All exchanges compete by making products available for trading and attracting traders to trade those products at their exchanges. But there is a difference between the securities and derivatives exchanges’ approaches to this competitive activity. First, a securities exchange's products are mainly stocks of companies that have agreed to list on them. So, product development involves seeking these company listings. The exchanges may also allow trading in companies that have listed elsewhere, or developed equity- or bond-based products such as exchange-traded funds (ETFs) or exchange-traded notes (ETNs) to offer investors tailored exposures not efficiently obtainable from individual equities or bonds.

Securities exchanges receive listing fees from public companies that list with them. ⁴ They do not receive listing fees from companies in which they allow trading but do not formally list. They also do not receive listing fees for products they create that are based on indexes published by others. On the contrary, the exchanges must pay for the rights to use these indexes. AMEX, now part of NYSE Euronext, for example, must pay fees to Standard and Poor's for the very popular ETF, Spider (SPDR), listed there.

Derivatives exchanges never receive fees from anyone for listing products, and, like stock exchanges, they sometimes even pay fees for the privilege of listing a product that utilizes the intellectual property of another company, such as the indexes of Standard and Poor's, Dow Jones, Wilshire, or Russell. At the risk of overgeneralizing, derivatives exchanges compete by creating new products and winning customers for these new products, whereas securities exchanges (within a single country) compete by listing the same products and enticing customers to their markets via a combination of strategies, including liquidity enhancement and actually paying for order flow. There is a difference here between stock exchanges and derivatives exchanges.

There was a time when competition among exchanges was local and regional. And, as regional victors became established, countries were peppered with a number of regional stock exchanges. The United States still has stock exchanges over 100 years old in New York, Boston, Philadelphia, Chicago, and Los Angeles, but there were once a great deal more. The Chicago Stock Exchange, for example, was the result of a merger of exchanges based in St. Louis, Cleveland, Minneapolis-St. Paul, and New Orleans. In fact, during the 19^th century there were roughly 250 stock exchanges operating in the United States. ⁵

As late as the 1990s, India had 22 regional exchanges in addition to the main exchange in the financial center of Bombay. England once had 20 stock exchanges and today has only the LSE and a few small competitors. In all these cases you needed regional exchanges to trade regional stocks because it was too costly, difficult, and slow to communicate and deliver stock certificates, even across a country as small as England.

But as communication became cheaper and faster, regional exchanges began trading national products. The regional stock exchanges in the United States have almost totally abandoned any notion of regional stocks. All stocks are now national. And all the regional exchanges compete for trades in the same stocks. The same is true in India. The 23 regional exchanges began competing in the same stocks and were eventually unable to match the financial might of Mumbai (known until recently as Bombay, when a nationalistic Hindu party began throwing out the old British names and restoring the original Hindu names of many cities). Therefore, business tended to migrate to the financial center and the regional exchanges either got absorbed, converted themselves into brokerage firms, or simply dried up and blew away. So, all that's left in England is the London Stock Exchange and a handful of niche players. Most of the Indian regionals—New Delhi, Kolkata, Chennai, and so on—no longer see any real trading. And in the United States, a system mandated by the SEC that connects all regional U.S. exchanges to the New York Stock Exchange has saved them by ensuring that as long as they offer competitive prices they will continue to get a piece of the action. However, over the past few years the number of independent regional exchanges has fallen from five to two (the Boston Stock Exchange and the Chicago Stock Exchange), with the others (Philadelphia, Pacific, and Cincinnati) being absorbed into Nasdaq, the NYSE, and the CBOE, respectively.

The relationship that an exchange has with its clearinghouse is a very important factor when we look at an exchange's ability to compete. There are really three possible relationships between an exchange and a clearinghouse:

From the point of view of the exchange, particularly an exchange that is an aggressive innovator or “first mover,” one that tends to be the first to market with new products, the internal clearinghouse is the best, and this is the model that futures exchanges have generally chosen for themselves. Since the internal clearinghouse is totally controlled by the exchange, its priorities can be changed quickly to deal with a shifting competitive environment. For example, if the exchange has a new product that it needs to launch very quickly, it can tell the clearinghouse to devote all necessary resources to prepare for this new contract and put other projects on the back burner. This is difficult to do with an external clearinghouse. There, the exchange's new product must take its proper place in the queue behind other products from other exchanges and wait its turn.

Though there are efficiency advantages to having several exchanges clear their products on a single common clearing system, competitive problems can sometimes arise. One of the best examples of problems with an external clearinghouse was that of the Board of Trade Clearing Corporation (BOTCC) and the exchange that created BOTCC, the CBOT. In 2003, the then largest futures exchange in the world, Eurex, decided to create a Chicago subsidiary to compete directly with the cornerstone products listed at the CBOT. At that time, BOTCC was and had been the entity that cleared all CBOT trades for the past 70 years. But because the BOTCC was an external, independent clearing entity, when Eurex approached BOTCC to clear its Treasury products and offered an attractive deal for doing so, BOTCC jumped at the chance. One of the motivations for BOTCC to agree to clear the products of its long-time partner's major competitor was that BOTCC feared that Eurex would be successful and the revenues from its then major client, the CBOT, would disappear. So, it took a calculated risk and decided to clear the products of the Eurex Chicago subsidiary.

Quite naturally, the CBOT decided to sever its relationship with BOTCC, and it asked the CME to take over the clearing of CBOT contracts. The CME agreed to do this because none of the CBOT products were competitive with its own products and it represented the chance that this could lead to a closer relationship between the two exchanges as they did battle against the rest of the world. In fact, as is mentioned elsewhere in this book, the two exchanges grew close enough that they actually merged in the summer of 2007.

