Competition and Integration of Stock Exchanges

Competition and Integration of Stock Exchanges Abstract The increase in competition of stock exchanges, due mainly to the transformation of the securities markets, has led to mergers, technological agreements among existing exchanges, price wars, takeovers, and the creation of new exchanges, even within the same country. Recently, exchanges have also faced competition from quasi-exchanges, which are also known as ECNs. They not only free-ride on the process of listing given that they generally trade only securities listed on other exchanges, but also on the price-discovery process facilitating members of exchanges to direct trade to them. ECNs are increasingly cannibalizing the businesses of the existing stock exchanges. The evolution of new financial instruments, the falling monopoly of banks as a source of direct funding to borrowers and of direct investment for investors, the tremendous improvement in information technology, and a greater financial culture among common people as well as the fluctuations in interest, price, and exchange rate due to the oil crises have caused the increasing importance of securities markets in the financial system. As the capital markets become increasingly globalized, investors have more choices and are demanding better trading facilities, market efficiency and quality from stock exchanges. To meet challenges, exchanges have to accelerate the construction of the market information infrastructure, rivalry among Europes stock exchanges emphasizes more on cooperation of trading technology than anything else. In Asia, the concept of forming a full financial service group within each market is the main consideration. Exchanges have recognized that faced with the challenge to respond commercially to competitors, they needed to become traded companies themselves. The underlying assumption is that, in the long run, only the most efficient exchanges should survive, trading stocks from other European countries and offering the most innovative and competitive financial instruments. Table of Contents (Jump to) I Abstract.. 2 II List of Abbreviations. 5 1. Introduction 6-11 2. Review of Literature 2.1 What is an Exchange. 12-16 2.2 Globalisation of Financial Markets 17-20 2.3 Nature of Competition of Stock Exchanges.. 20-24 2.4 The Effects of Increasing Competition among Stock Exchanges. 24-25 2.5 Revolutionary changes of Technology in the Securities Market.. 26-29 2.6 Integration of Stock Exchanges 29-30 2.7 Theoretical Influences 31-37 3. Methodology 3.1 Aim of the Project. 38 3.2 Objectives of the Project 38 3.3 Why I am Interested in this Topic. 39 3.4 Background 39-40 3.5 The General Approach.. 40-41 3.6 Data Collection.. 41-43 3.7 Criticisms of the Sources 43-44 3.8 Validity.. 44 3.9 Reliability.. 44-45 4. Qualitative Analysis 4.1 Analysis of Industry Dynamics. 46-56 Case Studies 4.2.1 International Exchange- LSE- A Prototype of Horizontal Merger 57-61 4.2.2 Hong Kong Stock Exchange A Typical Model of a Vertical Merger. 62-66 4.3 Implications and Discussion.. 66-69 5.0 Conclusion70-72 Appendices Appendix 1 Interviewees Questions74 Appendix 2 Interview Key Points.. 75-77 Appendix 3 Future Strategies of LSE HKSE. 78-80 Bibliography 81-87 List of Abbreviations ECNs Electronic Communication Networks ISD Investment Service Directive EU European Union iX International Exchange LSE London Stock Exchange DB Deutsche Borse NYSE New York Stock Exchange PSE Philippine Stock Exchange PB Paris Borse SGX Singapore Exchange TSE Tokyo Stock Exchange SEC Securities and Exchange Commission CCASS The Central Clearing and Settlement System HKFE Hong Kong Futures Exchange HKSCC Hong Kong Securities Clearing Company Limited 1. Introduction There are currently about 250 institutions recognized as exchanges in the world, and both individually and collectively they play a critical role in most national economies and also at a global level. They provide cash, futures, options and other forms of derivatives, markets for all major commodities and assets traded in the world. Competition among stock exchanges, both national and international, is a recent phenomenon. Until some decades ago, it was difficult to think of exchanges as firms that produce and sell goods to customers and compete among themselves. Traditionally, exchanges were seen either as public entities or as formally private bodies, deeply regulated by public rules. In both cases, they were often legal monopolist, given the special nature of their activity that very much resembled that of a public good. There was an era when exchanges were natural monopolies (Steil, 1996b), yet nowadays they no longer enjoy a monopoly in the provision of many of their services. When its members owned a monopolistic exchange, it did not have the incentive to maximize its profits because members in charge were prohibited from taking any distribution of profits from the exchange. Exchanges increasingly realize that if they have to compete like firms whose goal is to maximize shareholders wealth, they have to demutualise to turn a member-owned company into a stock company. Exchanges have never been considered as firms, but now they have reformed to become commercially driven corporations. To understand the firms view of an exchange, it is necessary to redefine what an exchange is, what its products are, where its revenues come from and who its customers and suppliers are. Exchanges are special kinds of firms that provide listing, trading and price dissemination services. Direct customers involve listed companies and those, which desire to go public, information providers and intermediaries