Suitable Suitors? Jun 16, 2006 URL: http://www.advancedtrading.com/showArticle.jhtml?articleID=189401880
In today's trading environment, where Reg NMS seeks to create a level playing field among exchanges, consolidation is the quickest way to shore up primacy in the market. As a result, it follows that the New York Stock Exchange and Nasdaq, having both acquired their biggest U.S. rivals, now would be looking overseas for potential partners and acquisitions. In the past few months, the media has been playing an international corporate version of "Where's Waldo?" trying to spot NYSE CEO John Thain and Nasdaq CEO Robert Greifeld near the doors of exchanges in Europe and Asia.
Although much of the merger talk is hearsay, there is evidence behind it: In April, Nasdaq made an unsolicited offer to acquire the London Stock Exchange, but quickly withdrew it. This spring, however, Nasdaq made a series of acquisitions that now make it the largest shareholder of the LSE, at 25.1 percent as of May 26. And, as Advanced Trading went to press, the NYSE made a bid to acquire Euronext. Meanwhile, Tokyo Stock Exchange (TSE) Chairman and CEO Taizo Nishimuro has indicated publicly that a merger with an overseas exchange is a possibility and that some kind of coalition, at the very least, is necessary to achieve the exchange's goal of running a 24-hour market.
Still, an overseas deal is not a given. Significant differences between the U.S. major markets and the second- and third-largest markets in the world - the Tokyo and London stock exchanges, respectively - present obstacles to any deal.
London Calling
The London Stock Exchange has traded shares electronically since 1986, and since has introduced the Stock Exchange Trading System (SETS), a matching system for trading in all LSE-listed shares. Although the LSE shares electronic trading capabilities with its suitor, Nasdaq, the two markets are structured quite differently.
Nasdaq is a quote-driven market, in which brokers are obligated to post prices in order to keep the market moving. The LSE, like the TSE and most of the exchanges in Europe, is an order-driven market, in which buy-side participants sustain the market and brokers respond to incoming orders, making the popular broker practice of trading against customer orders much more difficult than it is in the United States, notes Octavio Marenzi, founder and CEO of Celent Communications. Any sort of linkup between the two exchanges would have to consider this fundamentally different approach to operations.
Additionally, off-market trading is much more common at the LSE - where up to 50 percent of the volume does not cross the SETS limit order book but instead is crossed "upstairs," among brokers, or between brokers and institutions, according to Tony Mackay, president and managing director of Instinet Europe, a major contributor of volume to the LSE - than at the NYSE or Nasdaq. Further, while both the NYSE and Nasdaq hold dominant positions in the trading of their own listings, this is not the case with the LSE. Clearly, with an LSE buy, U.S. market operators would be entering a market with a different trading culture.
A third critical difference to the U.S. markets is the practice of both the LSE and TSE of charging per trade executed, rather than per share. The U.S. practice of frequently trading small-share lots of sliced and diced block orders is discouraged by this model, Mackay notes. Commissions also are attached to the monetary value of the trade, rather than the volume, he adds.
"If you buy $1 million worth in shares, you might pay 10 basis points or $100 commission; if you do $2 million you pay $200 commission, even if the number of shares is the same," Mackay says. "If you have a high-priced stock, you pay the commission on the monetary value of the trade versus the number of shares. But it is no more difficult for a computer to match a $1 or $10 million trade."
Because of this fundamental difference, Mackay points out that any future foray by an American exchange into Europe surely will have to involve an acquisition. Nasdaq's previous attempt to enter Europe, Nasdaq Europe, essentially tried to import the quote-driven model into a very well-established and well-protected European marketplace; the underperforming operation was shuttered in June 2003.
Clearly, acquiring the LSE would not be a walk in the park - it already has rebuffed an offer from Nasdaq. But the exchange went public with the knowledge that the move would make it easier to make acquisitions and be acquired, and the process already appears to be under way.
Technical Difficulties
The Tokyo Stock Exchange - in contrast to the LSE, Nasdaq and now the NYSE - is a membership organization. This, in addition to its place in a culture that is notoriously insular, protectionist and more foreign to Americans than the U.K., presents an obstacle to American suitors, as members are likely to look after their own interests. Further, some more-immediately critical problems also have surfaced at the TSE that have dampened its efforts to issue a public offering and expand internationally.
On three separate occasions, significant technical glitches have hampered the exchange, which handled an average of 1.9 billion shares per day in April. On Nov. 1, 2005, a capacity-related issue overwhelmed the clearing system and trading had to be suspended.
