12.26.2011
By Terry Flanagan

All Eyes on DB-NYX

It’s been three strikes, but global exchange consolidation is not out. Yet.

Following the failure of deals that would have united Singapore Exchange and Australia Securities Exchange, Nasdaq OMX and NYSE Euronext, and London Stock Exchange and TMX Group, the last big cross-border exchange merger still standing is Deutsche Borse’s $7.2 billion proposed buyout of NYSE Euronext.

A fourth strike, in the form of a non-consummated DB-NYX deal, would at the very least cast a pall over the promise of global exchange consolidation, and may scuttle merger ideas for a good long time. But if the trans-Atlantic deal manages to pull itself through the regulatory slog that it was in as of the second week of January, it is reasonable to surmise that a number of exchange-to-exchange dialogues will be revived.

“Does NYSE and Deutsche Borse combining give us an opportunity to merge? Perhaps,” said David Herron, chief executive officer of the 130-year-old Chicago Stock Exchange. “It certainly opens the door to that thinking.”

“Does NYSE and Deutsche Borse combining give us an opportunity to merge? Perhaps. It certainly opens the door to that thinking.” David Herron, chief executive officer of the Chicago Stock Exchange

As of early January, the fate of the proposed exchange tie-up remained very much in doubt as European regulators continued to study whether the deal would impair competition. Some published reports said the European Commission was ready to block the deal.

Deutsche Borse and NYSE Euronext are willing to offer concessions up to the point the deal stops making economic sense; it is unclear whether such concessions will be enough to appease regulators. The companies previously have said they expect to close the transaction in the first quarter.

A merger, or a failure to merge, would have implications not only for Deutsche Borse and NYSE Euronext, but also stakeholders, customers, and competitors of the firms. And whereas at one point early in 2011 when business headlines were rife with the next exchange combination (real or imagined), DB-NYX has the full attention of merger watchers.

“Everyone keeps an eye on it,” said Herron. “Do we have a dog in the hunt? No. But exchanges are merging and opportunities are growing out of it.”

Deal Detractors
Not surprisingly, some rival exchange groups such as LSE and Nasdaq have expressed apprehension about how a combined Deutsche Borse-NYSE Euronext would affect competition. LSE and Nasdaq executives have spoken out against the deal, which could pool an unacceptably high market share in derivatives trading.

“The exchange sector is watching this very closely,” said Richard Perrott, an exchange analyst at Berenberg Bank. “There are big implications within Europe with the derivatives dominance the combined entity would have. Combining (Deutsche Borse’s) Eurex and (NYSE) Liffe would be the equivalent of the combination of the CME and the CBOT.”

The Chicago Mercantile Exchange and the Chicago Board of Trade merged in 2007, creating the world’s largest derivatives exchange.

A combined NYSE-Deutsche Borse would create the world’s largest exchange group by revenue and Ebitda, or earnings before interest, taxes, depreciation and amortization. Based on 2010 financials, 37% of the merged company’s revenue would come from derivatives trading and clearing; 29% from cash listings, trading and clearing; 20% from settlement and clearing; and 14% from market data and technology services.

History suggests a done deal would touch off subsequent mergers, as exchange competitors seek their own additional scale and cost efficiencies. In the months following CME’s purchase of CBOT, Eurex acquired the International Securities Exchange, Nasdaq acquired OMX, and the London Stock Exchange bought Borsa Italiana; there were also smaller acquisitions of regional players including the Philadelphia Stock Exchange, the Montreal Exchange, the American Stock Exchange, and Nymex.

As erstwhile global, cross-border exchange mergers await the outcome of Deutsche Borse-NYSE Euronext, there are a slew of smaller, under-the-radar deals in the works.

In Japan, the Tokyo Stock Exchange said in November it would buy domestic rival Osaka Securities Exchange for $1.7 billion. The Moscow Interbank Currency Exchange (Micex) and the Russian Trading System (RTS), the two largest trading platforms in Russia, are planning to merge, as are Turkey’s Istanbul Stock Exchange and TurkDex. In the U.S., the CBOE Stock Exchange is buying the National Stock Exchange in a comparatively small deal that would combine less than 1% of U.S. equity trading volume.

A prime candidate for consolidation is the London Metal Exchange, which has received several expressions of interest from potential acquirers.

The exchange deals, while far-flung, share common rationales of shoring up liquidity, cutting costs, and boosting competitiveness and visibility on the world stage. Quite possibly, such prettying-up by merging could also lead to a subsequent buyout offer from a larger entity.

A merged Deutsche Borse and NYSE Euronext would create a so-called vertical silo business model, where trading and clearing are integrated under one roof. The London Stock Exchange is pursuing this business model with its bid to buy LCH.Clearnet.

Open-Minded

With numerous exchange deals on the table and the possibility of more on the way, even exchanges not linked to any specific partner or transaction are addressing the idea of consolidation.

Mexico’s BMV Group, the largest stock exchange in Latin America after BM&F Bovespa, would consider a merger or acquisition once the company’s technology upgrades are complete and it builds a stronger pipeline of initial public offerings. The exchange owner is also focusing on its existing joint venture with CME, which gives customers of both exchanges connectivity and access to each other’s products.

“We are open to looking at whatever possibility can enhance the company,” BMV Chairman Luis Tellez said at a press briefing in New York on November 17. A merger, acquisition or alliance with another exchange “would be a possibility,” he added.

The Chicago Stock Exchange looked into a few mergers a couple years ago but nothing panned out, Herron said. “We are open to the possibility” to a deal, he said.

Given the massive size and scope of Deutsche Borse and NYSE Euronext, reverberations from a deal would be felt by many market participants — those who execute trades on exchanges may be most directly affected.