that trade on the exchange. Intermediaries trade on behalf of both individual and institutional clients who are indirect customers of an exchange. Suppliers are network providers. Listed companies have a dual capacity as suppliers of information and shares for trading. The primary objective of this dissertation is to analyse the competition and integration strategies of stock exchanges like firms. The dissertation focuses on: 1. Industry dynamics of stock exchanges; 2. Evolution of stock exchange mergers; 3. Integration strategies; and 4. Future consolidation trends. Advances in technology have further accelerated the globalization trend. In particular remote access to trading systems, implying that the services offered by stock exchanges can now be accessed from anywhere, including firms having their stocks traded on international exchanges while still being easily accessible to local investors. This type of arrangement is likely to develop a competitive environment, where the most efficient exchanges will eventually win the confidence of investors, traders and companies (Cybo-Ottone, Di Noia and Murgia 2000). The structure of the European stock-exchange environment is changing rapidly. Almost every day, there are new alliances between stock exchanges, stock exchange privatizations, Internet exchanges and electronic exchanges, as well as online brokers, etc. appear in the media. The changes are driven primarily by intensified competition, which is related to the deregulation of stock exchanges, technological progress and the increasing internati onalization of the securities markets. Competition takes the form of existing exchanges and electronic communication networks (ECNs). The increase in competition of stock exchanges, due mainly to the transformation of the securities markets, has led to mergers, technological agreements among existing exchanges, price wars, takeovers, and the creation of new exchanges, even within the same country. Recently, exchanges have also faced competition from quasi-exchanges, which are also known as ECNs. They are parasites on stock exchanges. They not only free-ride on the process of listing given that they generally trade only securities listed on other exchanges, but also on the price-discovery process facilitating members of exchanges to direct trade to them. ECNs are increasingly cannibalizing the businesses of the existing stock exchanges. Mergers have been one of the most probable strategic interactions among stock exchanges. The concept presented here is drawn upon the network externality literature. Exchanges can be regarded as networks in which an increase in the size of the network leads to an exponential increase in the networks value (Shapiro Varian, 1999). In other words, larger networks are more attractive to users than smaller ones. Castells (2000) links a network to its connectedness and consistency. When firms decide on a listing exchange, they choose the one that is connected by the largest number of intermediaries and one that consistently provides the greatest liquidity. In Europe, the pressure for consolidation among stock exchanges has been the arrival of the euro. The full implementation of the Investment Service Directive 1992 (ISD), which allows its members to gain remote access throughout the European Union (EU), further facilitates the financial market integration in the region. The European Securities Forum is promoting the model of horizontal merger. In this model, national exchanges integrate along three functional levels trading, clearing and settlement, and custody. Each market participant can gain access to a range of pan-European services through a single point of entry. The proposed formation of International Exchange (iX) from London Stock Exchange (LSE) and Deutsche BÃ ¶rse (DB) and the recent establishment of Euronext (the merged entity among the exchanges of Paris, Amsterdam and Brussels) are outcomes of this model. An analytical framework will be provided to analyze industry dynamics and integration strategies. The models used include Porters Five Forces Model, Network Society and Ansoffs Product-Market Matrix. These models are utilized to explain how exchanges determined their merger motives and developed integration and consolidation strategies. Given the rapidly evolving nature of the industry, a total of 5 interviews were conducted with members of the London Stock Exchange and Hong Kong Stock Exchange, investment banks/brokerage firms. Primary data sources were based on the interviews. Secondary data sources included academic journals, books, newspapers and working papers. The deliverable is this report, which includes the literature review, findings and discussions, and two case studies. The implementation followed a traditional approach project specification, literature research, fact finding and investigation, case analysis and evaluation, and finally, report writing. The first finding from the interviews is that merger is a clear strategic option for exchanges. This strategy can achieve economies of scale, network externalities, improve profitability and enhance efficiency in the decision-making process and order routing facilities. In particular, a cross-border merger between two exchanges is made possible in Europe with the support of the financial markets harmonization. The second finding is that a merger brings about two patterns of convergence: vertical merger and horizontal merger. The former depicts that exchanges integrate to form a full financial service group offering the trades of a wide variety of financial products such as stocks, options, futures and other derivative products. The