For the first time in decades, there seem to be numerous possibilities. The incumbents – giant, vertically integrated trading hubs – are finding their oligopoly threatened by smaller, nimbler competitors. The challenges are coming from all quarters: dealers, systems specialists and even end-users are all interested in building alternative marketplaces that will accommodate cheaper and more efficient trading.
Exactly what shape those marketplaces will take remains an open question. In many ways, it has never been easier to set up an exchange. Thanks to modern communications, there is no need for traders to be on the same floor, or even the same continent, so there are few physical constraints. With basic technology available almost ‘out of the box’, a start-up exchange could (in principle) be ready to open for business within months.
One response to this commoditisation of exchange infrastructure is to aim for economies of scale, as exemplified by the recent transatlantic merger of NYSE-Euronext and the proposed CME-CBOT and Deutsche Borse/Eurex-ISE transactions. These transactions are predicated on the assumption that competition is now about little more than the need to attract ever-greater volumes of business. An ICE-CBOT deal would be a more transformational affair.
Another approach, however, recognises that today's market participants are becoming increasingly sophisticated, and increasingly interested in getting complex trades done as cheaply and efficiently as possible – and would therefore like to dispense with the baggage that weighs them down on more traditional exchanges. What might markets that cater to such requirements look like?
The coffee shop
Many of London's organised marketplaces started life in seventeenth-century coffee shops, including the London Stock Exchange and Lloyd's of London.
From these modest beginnings grew vast and powerful institutions, so the coffee shops must have incorporated the critical features of an exchange - liquidity, price discovery and standardisation, even if in embryonic form.
The proto-exchanges turned out to be very good at matching up providers and consumers of capital, and quickly came to occupy central positions in the nascent capitalist economies of Europe and North America. As they became more important, it became necessary to formalise their structures, membership and rules: for example, Jonathan's Coffee House had metamorphosed into the state-regulated and subscription-based London Stock Exchange within about a century.
These more formal exchanges then began offering additional services, ranging from product development and dissemination of prices and price-sensitive data (pre-trade) to transaction matching or facilitation and technology (trading) and clearing and settlement (post-trade). These services are financed in different ways, including membership fees, transaction rents and external investment; some, such as clearing or trading platforms, may be developed or managed by third parties but are nonetheless usually closely tied to the exchange itself.
This hub structure might seem restrictive, but it is motivated by the need to fulfil the same basic set of requirements as the coffee shops above, with the additional constraint of investor protection. Limiting the number of direct participants and requiring them to prove their bona fides and abide by codes of conduct helps to secure a deep, orderly market – ensuring deep liquidity, efficient price discovery and strongly enforced trading standards.
Bundling services is also more efficient. In the absence of modern information technology, the market operator was best placed to manage the day-to-day business of trading – publishing prices, clearing transactions – and it was easier to upgrade a single market than many. For example, the centralised hub structure provided a solid institutional framework for the funding and management of the transition from open outcry to electronic trading.
In fact, the centralised hub model worked so well that it has become the de facto standard for exchanges around the world. Some notable exceptions notwithstanding, most exchanges are seen as natural national monopolies, as the maxim "every country wants a stock exchange and an airline" attests.
The networked marketplace
The basic requirements of an exchange have not changed in the 300-odd years since Jonathan's opened for business. But the ways that they have been delivered have: first to cope with a vast increase in the volume of trade, and now with the advent of modern information technology. Liquidity, price discovery and standardisation have all been transformed by the development of fast, cheap and global computer networks in recent years, and by changes in the expectations of customers and regulators.
Just as various software standards have enabled this latest evolution in information technology, so a combination of technology and business standards is enabling changes to the structure of financial markets. The development of FIX, ISO15022, SwiftML and many other standards has enabled financial institutions to communicate with increasing ease – and thus enables business models that would previously have been impractical.
One key element is decentralisation, which has so far taken place only in terms of exchange participants moving to institutional dealing rooms, rather than meeting face-to-face on the trading floor. Markets have remained largely national in character. But communications technology, along with the globalisation of financial markets and business practices, means that the playing field now favours pan-regional or global trading platforms, which need not follow the traditional organisational patterns.
Electronic networks make it easier to locate liquidity without the need to aggregate it in a single location, or even under the aegis of a single institution. Algorithmic trading systems can provide convenient access to fragmented liquidity pools – breaking up orders and routing the pieces to the platforms or marketplaces where they can be best executed. That not only reduces the critical mass needed for viable trade in a product, but also the market impact of high-volume or high-frequency trading, and may prove the best way to meet ‘best-execution’ requirements such as those codified by Europe's MiFID.
Aggregation can be put to work in other areas, too: price data, for example, can be collated from disparate sources by third-party data providers – perhaps creating a more comprehensive picture of activity by using data from over-the-counter markets as well as organised exchanges. Price discovery then becomes a service that may be better served by parties other than the market operator itself.