Another major embarrassment highlighted one of the primary differences between the Japanese and U.S. markets: It is common in Japan for listed shares to be represented by extremely small floats with high per-share prices. The TSE trading system is supposed to account for this, but last January a trader for Mizuho Securities entered an erroneous order for 610,000 shares of J-Com at 1 yen apiece; the clear intent was to put in an order of one share for 610,000 yen, according to Neil Katkov, manager of research for Celent Communications' Asia practice. Authorities attempted to cancel the trade, but the system would not accept the cancellation, and opportunistic traders profited off the error throughout the day, resulting in losses of $330 million for Mizuho.
In a third incident also in January, legal action against an actively traded software company caused exchange officials to preemptively suspend trading on the entire exchange for the last 20 minutes of the trading day in order to head off a systems meltdown, rather than simply suspend trading in the security, as is the practice in the United States. Not surprisingly, "The exchange is under extraordinary pressure to clean up its house in terms of its IT and management," Katkov says.
Amid exchanges of blame between two of the system's manufacturers, Fujitsu and Tosho Computer, a series of remedial measures has been taken since the triple glitch. The Tokyo exchange announced plans to increase the capacity of the trading system from 9 million to 12 million orders per day by May 22, with an increase to 14 million orders per day planned later in the year; the clearing system also got an upgrade from 5 million to 8.4 million orders per day on May 4. An entirely new trading system is scheduled to be implemented by 2009, but in the meantime, traders will have to put up with stopgap measures.
"The current system makes the TSE very noncompetitive and it's really too slow in processing orders for the kind of algorithmic trading and automated trading" brokers are used to conducting in the U.S., Katkov says. "The infrastructure is very outdated; it's difficult for securities firms to use their favorite strategies." The exchange also does not permit direct market access from institutional clients, a popular, lower-cost form of trading in the U.S., mandating that all trades go through brokers. This is not likely to change as long as the company remains a membership organization, Katkov says.
Shaken by the flaws inherent in a system built and maintained by multiple vendors with on-site staff and a fairly skeletal in-house IT staff by U.S. standards, the Tokyo exchange has begun to recognize that it has structural issues as well as technological issues. In January, the TSE hired its first-ever chief information officer, Yoshinori Suzuki, formerly CEO of Japanese firm NTT Data Force, a bank payments system.
The TSE also may lower spreads (see related article, page 25), which typically are about 3 times the bid-ask differential in the U.S., but it may not be able to do so until the new trading system is installed, says Olivier Thiriet, managing director at Credit Suisse in Tokyo.
For Japan, by Japan
Another potential issue for U.S. suitors of the TSE is the protectionist nature of Japanese business culture, which does not necessarily share the shareholder-is-always-right mentality of U.S. businesses. This is reflected in the exchange's decision to build from scratch, for about $500 million, a trading system using Japanese vendors when exchanges worldwide now use out-of-the-box systems from companies such as OM and Atos-Euronext, technology offshoots of exchanges in Sweden and France.
"I think there is a big question why they have not considered foreign packaged systems," Celent's Katkov says. "But because of political sensitivities, they will buy in Japan. This is a national asset of Japan and the thought is that they will have a Japanese-built system."
Credit Suisse's Thiriet acknowledges the current system's flaws, but says grafting an out-of-the-box system onto a complicated regulatory structure is no simple task and might end up costing just as much in labor and time, even if the initial cost is less. "In early 2009 we expect a system that can execute within 10 milliseconds, versus a few seconds right now," Thiriet says. "I wouldn't be surprised if [the new system] held up well to any of the exchanges in the world. I think they have the right plan in place. Now that there is pressure to change and action is being taken, the frustration has subsided."
And whether the frustration has subsided or not, investors in Japan vote with their dollars as they do elsewhere, and the TSE still holds 92 percent of the liquidity in Japan. Rival Osaka Stock Exchange commands just 5 percent market share and Jasdaq handles about 2 percent, according to Celent's Katkov.
As much as recent trends in globalization imply that all trading will look the same someday, that is clearly not the case today. Strong cultural, regulatory and technological boundaries still exist among the world's leading economies and securities markets. While the search for listings and capital increasingly is a global effort, the leaders of the U.S. marketplaces on the hunt for acquisitions surely must be cognizant of these challenges. The biggest and most captivating stories in global trading for the rest of this decade are likely to come from watching what happens after the NYSE and Nasdaq have finished their courting dances.
NYSE, Nasdaq, LSE and TSE Officials did not respond to, or declined, requests for comment for this article.