latter describes the merger of specialized exchanges, the outcome of which creates compatibility, a concept in that intermediaries trading in one exchange are offered remote access in other member states, with reciprocity and without further requirements. The third finding is that the existence of national regulatory regimes, deeply embedded in their corresponding regulators, constrains further inter-exchange alliance or merger. The ultimate goal to have a supranational regulator that imposes its own standards on the globe is unlikely to happen in the near future. The fourth finding is that the single price and time priority is not an issue in an order-driven market such as Hong Kong Stock Exchange and the London Stock Exchange. In contrast, in a quote-driven mechanism such as Nasdaq, each market maker is itself an execution centre though operating within certain parameters set by the National Association of Securities Dealers (USA). In quote driven or hybrid environments, there creates space for the development of ECNs. The growth of ECNs is gradually threatening to replace quote-driven trading systems. The fifth finding forms an interesting consensus regarding the motives of investors who choose to trade on an ECN. Investors are not able to differentiate the functionalities of a trading system of stock exchange and that of an ECN as long as they can execute their orders at the best possible price. Competition only on price is inadequate for an ECNs survival. They lack the competencies in attracting liquidity and information dissemination. This dissertation is organised as follows: Section 1 defines an exchange as a firm; Section 2 analyses the existing competition and integration of stock exchanges in Asia and in Europe; Section 3 uses Porters Five Forces and network externalities to shape the industry dynamics; then it utilizes Ansoffs Product-Market Matrix to determine the strategic choice of a stock exchange; Section 4 presents the interview framework and cites opinions to analyse the two case studies: London Stock Exchange and the Hong Kong Stock exchange; and Section 5 further develops the findings and links them with the theoretical framework and literature review. 2. Review of the Literature 2.1 What is an Exchange? A stock exchange has two principal functions. The first is the listing of securities. The stock exchange must approve prospectuses for the eligible securities and also administer the statutory information obligations imposed on the issuers. Secondly, the stock exchange is a marketplace for its members to trade the listed securities. Previously, the brokers gathered physically on the floor where the price was fixed by auction. Today, most stock exchanges have introduced electronic trading systems in some form or other, so it is no longer necessary for the brokers to be physically present at the stock exchange. Stock exchanges can be seen as a market, not too much different from the one that fruits and vegetables are traded on. They operate according to the laws of supply and demand and the most successful, whilst having reasonable regulation, will be constantly changing and developing their market operations. Domowitz has given a comprehensive definition, stating: An exchange is a trading system that must: Provide trade execution facilities Provide price information in the form of buy and sell quotations on a regular or continuous basis Engage in price discovery through its trading procedures, rules or mechanisms Have either a formal market-maker structure or a consolidated limit order book or be a single price auction Centralize trading for the purpose of trade execution Have members Exhibit the likelihood, through system rules and/or design, of creating liquidity in the sense that there be entry of buy and sell quotations on a regular basis, such that both buyers and sellers have a reasonable expectation that they can regularly execute their orders at these quotes An exchange is generally described by regulatory authorities as an organization, association, or group of persons that provides a marketplace for exchanging securities between purchasers and sellers. Traditionally, an exchange is owned by members who are also intermediaries. Under a member ownership structure, members did not have the incentive to invest in the exchange infrastructure including technology and trading facilities because returns from these investments could not be distributed to them. The lack of motivation undermined the profitability of an exchange and hence its competitiveness. In addition, intermediaries trading on a monopolistic exchange were subject to higher prices. They passed the increased costs of operations onto their customers. Therefore members were reluctant to vote for an increase in transaction levy. Hansmann (1980) notes that: The nonprofit producer, like its for-profit counterpart, has the capacity to raise priceswithout much fear of customer reprisal; however it lacks the incentive to do so because those in charge are barred from taking home any resulting profits. As time has gone by, exchanges have had to compete in the global market to attract quality companies to list and intermediaries to trade; many of them have converted their member ownership structures into a stock company by means of demutualisation. Under the plan of demutualisation, members are issued shares of the exchange. They become shareholders of the exchange and therefore can be eligible for profit distribution. Since then, exchanges have reformed to become commercially driven corporations whose goal is to maximize shareholders wealth. 