The evolution of the Exchange

Industry in the last 20 years

Carmine Di Noia

Financial Market Law and Regulation

Luiss-Guido CarliOctober 13, 2014

The stock exchange... like Mary Poppins!http://www.youtube.com/watch?v=C6DGs3qjRwQ&feature=related

Different exchanges...

L.O.V.E. ("Libertà. Odio. Vendetta. Eternità.“) di Maurizio Cattelan a Piazza Affari di Milano.

Direct research of counterparties: issuer find directly counterparties. Risk on issuer

Brokers markets: issuers ask brokers (pure, third party account, intermediaries) to place the securities. Risk on issuer

Underwriters Market: issuer place securities to a syndicate; then placing to investors

Auction market by issuer

The organization of financial markets: primary markets

Direct research of counterparties: investors look for counterparties; no guarantee of best price counterparty, low volumes; worthless to create intermediaries

Broker market: brokers look for counterparty at a lower price (commission) than direct research, due to expertise and information (economies of scale); low volumes but high unitary value. Typical of sophisticated market segment; no guarantee of best price due to direct negotiations

The organization of financial markets: secondary markets - 1

Dealers Market: market of intermediaries dealing on own account (when volumes at least on some securities increase, is cheaper to keep a reserve). Direct dealing. Good price only if there is competition among dealers

(from dealers to market makers: dealers who oblige themselves to make market in a security)

Dealers gains from spreadAuction market: supply and demand in one place

(physical or virtual). Call auction (ideally perfect but no guarantee of execution anytime; then continuous auction)

The organization of financial markets: secondary markets - 2

Public entities or private mutuals: like golf club! Only members play!… (coop of intermediaries; corporations controlled by intermediaries or by intermediaries, institutional investors, and issuers; corporations controlled by outside owners; or board may be composed of representatives not elected by shareholders)

National Regulation: Exchanges like national airline: national pride

National exchange with national issuers with national intermediaries with national investors

Little national competition (US Nyse vs. Nasdaq)International competition: via listing (US) or dual listing, trading

(SEAQ international)

Securities exchanges: in the beginning customer-controlled firms

European Monetary Union has increased the level of substitutability between debt and, to a less extent, also equity instruments given that country interest factors disappeared (!?)

Euro impacted the demand side of exchange business, by altering the slope of the demand function for European securities and making them more and more quasi perfect substitutes

Euro induced investors to price macro risk with a pan-European index and further decompose remaining risk along sector rather than country, bringing reorganization of the asset management industry

Securities exchanges:Effect of EMU and Euro

e.g.: Stockholm, Helsinki, Copenhagen, Amsterdam, Italy, ….

Listing (e.g.: Tradepoint,OM-Stockholm, Amsterdam, Paris, Euronext, Lse, DB, OMX, Nyse, …)

No more coincidence between shareholders and members

Likelihood of consolidation due to lowering to barriers of entry in the market for corporate control

Securities exchanges: demutualization/privatization

Listing date Listed exchange Market value (US$m.) Mar. 1987 OMX Group 1,645Oct. 1998 ASX 2,407 June 2000 HKEx 4,407 Nov. 2000 Singapore Exchange 1,803 Feb. 2001 Deutsche Boerse 11,028 July 2001 Euronext NV 5,879 July 2001 London Stock Exchange 2,710 April 2002 Sydney Futures Exchange 1,315 Nov. 2002 TSX Group 2,745 Dec. 2002 Chicago ME 12,651 April 2004 Osaka Securities Exchange 560 August 2004 Archipelago 2,365 Mar. 2005 ISE 1,030Oct. 2005 CBOT Holdings Inc. 4,951 Nov. 2005 InterContinental Exchange 2,015

NYSE, Bombay,…

Selected xchanges “listings”

Network economics says that industries characterized by network effects start with very low value but after reaching a critical mass, they grow exponentially (e.g. Katz-Shapiro (1985))

This literature suggests for the exchange industry (Cybo-Ottone et alii 2000): Network effects on listing and network effects on trading (and cross-network, Di Noia 1998)

Securities exchanges: a typical network industry?

Notion of regulated market (appears on the list, functions regularly, is characterized by the fact that regulations issued or approved by the competent authorities define the conditions for the operation of the market, the conditions for access to the market and, where Directive 79/279/EEC is applicable, the conditions governing admission to listing imposed in that Directive and, where that Directive is not applicable, the conditions that must be satisfied by a financial instrument before it can effectively be dealt in on the market, requires compliance with all the reporting and transparency requirements laid down pursuant to Articles 20 and 21)

Allow concentration rule on regulated marketsIntroduce remote membership

Securities exchanges: Investment Services Directive (93/22) - 1

Make more instruments accessible to larger pools of liquidity and investors internationally;

give intermediaries the opportunity to enhance their operating efficiency;

give the operators of trading platforms greater opportunity to increase volumes, achieve economies of scale;

open the trading process to more vigorous competition and innovationRemote access regulation, induces electronic exchanges to pursue

compatibility, which also turn increased the likelihood of consolidation

Securities exchanges: Investment Services Directive (93/22) - 2

The impact of ISD on the restructuring of European exchanges is important and overlaps with the introduction of the Euro. ISD allowed all recognized exchanges to install terminals in other jurisdictions and invite remote access from there

This has substantially increased competition in domestic markets by giving more access to foreign brokers, whom have been the main users of this option

Advances in technology, adoption of open architectures, decreasing costs for international data transmission, convergence of market microstructures, have all made de facto compatibility, as compared with the eighties where exchanges were more isolated technologically

ISD, in practice, made remote trading mandatory!

