Prior to last fall, the past several years were exceptional for most financial institutions, and for none more so than the exchanges. These companies—established stock and derivatives exchanges, new entrants such as electronic communications networks and multilateral trading facilities, and the clearinghouses and depositories (where trades are settled and securities held)—have seen their margins, profits, and other performance metrics rise spectacularly. Across the globe, they increased their EBIT¹ margins to 39 percent, from 18 percent, in the years from 2001 to 2006.

The gains of incumbent exchanges are all the more impressive for coming at a time of great uncertainty: a wave of regulatory change has reached its crest in US equities markets and is now gathering force in Europe and other US exchange-traded markets. Regulators have opened the trading, clearing, and settlement markets to competition. In the United States, entrepreneurs, typically competing on lower transaction fees and more flexible technologies and sharing surplus with those who control liquidity, have gained impressive market share in both cash equities and derivatives.

Yet thanks to high trading volumes, exchanges are thriving. Their near-universal business model—a scalable order execution and fulfillment engine filled with as many trades as possible—has been well suited to a period of strong bull markets in most asset classes, a burgeoning hedge fund industry, and exceptional growth in algorithmic, high-volume trading strategies.

At some point, the merry-go-round of ever-expanding trading volumes may slow or stop. Hedge funds might pull in their horns—some are sure to go out of business, and new ones will find it harder to get started. In addition, the marginal value of slicing and dicing trades into ever-smaller increments and trading against infinitesimal pricing differentials could peak. A sustained global economic downturn, which may be in the offing despite the best efforts of the Federal Reserve and the European Central Bank (ECB), would surely dampen retail volumes. Other unforeseen turns may adversely affect investors and trading. Should growth slow, US exchanges will enter another period of painful contraction; the pinch of competition will be felt more keenly than before, with dozens of players fighting for liquidity in a fragmented market. Exchanges have performed even more spectacularly over the past five years in Europe than in the United States. They will be less exposed than US counterparts to the effects of slowing growth, but those of growing competition will be felt more acutely. Forward-looking exchanges should prepare for a range of scenarios for growth and price erosion in a more competitive world.

If conditions appear set to deteriorate, it will be necessary to explore new sources of growth, beginning with a fresh look at potential M&A opportunities. Despite the recent industry consolidation, many interesting combinations of geographies and products remain. The Chicago Mercantile Exchange’s offer for Nymex extends the CME’s reach into new commodity contracts and begins the consolidation of the Chicago and New York futures markets. NYSE Euronext, Deutsche Börse ISE, and Nasdaq OMX have all bridged the Atlantic, but major Asian exchanges have yet to participate in these global tie-ups. There are two other possibilities: many exchanges can do much more with their offering to customers, for example, making themselves indispensible in a “best execution” world through smart order routing in equities. And most can tap new sources of growth beyond the core business, as they still capture only a relatively small part of the value associated with securities and derivatives trading. Exchanges with diverse and independent revenue streams and strong value propositions—including buy-side sensitive pretrade services, best execution that protects customers’ interests, and efficient post-trade services—will fare best in the years to come.

Storm clouds

By most measures, exchanges have been world-beaters for the past decade (Exhibit 1). In capital productivity, they have performed better than the rest of the financial sector and much better than other traditional industries. Their profitability has proved extraordinarily attractive to investors; total returns to shareholders have outpaced those even of red-hot sectors, such as materials and energy.

Incumbent exchanges have also boosted their income in other ways (fees for listings, information and IT services, and so on) but most of the growth has come from higher trading volumes—despite price competition, particularly in US cash equities (Exhibit 2). Because exchanges have held the line on costs—a noteworthy accomplishment given continual pressures to expand processing capacity and enhance execution functionality—growth in revenues of all kinds, however derived, produced dramatic growth in the bottom line.

All this has happened even as four forces—liberalized market entry, a centralized post-trading infrastructure, advanced technologies, and savvy entrepreneurs—have combined to challenge the position of exchanges.

Consider, first, the reduced barriers to entry. The European Union’s Markets in Financial Instruments Directive (MiFID), which became effective in November 2007, explicitly authorized new entrants called multilateral trading facilities and abolished the “concentration rule” requiring most trades in some European countries to be executed on the local regulated exchange. Now, trades must be sent to the exchange or facility offering the best price.