Given a common language for trade data, there are also opportunities to unbundle other services conventionally offered as a package by incumbents. For example, trade registration and completion guarantee services are usually packaged together, but can readily be separated, as can settlement, delivery and custody. Even market supervision, perhaps the most intractable component of the current service package, can be addressed by consolidating and monitoring trading patterns across disparate markets in real time.
But these technological possibilities would probably remain just that – possibilities – were it not for the changing attitudes of regulators and customers. Regulators have made things easier on several fronts. They are more willing to countenance new competition, rather than defending ‘national champions’, as evidenced by recent cross-border activity. They recognise that not all customers require the same levels of protection, removing some of the constraints on market supervision. And they have begun to stress ‘best execution’ as an important objective (for example, through Europe's MiFID).
This latter point is worth noting, since it gives alternative liquidity providers a strong selling point if they can demonstrate that they offer better execution than the incumbents – and the argument grows stronger still once the changing composition of the buy-side is taken into account. Hedge funds, who account for a large and growing share of trading volumes, frequently use strategies that are particularly vulnerable to market impact; many fund managers therefore prefer to supplement their use of established trading hubs with other trading venues. Marketplaces that can tap into this demand could ride profitably on the coat tails of the major exchanges – and perhaps begin to supplant them.
Customers are also less interested in specialised marketplaces than they once were – or rather, are less interested in product specialisation. Products are increasingly traded in similar ways, as idiosyncrasies in market conventions and instruments have been ironed out, and large financial services firms increasingly trade across a broad range of markets. These users are most interested in finding providers who can supply each component of the trading value chain as efficiently and cost-effectively as possible.
Specialisation has thus become a question of the market's model, rather than the products it lists or the community it attracts. That opens the door for service providers to focus on individual links in the value chain, reapplying their model to many different products to reap economies of scale – horizontal integration, rather than the vertical model prevalent among today's dominant players.
The way forward
The competitive landscape has traditionally been dominated by institutions built around vertical silos defined by product or geography.
In the future, however, the market model, rather than the instruments traded, may become key to the exchanges’ identities. In this scenario, rival global trading models could compete on a transaction-by-transaction basis to attract trades from a wide range of participants, with trading-related services potentially supplied by a number of specialist providers. A number of such models are already evident:
- Public central-limit order book: automated matching of anonymous trade halves
- Investor networks: buy-side participants deal directly, matching large block orders
- Dealer markets: broker-dealers provide liquidity in traded products.
It is now entirely possible for entrepreneurial players to provide a service along any of these lines, or combinations of them (such as Equiduct’s Hybrid Book model), often putting them into direct competition with the incumbents. The ability to link these markets to services such as clearing makes them more user-friendly to participants who might traditionally have been wary of venturing away from the security of mainstream trading venues.
Each of these services has characteristics that suit specific groups of participants, or specific trading strategies. For example, investor networks enable large institutional asset managers to trade in quantity against each other, rather than seeing prices slip as their large trades are matched against retail flow or exploited by scalpers. A fast, competitively priced public Central Limit Order Book venue may well suit execution-focused players, while dealer markets often cater best for sophisticated participants seeking to minimise market impact while executing complex structured transactions.
Each of these models provides the functions of an exchange in different ways, but all of these functions can be provided in each case. The fundamental drivers of change – pressure from regulators and the buy side – enabled by network technology, are likely to distribute liquidity more evenly between these options than in the past.
Exactly how this will play out is inevitably uncertain, but we can make a number of educated guesses at some of the themes that will be important:
- Horizontal specialists will increasingly be capable of taking on the core business of the exchange. With a range of trading options available, the buy side will route trades according to specific characteristics of execution.
- The critical requirement for existing exchanges to maintain (and expand) the range of services they provide is an ability to offer a non-replicable menu of instruments to investors. To do this exchanges must either attract top-quality listings, or structure contracts that attract business currently transacted off-exchange.
- Businesses focusing solely on origination can be expected to proliferate. These will develop and market instruments, but subcontract the provision of a trading venue and associated infrastructure. The distinction between the activities of the more entrepreneurial exchanges and the big investment banks will become weaker.
- Provision of pre- and post-trade services will be fiercely competitive, with incumbents facing nimble new entrants. Success will be determined by possession of top quality technology platforms and effective marketing, but also by the ability to pick the best partners to prosper in the rapidly changing industry.
- This environment will give rise to opportunities for entrepreneurial businesses in parts of the market previously seen as backwaters; expect fierce competition in clearing, central counterparty provision and elsewhere as service providers rush to supply infrastructure to new entrants.
All this amounts to a significant strategic threat to the incumbents, who are no longer protected by either statutory or logistical barriers to entry. The new entrants need not provide the full range of services; it is their characteristics as a trading venue (their dealing dialogue) and the composition of their clientele (eg wholesale-only liquidity networks) that will provide their competitive edge. Or to put it more simply: they are offering, in effect, rival coffee shops: and it will be up to customers to choose which surroundings they find most convivial.