2.1.1 Products Stock exchanges cannot only be perceived by the function they fill in an economy, they can also be viewed as a firm, producing a product. The product is the creation of a market in financial instruments, thus leaving the property of the price information produced with the stock exchange. More specifically the products a stock exchange offers encompass: listing, trading, price-information services and clearing settlement, the percentage of which are shown in Table 1. The distribution of revenues from these various offerings shows that the focus lies mostly on listing and trading, as other services are not always part of the offering. Table 1 Fees Europe % N. America % Listing 19.3 32.1 Trading 45.1 39.7 Services 24.4 22.6 Other 11.2 5.7 The firm view focuses on the production and profitability of an exchange. Mulherin et alii (1991) defines a financial exchange not as a market, as it normally is, but as a firm that creates a market which is characterized by the use of financial vehicles. Lee (1998) suggests that a security market be regarded as a firm that produces goods: listing, trading of securities, clearing and settlement services, price information dissemination, and research. In this dissertation, the aspect of the provision of settlement services is omitted because many of the exchanges either dismiss it or do it by a separate entity. The dissertation considers the exchange as a producer of listing and trading services, given that the network externalities effects created by listed companies and intermediaries are the main focus. 2.1.2 Revenues The revenues from listing and trading are in general fees, both initial and annual. Services include Settlement Clearing and price-information services. Thus the trading services offered by a stock exchange can be structured in three parts: the object traded (issued by some entities that generally pay a fee to have it listed), the means of trading (trading facilities, computers, a computerized floor, settlement) and price dissemination. The listing and trading and related services can be segregated and tagged as the front-end of stock exchanges. Clearing and settlement is the unglamorous bit after equities or bonds are traded on an exchange. A clearing house ensures that buyer and seller have the cash and securities to do the deal; a securities depository settles the trade by moving the securities from one account to another. The profitability of an exchange establishes the extent to how successful it is in attracting order flow and in attaining the ability to generate revenues (Lee, 1998). Order flow implies the liquidity of the market and the trading volume that includes the number of trades over a specified period and the total value of the shares traded. It directly and indirectly generates revenues for an exchange. The direct effect comes from an exchanges receipts for transaction services, which are dependent on the number of trades it executes. The indirect effect exists because the trading volume reported on an exchange is regularly used as a marketing tool to attract new listings to the exchange. 2.1.3 Customers An exchange has direct and indirect customers: Direct customers include listed companies and those which desire to go public; both pay for their use of listing services. They also include intermediaries who pay to be admitted to trading; and information providers who pay to have terminal access and the right to disseminate price information. Indirect customers are individual and institutional entities that send orders to intermediaries for execution on an exchange. They can either trade through an intermediary or via the Internet. In both cases, they take into account the quality of the exchange, price factors and transaction cost. Market microstructure, such as liquidity, price discovery, or immediacy, and reputation and fiscal regulation all influence their choices. Other income includes share registration service fee income arising from initial public offerings. 2.1.4 Suppliers Listed companies are also suppliers because they provide the information and the shares for trading. Another type of suppliers is the network provider who provides physical connectivity services on an exchange infrastructure. The above describes an exchange as a firm; globalization of financial markets and competition of exchanges have caused the transition of an exchange from a market to a firm. 2.2 Globalisation of Financial Markets Since 1980, cross-border securities transactions have grown very rapidly. A quarter of stock market trades worldwide involved either a foreign security or a foreign counterparty by 1988 (Howells and Bain, 2000). Between 1989 and 1995, estimated global turnover in foreign exchange more than doubled. With the formation of the European Union, cross-border trading in Europe is growing in popularity. The introduction of the euro and a wider acceptance of equity as a financing tool are encouraging investors in Europe to engage in more cross-border transactions in search of profit-making opportunities. Yet despite the appeal of cross-border trading, most stock exchanges in Europe are national institutions that trade only local, country-specific stocks. This market structure appears to be changing, however, as an increasing number of stock exchanges are attempting to operate across national borders. A Transaction Survey done by Hong Kong Stock Exchange in 2000 indicated that overseas investors (mainly institutions) had significantly increased their participation in the Hong Kong market. In Europe several ambitious initiatives have been undertaken of late to create, through mergers or other consolidations, pan-European exchanges that offer trading