The EU Directive resembles, to a certain extent, the approach taken by the US Securities and Exchange Commission (SEC) over the past decade in the cash equities markets. The 1998 Limit Order Display Rule facilitated the creation of electronic communications networks, which often have better prices than Nasdaq market makers do, by forcing Nasdaq to integrate the networks into their systems. The SEC’s new Regulation National Market System (Reg NMS) goes much further, requiring trades to be routed on a trade-by-trade basis to the venue offering the best execution price on a price/time priority basis. As such, Reg NMS is more radical then MiFID. MiFID only requires market participants to implement best execution policies in cases where the best deal for clients can generally be found. The US market has also felt the pressure of other regulatory developments such as “decimalization” rules, which have forced pricing into finer and finer increments, explicitly reducing opportunities for the likes of NYSE specialists or over-the-counter (OTC) market makers to make money between the bid and the offer. Importantly, while forcing pricing transparency and routing among Reg NMS members, the new ruling permitted market participants below a certain size to operate as “dark pools”—ensuring market fragmentation as institutional investors sought anonymity.

The regulation of clearing and settlement has changed as well. Since the 1970s, the United States has had a central clearing and settlement structure, with a single, not-for-profit, member-owned utility clearing facility for all cash securities. Clearing for exchange-traded futures has long been an important exception in the United States; however, recently the Department of Justice has raised anticompetitiveness issues around this valuable source of profits for the futures exchanges. The picture elsewhere has been very different: only now are regulators in Europe pushing for a unified, centralized post-trade infrastructure serving all exchanges and customers in some asset classes. While a complete solution is not yet in place, recent regulatory and industry initiatives point to a more integrated future. Under the voluntary code of conduct, for example, Europe’s equity clearinghouses and central securities depositories have agreed to move toward interoperability. Already, new entrants are creating more pragmatic solutions to make pan-European clearing possible for equities.

Arguably, the changes in clearing and settlement are as important as those that opened up markets: after all, competing with an incumbent exchange isn’t easy if trades must be settled through its facility. Further, high clearing and settlement costs can offset the incremental value captured by US-style, high-velocity algorithmic trading that optimizes pricing across venues by “smart” routing.

Deregulation has to some extent unleashed the last two forces affecting exchanges. One is technology. Smart routing systems that identify the best market are becoming standard on traders’ workstations. This development works against the incumbent exchanges, which rely on proprietary systems to lock in traders. What’s more, the Financial Information eXchange (FIX) protocol, a de facto industry standard for communications among financial institutions, makes connecting to a number of systems far easier for market participants. Further, the exchanges’ systems are often much slower than those of new entrants, which use streamlined technology unencumbered by the burden of older programs and hardware. Thus, even when the exchanges’ systems are integrated in a smart routing platform, traders may be tempted to bypass them for faster alternatives. Today’s technology is smarter, faster, and much cheaper. We estimate that the upgrade of the London Stock Exchange trading system completed in 2007 cost about $80 million. In contrast, it would have cost only $20 million or so to set up a new, competitive trading system from scratch. Similarly, when the NYSE acquired Archipelago in 2005, its annual technology spend was $139 million, whereas Archipelago spent only $17 million² per year to deliver competitive trading functionality in the same markets. While part of the difference results from the expense regulated exchanges incur setting up and maintaining backup sites and servers, most is attributable to the wide availability of fast off-the-shelf trading platforms.

Entrepreneurs are the other force unleashed by deregulation, though their impact varies by region. In the United States, banks, brokerages, and exchanges have used regulatory and technological change to create new trading ventures: these have enjoyed ample access to funding from investment companies and broker-dealers aiming to shake up the industry. The role that former start-ups like International Securities Exchange (ISE) and Archipelago now play in the maturing US exchange landscape (and the wealth created for founding owners) continues to inspire new entrants.

The post-MiFID European trading landscape will be an interesting test case for the power of entrepreneurship: banks and broker-dealers are willing to fund attackers who can reshape the industry, but they will still face a complex web of subtle and not-so-subtle advantages enjoyed by current leaders.

In contrast, in Asia, where regulation still very much protects the industry and government ownership of infrastructure is still the norm, entrepreneurs direct their energies and investments toward the region’s abundant other opportunities.

What’s next?

Incumbents are acutely sensitive to the turmoil these changes have created. Indeed, across a representative sample of leading European and US cash and derivatives exchanges, costs remained almost flat at 2001 levels until 2006—a significant achievement, considering inflation. What’s more, in a frenzied search for cost savings and revenue synergies, exchanges have combined or sought to combine at a surprising speed for an industry that was virtually devoid of M&A until a few years ago.

Will cost cutting and M&A, the main remedies to date, be enough? Have exchanges taken all the steps needed to preserve their franchises? The answers depend in part on the sustainability of the growth in trading volumes and in the transaction and market data revenues those volumes generate. Exchange investors are optimistic about this kind of topline growth. We analyzed several publicly held exchanges and found that expectations of long-term growth explain 48 percent of their current share prices—a much higher percentage than the one for software companies (33 percent), let alone other financial institutions (only 6 percent). Yet with the recent turmoil potentially retarding growth in volumes, and competition exerting downward pressure on pricing, exchanges would do well to prepare for a more spartan future.