“Broker-dealers are taking a very close look at the deal,” said Perrott. “There would be cost savings for them in terms of connection costs and technology costs. But they would also be concerned about the reduction in competition.”

A concern for broker-dealers is that a mega-merger in the exchange space would reduce competition and lead to higher fees and costs. However, as the synergies surrounding the DB-NYX transaction are derivatives-centric, the brokers that operate primarily in equities are not likely to be affected to any large degree.

With thin margins and fragmented order flow, exchanges and other trading platforms see mergers as a way to cut costs and build scale. “We face the same economic pressure as any industry,” said Jose Marques, global head of electronic equity trading at Deutsche Bank.

“Whether it’s airlines, car manufacturers, or exchanges, at some point you see the same evolution: you have innovators start new platforms, platforms proliferate, (and then) at some point the cost of having many operators is simply inefficient,” Marques said during a sidelines interview at Markets Media’s Global Markets Summit on Nov. 30. Subsequently, “you see a round of consolidation, driven mostly by the need to get scale in the process. This is a natural evolution.”

NYSE Euronext Chief Executive Duncan Niederauer has said that a merger would help deliver $4 billion in “capital efficiencies” to clients, as well as $100 million in cost savings. The single biggest efficiency would come from merging onto one technology platform.

Exchange consolidation “is one of those things that seems to go in cycles,” said Joe Mecane, NYSE Euronext executive vice president and co-head of U.S. listings. “You tend to see more fragmentation when people either create something differentiated or see an opportunity to serve a different part of the market. The consolidation theme is generally around the need to get scale and the need to diversify.”

“Globally there’s a glut of matching capacity and services, so at the moment, a little bit of consolidation is probably healthy, from the perspective in that it will bring down the costs of maintaining all these infrastructures,” said Marques. “As long as the competitive environment is healthy, we’re happy for exchanges to evolve their business models.”

Cross-border mergers allow exchanges to diversify globally, reach new pools of liquidity, and expand product lines. By buying Euronext in 2006, NYSE combined two substantial pools of liquidity, expanded its derivatives and European presence, and reduced costs.

“As margins continue to decline from competitive dynamics in the space, like a lot of other industries, it becomes a question of spreading your fixed costs over as many business lines as possible,” said Mecane. “So clearly, there’s a scale and efficiency piece to it. While firms increasingly look to have global markets and to raise capital globally, we want to be able to be at the forefront of creating an exchange that can mirror that trend.”

Global Path
NYSE’s path from an iconic, though largely domestic, brand to a global exchange superpower can be traced back for the better part of two decades. During Dick Grasso’s eight-year tenure as CEO that ended in 2003, NYSE saw substantial increases in trading volume and market share amid a plethora of sweeping changes, including decimalization. Grasso’s successor, John Thain, led the exchange operator through a period of market-structure changes, including Regulation NMS, which lowered the barriers of entry for competition.

Thain also oversaw a period of consolidation in the exchange space, including NYSE’s reverse merger with Archipelago in 2006. Not long after the Archipelago deal, NYSE merged with trans-Atlantic counterpart Euronext, setting a precedent for cross-border deals to follow such as Nasdaq-OMX. Niederauer, who took the reins of NYSE Euronext in December 2007, has continued the exchange’s expansion strategy, from the acquisition of the American Stock Exchange in 2008 to the current proposal with Deutsche Borse.

Many exchange operators are publicly traded entities themselves, so mergers are driven by shareholder interests first and foremost.

“Mergers in any sector are often from the investor perspective to advance the value of a company’s own shares,” said William O’Brien, chief executive officer of Direct Edge. “However, the most sustainable reason for consolidation is when it makes the lives of customers better.”

Mergers can help an exchange regain market-share losses incurred from competition and fragmentation. NYSE Euronext now accounts for about a quarter of all U.S. equities trading volume, down from about 80% earlier in the 2000s. Combining with Deutsche Borse would not bring back all the lost volume, but it should make for a stronger competitor versus rival exchanges and alternative trading systems.

Should the Deutsche Borse-NYSE Euronext merger fall through, market participants and observers have said it could be a long time before another large, cross-border exchange deal is floated. Smaller transactions may be the path some take going forward, as these are more likely to pass muster with regulators.

As some exchanges pursue acquisitions of smaller rivals and others expand by buying companies in ancillary businesses such as technology and risk management, another option for those looking for more trade-matching scale is alternative trading systems.

Such a precedent was set in 2009, when the London Stock Exchange bought Turquoise. This allowed the two-century-old exchange operator to rid itself of a competitor, realize cost savings and expand its reach. An exchange-ATS deal is not as apples-to-apples as an exchange-exchange deal, but as they are very similar businesses, such non-traditional combinations can create substantial efficiencies.

“The separation between an ATS and exchange is de minimis,” said Marques of Deutsche Bank. “An exchange acquiring an ATS can make a lot of sense. The challenge for exchanges going forward is that they need to be introspective and try to figure out how to create unique economic value. Matching orders in a price-time limit order book is not a hard problem anymore.”

Mecane of NYSE Euronext didn’t rule out the idea of an ATS acquisition. “A lot of it comes down to the price, what you get for it and creating synergy out of it,” he said. “As frequently gets highlighted, just taking two pools of liquidity and putting them together doesn’t necessarily yield more for customers or for the owners. It comes from the structure of creating either a significant synergy or cost-reduction opportunity or a differentiated value proposition for customers.”

Added Mecane, “all the different iterations of ATSs or exchanges and technology companies are on the table. It’s a matter of finding the right pieces to put together.”

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