on two continents. Just as NYSE Group and Nasdaq Stock Market are integrating acquisitions and looking to Europe for expansion while competition is stirring at home, new industry-backed ventures are mounting challenges to the dominant Australian and U.K. exchanges.

A week ago, the New Zealand Exchange (NZX) announced that it incorporated an electronic communications network (ECN) to offer trade execution and reporting services in direct competition with the Australian Stock Exchange (ASX), which is not only that country’s principal equities market but is also merging with the Sydney Futures Exchange to form a cross-asset-class mega-market. NZX will own 50 percent of the new entity, with partners Citigroup, Merrill Lynch, Goldman Sachs JB Were, Macquarie Bank and Commonwealth Bank of Australia’s CommSec subsidiary each holding 10 percent.

That news came a month after published reports in London that a group of ten banks were collaborating on a trade reporting facility that would provide an alternative to the London Stock Exchange (LSE). Dubbed “Project Boat” and scheduled to launch in 2007, the initiative is backed by Citigroup, Deutsche Bank, Merrill, UBS and six other firms that have not been publicly mentioned. The banks did not respond to requests for comment last week.

An ASX spokesperson said the exchange would not comment, and spokespeople from the banks in the NZX-led effort referred questions to NZX, whose CEO, Mark Weldon, said in an interview with the Australian Broadcasting Corp., “The brokers have very much decided, around the world, that as exchanges consolidate, it’s important that there is competition on price, on innovation and on technology.”

An NZX official who asked for anonymity told Securities Industry News that the new ECN is scheduled to go live in 2007 on the NZX technology platform–which is in line for an upgrade–and is waiting for a license to operate in Australia. “We think the regulators are in favor of this,” said the source. “They welcome the competition.”

The new London trade reporting facility would let investment banks that internalize trades and use other alternative markets avoid the fees they pay the LSE to print their trades. Until last year, U.K. regulations required all trades in LSE-listed shares to be reported to the exchange. But with market data fees on the increase, both buy- and sell-side firms have been looking for cheaper alternatives.

The LSE issued a statement about Project Boat that said, in part, “Developing new and disparate solutions can add extra cost, but the investment banks are exercising normal business rationale by looking at a range of options. We are confident that a central infrastructure solution will ultimately be the most efficient as we have the links in place to perform these functions on behalf of the investment banks.”

Market observers and participants see the face-off between exchanges and investment banks as the latest result of competitive pressures dating back to the deregulation of brokerage commissions in the U.S. in the 1970s. These pressures have intensified as exchanges in most major markets have demutualized in recent years, adopting the mindset of publicly traded, for-profit companies, making them less beholden to the investment banks that used to own them. Consulting firm BearingPoint, in a study on capital markets published last spring, identified exchanges’ encroachment on their former owners’ competitive turf as one of the major transformative forces in securities markets over the next decade (SIN, June 12).

The recent surge in algorithmic trading, which has reduced order sizes and contributed to increased volumes in the equities markets, is another factor weighing on industry operations and costs. Exchanges are exacting higher fees from active traders such as hedge funds and brokerages’ proprietary desks.

What’s more, a new regulatory regime that will unfold over the next year as the Securities and Exchange Commission’s Regulation National Market System (NMS) and Europe’s Markets in Financial Instruments Directive (MiFID) take hold is likely to encourage more trade executions away from traditional securities markets.

Cost Squeeze

“Commissions have fallen precipitously for the past 20 to 30 years,” said Peter Horowitz, a managing director in BearingPoint’s capital markets practice in New York. “The agency business is becoming less and less profitable.” That leads brokerages to invest in alternative trading facilities or internalize more of their trading to avoid exchange fees.

“There’s a massive focus on transaction costs today,” said Alasdair Haynes, CEO of Investment Technology Group’s ITG Europe subsidiary in London. Haynes spent two years lobbying officials from the LSE and U.K. Financial Services Authority to amend LSE rules and permit reporting of off-exchange trade prices to a non-LSE facility. The LSE finally went along last year. ITG Europe now reports trades from its Posit crossing network to market data providers such as Bloomberg, Reuters, Fidessa and ComStock. According to Haynes, most exchanges’ trading fees tend to be much higher for a series of small trades as opposed to a large block order.

“The explosion in volume has created very good financial results for the exchanges,” said Stephen Kingsley, a BearingPoint managing director who heads the financial services practice in London. “In this new world, where they don’t have to return most of those revenues to their members, they have become real money makers. But the traditional customers of the exchanges–the investment banks–are deciding that the costs of trading are too high. They are doing that partially under pressure from their own customers, the fund managers, who are saying, We want much better deals from you guys.'”

The exchanges contend that their fees are not excessive. An LSE spokesperson said that at least since 2004, volume discounts have been available to active traders. The New York Stock Exchange and Nasdaq Stock Market have amended their fee schedules to give discounts to high-volume traders, but there is pressure on them to go further.

The NZX official said that its Australian joint venture will result in lower prices for the brokerages, which in turn should pass savings to the market as a whole. “It’s monopoly pricing in Australia right now,” he said. Not only is ASX the dominant exchange in Australia, but all trades have to go through its system. “And recently, the prices have been raised,” he pointed out.

Natural Conflict

The flare-up of competition “was inevitable,” said Benn Steil, senior fellow and director of international economics for the Council on Foreign Relations in New York. “I’m surprised it hasn’t broken into an all-out nuclear war.” It has been manifest in the U.S. with investments–by some of the same brokerage firms involved in the Australia and U.K. initiatives–in regional exchanges in Boston, Chicago and Philadelphia and in the International Securities Exchange’s new ISE Stock Exchange. New ECNs such as Bats Trading and Track Data Corp.’s Track ECN have also entered the fray after the previous generation of those platforms consolidated, the largest merging into NYSE and Nasdaq.

Steil added: “Brokers have always wanted to match orders, just like an exchange. If you matched two orders, you got two commissions. That incentive was always there. It’s just that they weren’t in a position to do it.” Advances in technology made it “possible for brokers to internalize trades,” Steil noted. “Now, in a completely computerized trading environment, the old distinctions of buy side, sell side and exchange are really archaic. There is no need to pass the trade on to an intermediary. This is where the nuclear war is coming.”

After demutualizing their ownerships, the exchanges are rethinking their business models and asking who their true customers are. The investment banks “are just intermediaries,” Steil said. “The exchanges are saying, If we can go directly to the client, the hedge funds, we can reduce the cost of trading.'”

David Easthope, an analyst with Boston-based research firm Celent, said the up-front investment requirements of ECNs, regional exchanges and internalized trading systems are “not huge. … That’s why you’re seeing the investment banks do this.” For a few million dollars, a sell-side firm can lower clients’ trading costs while offering more sources of liquidity. And with the alternative trade reporting facilities that are part of these efforts, the brokerages also guarantee themselves a larger share of market data rebates, which have become more important as trading volumes have increased.

European market players are keenly aware of MiFID. The investment banks believe that they can get a head start in dealing with market-structure and economic changes by forming an alternative trade reporting facility now.

“The changes in technology are going to force these firms to revolutionize how they do their business,” said ITG’s Haynes. “It’s not just a world where the exchanges are changing or the brokerages are changing. The whole market microstructure is changing, and it’s changing right now.

Article originally appeared in Securities Industry News, which has since closed down.