What could this future be? To answer that question, we analyzed the exchanges’ current revenues and the potential effects of changes in trading volumes, the larger number of players competing in the industry, and the resulting fragmentation of the market.³ Our analysis suggests four possible scenarios for the next stage of the exchanges’ core trade execution business in Asia, Europe, and the United States (Exhibit 3).

In a “perfect summer,” resembling the conditions that prevailed in Asia and Europe during the last few years, incumbent exchanges will benefit from strong market growth and limited competitive pressure. In a “cool spring” scenario, incumbents and attackers alike will profit from rising growth—though with greater competition, no one will benefit more than customers. In a “mellow autumn” market, industry profits would slow as volume growth declines, but players that can hold onto liquidity will do better than others. Finally, if everything goes wrong, a “long, dark winter” will set in as scrabbling for relatively scarcer trade flows destroys value across the industry.

Expectations vary dramatically as to the effect on revenues in each region. Asia presents the clearest picture. Exchanges there start in something like a perfect summer, with approximately €2 billion in revenues annually and all fundamentals pointing toward growth in capital stock, derivatives usage, and more active trading. We expect competition for volumes and associated pricing to remain low, with governments and regulators still pursuing relatively nationalistic agendas that tend to favor and protect incumbents. At best, these near-perfect conditions will continue, with 2012 revenues of €4 billion; at worst, Asian exchanges could be headed for a mellow autumn, with revenues of €3 billion.

In the United States, exchanges are already operating in the cool-spring scenario. The genie of deregulation left the bottle long ago and will not return: in cash equities, electronic communications networks and other attackers are here to stay, and continued price cutting will offset the benefits of trading volume growth. Exchange-traded derivatives growth will be strong, but we anticipate regulatory action putting pressure on revenues. The most likely outcomes are that revenues—€5.7 billion in 2006—will either remain broadly flat until 2012 if market growth slows (a winter scenario) or increase to €7 billion if volumes continue to grow strongly (a continuation of the cool spring). Other more positive outcomes are unlikely.

The path of development in Europe is least certain of all. Exchanges there enjoyed about €7.8 billion in revenues in 2006. Near-perfect conditions are quite unlikely to persist: greater competition and the emergence of attackers will make it difficult for exchanges to sustain their current revenues and profits. If volume growth remains strong, the exchanges will probably land in a cool spring, with €8 billion in revenues in 2012. If exchanges continue to consolidate and take steps to preserve liquidity, they can protect themselves even if volume growth slows: in this case, they will face a mellow autumn, also with €8 billion in industry revenues. But if they do not take steps to fight off attackers and volume growth slows, a long, dark winter is likely, with revenues shrinking to €6 billion. While each of these three scenarios is possible, favorable fundamentals (such as hedge fund growth) will help fire trading volumes; further, experience in the United States suggests it will take time for attackers to push leading exchanges into lower pricing.

Adjusting to a new climate

Volume swings owing to market fluctuations lie outside the exchanges’ control. But their hands are hardly tied—far from it. They can influence the dispersion of the industry’s liquidity in three ways. M&A will clearly remain at the forefront of exchange strategy. Formation of a limited number of major global exchange groups is, to a certain extent, already a fait accompli. Ultimately, we expect today’s large groups, and potentially one or two others, to be diversified across cash and derivatives and to have footprints in Asia, Europe, and the United States.

Based on size and economic performance today, three groups appear strong enough to control their own destiny and shape consolidation: NYSE Euronext, Deutsche Börse Eurex and CME Chicago Board of Trade (CBOT). LSE and Nasdaq appear poised to engage in further transactions; their choices will determine whether one or two other Western dominated groups figure in the end game.

While Western exchanges will successfully court some of today’s Asian leaders (the NYSE already has ties with, including ownership stakes in, several Asian exchanges), we are confident that one or possibly two Asian giants could emerge and thrive. After all, the fundamentals of securities and derivatives market growth are strong, the region is becoming increasingly interdependent, there is a desire for strategic control at the national and regional levels, and exchange know-how is readily obtainable.

Smaller, national exchanges, meanwhile, have to choose if and when to combine with larger suitors. In Europe, the combination of several of the Nordic exchanges to form OMX was not enough to win control over LSE, but Nasdaq and Dubai competed for the exchange’s favor. Asian exchanges outside Japan and Greater China will have to consider combinations that strengthen them relative to powerful and expansion-minded neighbors. In the United States, as market structure has evolved and attackers have proliferated along the trading value chain, smaller acquisitions to obtain critical functionality, such as NYSE’s purchase of Wombat Financial Software to strengthen its transaction- and data-management solutions, are at the top of the agenda.

