The death and rebirth of the stock exchange

Trading venues have grown in value despite regulatory, technological and competitive disruption
Ingram Pinn illustration©Ingram Pinn
The clue as to why the London Stock Exchange has risen sevenfold in value in the past seven years is not contained in its name. The best days of being a stock exchange are in the past, when they were near-monopolies owned by market-making members and could easily make money.
That was long ago.
But a funny thing happened on the way to their demise. The businesses formerly run as stock exchanges became more valuable despite a wave of disruption unleashed by regulation, technology and competition. They should be in trouble but the leading ones have instead been transformed.

This phenomenon is on show on both sides of the Atlantic. The IEX trading platform, made famous by Michael Lewis’s book Flash Boys, has applied to become the 13th US stock exchange. The buttonwood tree under which 24 brokers agreed to form the New York Stock Exchange in 1792 has become a forest of competing bourses.

In Europe a battle looms for control of the LSE, which looked vulnerable after the 2008 financial crisis but is now highly prized. It is planning an agreed merger with Deutsche Börse and rivals such as Intercontinental Exchange (ICE), which owns the New York Stock Exchange, are considering counterbids.
The oddity of all this activity is that, as one equity trader puts it: “The core business of matching buyers and sellers is not very profitable and does not have great prospects.” Being a stock exchange was fine while entry barriers were high and they could shield themselves from competition. As soon as that was undermined, particularly in the US, they became vulnerable.

The NYSE’s share of US equity trading has fallen from 72 per cent to 24 per cent in the past decade amid competition from new exchanges and “dark pools” — platforms run by banks and others for institutions to trade privately. Exchange fees are razor-thin; some dark pools in effect pay to attract business.

IEX has provoked an uproar by seeking to impose an infinitesimal delay on outside orders routed through its exchange — 350 microseconds, or less than one-thousandth of the time needed to blink.
The fact that regulators are wrestling over an interval of time that they would not even have noticed a decade ago shows how high-speed trading by computers has taken over.
Trading volumes are huge — the global number of trades rose by 55 per cent last year — and IEX says the delay is needed to stop equity markets being rigged in an arms race of rapid-fire trading.
Exchanges were once strong enough to enforce discipline on brokers; they now accept fees to let high-speed traders locate servers in their buildings and gain a tiny time advantage.
If stock exchanges are so weak, why are the companies that own them so resilient? The answer is simple: the LSE is not really a stock exchange any more. Equity trading comprises about 10 per cent of its revenues (and 7 per cent of the revenues of ICE). The bulk of its business is based neither on shares nor on trading but on other securities and activities.

One of its biggest operations is clearing — taking care of the contracts after trades are done. Its SwapClear division now clears 95 per cent of the global market in over-the-counter interest rate swaps (private interest rate contracts reached by banks). This is less exciting or visible than equity trading but bigger and more profitable; SwapClear often clears $1tn of swaps daily.

War has broken out in the US stock market.

On one side is the establishment, led by the New York Stock Exchange and Nasdaq. On the other is IEX, an upstart trading venue with a tiny sliver of the business but outsized ambitions to disrupt the world’s largest equity market by becoming an exchange itself.

Derivatives clearing has another advantage over share trading: it takes a long time. A clearing house holds cash to cover the moves in the value of a contract over weeks or months. It is a steady money-earner that is far less exposed to competition than a stock exchange. Fees such as these, from derivatives clearing, data and financial indices, are valuable.

The transformation of exchanges offers three lessons. First, regulation works. It does not always work as intended but it affects behaviour. US and European regulators encouraged stock exchange competition and, after the 2008 crisis, pushed banks to use clearing houses to curb risk. Exchanges altered course as their old business grew tougher and another one expanded.

Second, capitalism is highly adaptable. The world of stock exchanges was dominated for decades by entrenched institutions, particularly those in global financial centres such as London and New York. Changes in regulation and financial markets undermined that position so they adapted.

In some cases, such as the LSE’s, stock exchanges remodelled themselves behind the scenes into clearing and data operators. In others, futures exchanges such as the Chicago Mercantile Exchange outstripped stock exchanges in value or acquired them, as ICE has done. Within a decade, stock exchanges were absorbed into exchange groups that mostly do other things.
Last, traditions endure. Exchanges are largely but not wholly unrecognisable from the days of the buttonwood tree. Networks remain powerful — exchanging contracts through a hub rather making a multitude of bilateral deals creates economies of scale. This applies as much to the central clearing of interest rate swaps as to exchange-based share trading.

Stock exchanges remain exchanges, despite all the fragmentation and upheaval. Unlikely as it once seemed, they are still in business.

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