in stocks from many European countries. The establishment of these exchanges will likely lead to important benefits for the financial markets. For example, a standardization of trading platforms across exchanges, an increase in market liquidity, and a reduction in market fragmentation potential by-products of consolidationcould help minimize the costs and problems associated with cross-border trading in Europe. Despite the persistence of protectionism and restrictions to free trade, markets for goods and services are becoming increasingly globalized (Castells, 1996). Financial institutions are extending their activities either by developing new products or by penetrating new markets in response to growing competition. They are also widening their customer base to benefit from economies of scale and scope. Expansion occurs both within national boundaries, and also across borders to establish presence in international markets. Globalization of markets has been made possible in the late twentieth century by new communication and transportation technologies allowing for more efficient delivery of information, goods and services. 2.2.1 Europe: Vision to Become a Pan-European Financial Market The concept of harmonization of financial regulations to establish a single financial market across the EU was brought out since the 1957 Treaty of Rome when it established the European Economic Community (EC) (Howells and Bain, 2000). Extensive liberalization of financial markets was seen in the 1960s regarding direct investments, commercial credits and the acquisition of securities on foreign stock exchanges. A genuine single financial market across the EU extended to include the securities markets and the insurance services industry. In 1979, the Directive Co-ordinating the Conditions for the Admission of Securities to Official Stock Exchange Listing allowed companies to list their shares or raise capital on other EU stock exchanges. The ISD, based on the Single European Act principles, applied the single passport principle to non-bank investment firms, removing barriers to both provision of cross-border securities services and the establishment of branches throughout the EU for all firms. It also liberalized the rules governing access to stock exchanges, and financial futures and options exchanges. Mutual recognition and home-country control for all security firms and banks performing investment services were shared among all member states. As with other financial services, the insurance industry saw the promulgation of certain directives; all established the right for companies to operate in other member states. The Euro launch as a common currency on 1 January 1999 by 11 European nations has been considered a step toward Europes economic convergence. Euro facilitates to establish shared, centralized accounting and administrative systems dramatically reduce currency exchange costs and increase price transparency for the member countries. Even non-members dealing with member countries may also benefit from greater price transparency when dealing with one, rather than a number of different, currencies (Geradine, 2000). As discussed above, globalization has become a major driver of change, which was confirmed by rapid growth in cross-border portfolio investment and cooperation of markets 2.2.2 Asia: Evolution of Strategic Alliances and Cooperation Asia Pacific saw the frantic pace of exchange alliances and cooperative arrangements. Most recent examples include: On 1 February 2000, HKSE jointly agreed with Nasdaq to launch the NASDAQ AMEX Pilot Programme for the trading of seven global securities (Amgen, Applied Materials, Cisco Systems, Dell, Intel, Microsoft and Starbucks) in Hong Kong. These shares can be traded and settled in Hong Kong dollars following the standard T+2 (the second trading day following the transaction) settlement period. Memorandum of Understanding among various countries were signed to facilitate information sharing and cooperation of regulatory matters: examples are Jakarta Stock Exchange and the Amsterdam Exchange; The Singapore Exchange and the Australian Stock Exchange; The Stock Exchange of Thailand and the Tokyo Stock Exchange. In Japan, The Osaka Securities Exchange signed a Business Cooperation Agreement with Nasdaq Japan Inc. to establish the Nasdaq Japan for acceptance of listing applications on the Nasdaq-Japan market. Another collaboration accord was signed between The Tokyo Stock Exchange and the Korea Stock Exchange for the effective management of their operations and better investor protection, which allowed for useful information swap regarding promotion of stock investment and supervision of market activities. 2.3 Nature of Competition of Stock Exchanges The evolution of new financial instruments, the falling monopoly of banks as a source of direct funding to borrowers and of direct investment for investors, the tremendous improvement in information technology, and a greater financial culture among people as well as the fluctuations in interest, price, and exchange rate due to the oil crises have caused the increasing importance of securities markets in the financial system, both as regulated exchanges and over the counter (OECD, 1996). New theories of financial intermediation (Allen and Santomero, 1996; Allen and Gale, 1997) underline the importance of the markets in such a way that all intermediaries (banks, mutual funds, etc.) perform a risk-management activity in between borrowers and lenders on one side and markets on the other, providing a kind of risk insurance. In spite of that, banks and markets can still coexist (Boot and Thakor, 1997). Th