Beyond that, exchanges can pursue a number of initiatives, with two goals in mind: keeping attackers at bay by improving the value proposition and finding new sources of growth outside the core business. Neither of these ideas is new or radical, but given the scale of the changes ahead, especially in Europe, the leaders of exchanges should act with far greater resolve than they did in the past. Although the exchanges have held their cost base steady over the past five years, they have invested little in growth—and that must now change.

Keep competition at bay

In the 1990s, many European exchanges became more advanced than their US counterparts—for example, by investing in electronic trading and developing derivatives products. More recently, however, the pace of innovation and investment at incumbent European exchanges has slowed. Asian exchanges generally haven’t made such investments. US exchanges are adding functionality rapidly, but they face a complex array of specialist attackers with distinctive niche capabilities. If exchanges in these regions want to keep ahead of the competition, they should radically rethink their services and offerings in the light of new technological opportunities and changing customer needs.

One area is trading performance. The incumbents, which have long touted their reliability and their skill in keeping markets open during turbulent conditions, have tended to dismiss the claims of new market entrants. Attackers, however, cite impressive performance statistics: Chi-X, Europe’s new multilateral trading facility, claims a 2-millisecond mean trading latency (the time elapsing from the placement to the execution of an order) against what it says are 10 and 16 milliseconds, respectively, for Deutsche Börse and LSE. If incumbent exchanges can’t beat or match industry-best performance across most trade types, volume could continue to shift elsewhere.

Many exchanges recently cut prices for trading. These reductions, though welcomed by customers, typically occurred in isolation, unconnected with any larger initiative to improve service. One such initiative would involve recognizing the importance of the post-trade experience in the total value proposition of an exchange by pressuring the clearinghouse and depository to improve post-trade services. (A possible move would be to offer cross-asset netting of positions.) Prices will remain an issue for customers and serve as a weapon for new entrants. Established exchanges need to move the focus away from an exclusive preoccupation with price to the potential of new trading capabilities.

As European (and eventually Asian) markets begin to give brokers a choice of execution venues, exchanges should seek to influence end investors—the buy-side firms that place their orders through brokers—and put such decisions more directly in their hands. NYSE’s acquisition of MatchPoint Trading in 2006 is a good example. MatchPoint Trading is a platform that lets investors execute complex block transactions without the help of brokers.

Finally, exchanges have at least one strength that new trading platforms can’t match: the ability to bring new companies to market. Listing fees represent 18 percent of revenues for the world’s largest stock exchanges, but the significance of this business goes beyond that. New listings create new liquidity, attract new trading customers, and reflect the overall health of the equities exchanges. While some factors in these shifts are beyond their control—for instance, onerous corporate governance regulations in the United States—they must commit more resources to attract and retain listings both in their home markets and beyond. Such moves might involve investing larger sums in efforts to understand the requirements of companies, to lobby regulators, and to hire additional sales staff.

Grow outside the core

In the search for new sources of growth, exchanges can pursue three main avenues. First, they could use better technology and specialized offerings to facilitate new trading styles. Deutsche Börse, for example, has designed a new service to accommodate the needs of algorithmic (or program) traders by allowing them to locate their computers alongside or very near those of the exchange, thus reducing latency delays on telecom networks. (Fractions of a second are critical to program traders.) To make it easier for customers to purchase and manage these services, the exchange has combined them and several other IT-related ones in a single package.

Exchanges should also launch new asset classes more aggressively, as CBE did when it offered new credit-default swaps products. The wave of new exchange-traded funds in Europe, many created by exchanges, also exemplifies this kind of innovation. In the past, exchanges too often innovated defensively, to protect the existing business, rather than offering new products that could create new markets.

Finally, exchanges without a post-trading platform must come to terms with the implications for their franchise. Where possible—as in the merger of LSE and Borsa Italiana—an exchange should evaluate the possibility of securing ownership of and access to a clearinghouse or a central securities depository. Although such ownership and access aren’t possible in every environment, they give an exchange higher revenues, greater control over the trading value chain, and the ability to launch integrated products.

Exchanges, with their sky-high profitability, now occupy an exalted position in the world’s financial markets. Our research shows that they make more money per employee than banks, brokers, insurers, and all other financial players. Since this enviable position has attracted the attention of regulators and new entrants, the exchanges should use their moment in the sun to prepare for times to come, when conditions may prove less favorable.