Stock exchange mergers spark fears of ‘friction’

Some institutional traders and brokers fear growing global consolidation of stock exchanges could decrease competition and increase trading costs.

"The real concern about consolidation is that there will be less competition and more friction," said John Fay, co-president of institutional brokerage firm Instinet LLC, New York, who runs Instinet's business in Europe and Asia. "Higher prices and miscellaneous trading fees all create friction (disincentives to trade), which leads to higher spreads and costs."

Andrew Larkin, a managing director at institutional broker ITG Inc., New York, agreed that a lack of competition would trouble institutional investors.

"They like the idea of there being competition," he said. "I don't think they want to go back to an era where one marketplace is dominant. If the field consolidates to a handful of exchanges, that would be fine, but if it consolidates beyond that to one or two, there would be concern."

Most market participants agree that the main question is when, not if, stock exchanges will merge.

John Thain, chief executive officer of NYSE Group Inc., New York, which operates the New York Stock Exchange, has made no secret of his desire to be a player in global exchange consolidation. Some industry observes suspect he might make a bid for the London Stock Exchange PLC, London, which in March rejected a buyout offer from the Nasdaq Stock Market Inc., New York.

Nasdaq, meanwhile, added to its LSE holdings on May 10, making it the exchange's biggest shareholder at 22.7%.

"We look forward to working constructively with LSE as its largest shareholder," said Bob Greifeld, Nasdaq president and chief executive officer, in a statement. NYSE spokesman Richard Adamonis did not return phone calls seeking comment.

In addition to the London bourse, two other European exchanges are considered merger partners, takeover targets or acquirers: Deutsche B%F6;rse AG, Frankfurt; and Euronext PLC, Amsterdam, which operates the Paris, Amsterdam, Brussels and Lisbon stock exchanges as well as Euronext.liffe, the London-based derivatives exchange.

On May 3, Euronext officials said they ended exploratory merger talks with their counterparts at the London Stock Exchange and at the same time recommended that investors reject a shareholder proposal formally stating that a merger between Euronext and Deutsche B%F6;rse would be in the best interest of all Euronext shareholders. Euronext is scheduled to hold its annual general meeting on May 23.

For investors, trading in some European stock markets already costs more than in the United States, which should raise a warning flag, according to Instinet's Mr. Fay. "In Europe, there's a lot of friction because there's no competition within the markets," he said. "London has a monopoly. If you want to change or cancel an order, it costs 4 cents. That's friction."

In the U.S., investors typically do not pay to cancel or change an order.

The result is that traders, wanting to avoid canceling orders, will place orders slightly away from quoted prices, which leads to wider bid/ask spreads and higher cost.

Another example that illustrates the pricing power Europe's exchanges have is in their profitability, Mr. Fay added, comparing Deutsche B%F6;rse to Nasdaq.

In the first quarter of this year, Deutsche B%F6;rse's net income reached $204.4 million, or $2.06 per share. Nasdaq reported first-quarter net income of $18 million, or 16 cents per diluted share.

"Deutsche B%F6;rse is one-third the size of Nasdaq but its profit is over 10 times the size," Mr. Fay said. "That means they're taking money out of the market, which comes out of returns."

Still, consolidation of exchanges could help institutional investors in some ways.

George Bodine, director of trading at General Motors Asset Management, New York, said that in markets where there are several pools of liquidity, consolidation would force those pools to merge, increasing the likelihood that traders will get their trades filled.

Still, he noted that most countries have few market centers.

"In a lot of the global venues, there's really just one (primary) market," he said. "Here in the U.S., you've got a potpourri of choices. In France, for example, you've got one primary exchange."

But that primary market structure could change despite the interest in consolidation, said Peter Kearns, president of NeoNet Securities Inc., New York, the institutional U.S. brokerage unit of NeoNet AB, Stockholm. NeoNet provides direct market access to stock exchanges around the world.

Major regulatory changes that effectively make price the key determinant of where a stock gets traded — like Regulation NMS in the United States and Europe's MiFID, or Markets in Financial Instruments Directive — encourage the creation of new market centers, Mr. Kearns said.

"There's concern by the buy side (money managers) that if there are too few exchanges, then you could see costs go up," he said. "But that's what I think people like about Reg NMS. It's led to the reproliferation of multiple places to execute."

In fact, later this year, Instinet is planning to launch Instinet Chi-X, a pan-European electronic alternative market center that will allow money managers to execute trades on any European stock.

"It's a high-speed, low-cost marketplace as an alternative," Mr. Fay said. "We're doing that to force competition. We think there's an opportunity, particularly if two (European) exchanges get together."

However, if the history of electronic communications networks in the U.S. is any indication, some market observers said that even with a growing list of market centers, over the long term, the list will indeed shrink. ECNs flourished under new order handling rules in the late 1990s, but their number declined dramatically amid a wave of consolidation that culminated last year when Nasdaq acquired the INET trading platform from Instinet.

Howard J. Schwartz, chairman and chief executive officer of Tradeware Global Corp., New York, which provides electronic trading capabilities to 58 markets in about 40 countries, said any benefits of global exchange consolidation will take time to emerge.

"Laws are different in every country; some countries will permit electronic trading and some don't if they don't have the technology," he explained. "Different countries have different order types. It's a question of the consumer becoming educated, and it's not as easy as it sounds. There are time differences, language differences and cultural differences.

"We're not in a well-oiled, well-integrated global trading structure," he said. "But we're getting there."