Securities exchanges: Investment Services Directive (93/22) - 3

increasing cross border dealsmerger mainly domestic (regionals, beginning nineties, vs

full integration cash-derivatives-)x-border mainly contracts and jvexchanges buy (and sell) scale from outsourcingless dropped deals; no domestic

Securities exchanges: after ISD, competition in the industry and

explosion of new deals

Many attempts, a few deals:many INTRA-national (vertical and horizontal)

mergersmany INTER-national alliances (implicit

mergers)no INTER-national legal mergers

Securities exchanges: the evolution of the industry in the nineties

The Exchanges – Consolidation(Recent Developments in the Structure of Securities

Markets A.Cybo Ottone, C. Di Noia, M.Murgia)

311

5

111

112

1 21

2

41

2

9

5

16

6

12

2

12

4

5

22

0

5

10

15

20

25

30

35

40

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

Table 2: TIME EVOLUTION OF SELECTED DEALS AMONG EXCHANGES (1990-99)

NEW

OTH

M

C

JV

Ix (DB-LSE): No!EuronextOMXLondon Stock Exchange-Deutsche Borse-Euronext: NO!Borsa Italiana-Euronext-DB:NO!Euronext-NYSENasdaq-LSE: NONasdaqOMXBorsa Italiana-LSEDB-Nyse Euronext blocked by EU CommissionIce gets Euronext-Nyse (and sell Euronext?)

Securities exchanges: selected events in the last ten years

19

Single System

Single Rule Book

Exchange A

Investors

Brokers

Issuers

Exchange B

Investors

Brokers

Issuers

Exchange C

Investors

Brokers

Issuers

Integration Model: Euronext (and OMX and…)

Cross border trades Cross border trades

Remote membership

Single market by integration

20

Single System

Single Rule Book

Exchange A

Investors

Brokers

Issuers

Exchange B

Investors

Brokers

Issuers

Exchange C

Investors

Brokers

Issuers

Integration Model – Five Economic Benefits

Cross border trades Cross border trades

Remote membership1. Cost synergies

2. Direct accessto full range = cost savings

5. No disruption of “home” markets4. More international exposure

3. Reduce implicittrading costs by increased liquidity

…(see Lucantoni)competition among different trading venues

(regulated markets, multilateral trading facilities, internalizers)

No more concentration rulecreation of new investment services (including

operation of an MTF)admission without consentpre and post trade transparencypossible consolidation of info

MIFID 2004/39/EChttp://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CONSLEG:2004L0039:20070921:EN:PDF

Competition among trading venues (MIFID): no more concentration rule; MTF role; access to post-trading services (Role of the Code of Conduct?)

Greater disclosure for listed companiesSeparation admission to listing/trading

(admission without consent)Less importance of voluntary listings; increasing

delistings of dual listed companiesHarmonization of (detailed) rules for disclosure

and investor protection

The emerging market framework after MIFID

The exchange industry after Mifid:

Trade creation or trade diversion?

Mutuals public/privateDemutualization/PrivatizationListingCustomers sell shares: become public companiesDo they maximize profits? Institutional

Investors/Hedge fundCustomers become again shareholdersGoing back to mutuals (Proxies: Turqoise, Boat,

…)? …and Central Bank role (T2S)?Optimal governance structure?

The evolution of exchanges governance

Federal vs. national regulationGreater powers for regulators even if Member

States and Authorities have already lost their regulatory powers

Euro (but not in UK), single monetary policy.Different rules, conglomerates, cross-listings, cross trading, integration of financial markets

But: existing national rules (company laws, company and market failures, fiscal) (Giovannini reports)

The emerging regulatory framework

The exchange industry today:

Market cap in €bln

The explosion of derivatives - 1

The explosion of derivatives:

Credit default swap

The exchange industry today in Italy - 1

Borsa Italiana ... And Tlx

The exchange industry in Italy – 2

Funds raised and distributed by issuers

Regulation of Organised Trading Facility (OTF) (organised platforms currently not regulated)

In order to facilitate better access to capital markets for small- and medium-sized enterprises (SMEs), the proposals will also introduce the creation of a specific label for SME growth markets.

New safeguards for algorithmic and high frequency trading activities which have drastically increased the speed of trading and pose possible systemic risks. These safeguards include the requirement for all algorithmic traders to become properly regulated, provide appropriate liquidity and rules to prevent them from adding to volatility by moving in and out of markets.

The future of the exchange industry: Mifir/Mifid- 1

Improve conditions for competition in essential post-trade services such as clearing, which may otherwise frustrate competition between trading venues.

Increased transparency: By introducing the OTF category, the proposals will improve the transparency of trading activities in equity markets, including "dark pools" (trading volumes or liquidity that are not available on public platforms). Exemptions would only be allowed under prescribed circumstances.

New trade transparency regime for non-equities markets (i.e. bonds, structured finance products and derivatives).

Newly introduced requirements to gather all market data in one place.

The future of the exchange industry: Mifir/Mifid - 2

Consolidation with (implicit) mergers?Price consolidation due to pre- and post-trade transparency: CLOB?

European Market System (revenue problem…)? Exchange as info vendors

Intermediaries more as markets (internalization?) or exchanges more as intermediaries (direct access of companies and individuals?)

HFT?Specialization of exchanges: exchanges as rating agencies, trading

systems? Payment for order flow and listing?Exchanges: for profit or natural coopPost-trading: public facility?European SEC?

The future of the exchange industry: what’s next?