The third model of several exchanges commonly clearing identical, fungible contracts is both the best and the worst of all models. It is difficult to imagine a group of competitive exchanges choosing this model, and thus it would most likely exist when imposed by a regulatory entity, as it was when the SEC mandated it for the securities options industry in the United States.

Back in 1973, the CBOE was founded by the CBOT to allow trading of options on individual shares of stocks, and this involved the creation of a captive clearinghouse. The CBOE was successful, and naturally a number of the existing equity exchanges decided that they too would like to list options, a logical product extension for them. The SEC, which regulates all U.S. securities, including options on securities, required that the CBOE spin off its internal clearinghouse and make it available to all other options exchanges in the United States. So, in 1975 the CBOE clearinghouse was spun off and renamed the Options Clearing Corporation (OCC). The SEC further required fungibility of products so that not only would the now independent clearinghouse clear the products of all options exchanges, it also would allow an option that was listed on more than one exchange to be purchased on one exchange and then be sold on the other options exchange cleared by the OCC. This allowed positions to be put on at any U.S. options exchange and offset at the same or any other U.S. options exchange. What this meant was that if one exchange had a successful product, and another exchange decided that it wanted to list that same product, traders knew that if they took a position at the new relatively illiquid exchange, they could always offset the position at the more liquid exchange, if they needed to do so. This basically gave a helping hand to any exchanges that wanted to compete with a product that was already successfully listed at an exchange. The SEC felt that this would create price competition among the various options exchanges and keep transaction fees low. From this point of view, it actually was the best of the models because it encouraged vigorous price competition. However, from the point of view of an individual exchange, especially an exchange that had worked hard to develop liquidity in some new product, this was the worst of all systems because it gave the least protection to the new product.

This third model has been exclusively applied to securities options in the United States. However, there have been proposals to also apply this model to U.S. futures. The brokerage firms, which are always concerned about the fees being charged to them by the exchanges, lobbied in 2003 through their trade association, the Futures Industry Association (FIA), for the CFTC or Congress to impose an SEC-type model on the futures industry. The closest that futures markets came to “real interexchange competition,” said John Damgard, FIA president, was the “single stock futures exchanges where U.S. law has mandated fungible contracts [and a single clearing entity].”⁶ Damgard was referring to the new futures on individual stocks, which Congress insisted be regulated jointly by the SEC and CFTC and follow the fungible contract model of single stock options. Damgard went on to say that if Congress continues to pay attention to consumer and user concerns, then fungibility would spread to traditional futures as well.

Of course, the futures exchanges have argued that futures contracts are the intellectual property of exchanges and they should be able to protect and not be forced to share this property with every latecomer who stumbles into the party. In addition, they argue, forced fungibility would actually harm the users because the new competition would fragment liquidity into several smaller pools, each with a bid/ask spread that would be wider than the ones in the existing monopolistic pools. So, even if competition did drive down exchange fees, this savings could be more than offset by the cost of wider bid/ask spreads. ⁷

While the debate raged between the brokerage firms and users, who wanted product fungibility and common clearing, and the exchanges, who felt these were an invention of the Devil, the federal futures regulator stayed neutral. CFTC Chairman James Newsome made it clear that he wanted the industry members to work it out among themselves; he even had his staff facilitate meetings between the exchanges and FIA members. He also held a formal roundtable discussion on the issue.

Government neutrality was pushed aside when the U.S. Department of Justice (DOJ) dropped a bombshell. In late 2007, the DOJ requested comments from other agencies regarding a possible revamping of financial regulations in the United States. The DOJ responded by arguing in a January 31, 2008, 22-page letter that product fungibility and common clearing should be imposed on the futures exchanges. The DOJ maintained that because futures exchanges in the United States have captive clearing organizations, competitors are not able to tap into the existing liquidity at the exchange that first listed the product. The letter noted that futures exchanges, when they compete for new products, find themselves in a winner-take-all situation. The network liquidity effects, ⁸ which is to say the fact that buyers and sellers all want to be in the market with the greatest liquidity, result in buyers and sellers congregating eventually at a single exchange when two exchanges compete. And the DOJ maintains that if the futures industry followed the model of the securities industry, specifically the equity market and the equity options market, this would significantly enhance competition among the exchanges, resulting in lower costs of doing business and greater innovation.

It was interesting to note that this DOJ comment letter had such a chilling effect on the industry—and specifically on the CME, which was in the process of trying to acquire NYMEX—that the stock price of both the CME and NYMEX dropped like a rock. ⁹ The DOJ had gone along with the CME's first big merger with the CBOT in the summer of 2007, but the question now was, would it go along with the proposed CME merger with NYMEX and would it require a restructuring of the industry as the price the CME had to pay for the approval?

In the beginning there was only the Chicago Board Options Exchange (CBOE). The CBOE, which was conceived by a group of traders at the CBOT, was the first exchange in the world to list options on equities. It was an idea whose time had come. In fact, a number of stock exchanges around the country (like the AMEX, the Philadelphia Stock Exchange, and the Pacific Exchange) saw the CBOE's initial success and felt that the idea was sufficiently powerful that they also began to list options on individual stocks. Initially, the exchanges did not compete directly over identical products, and in a manner similar to basketball or football drafts, the options exchanges would take turns picking stocks on which they would list options. One exchange would choose first, then another exchange, then a third exchange, and so on. Unlike the basketball and football drafts, which are held annually, the options sessions were done a number of times each year. While this was convenient for the exchanges to each have monopolies on the various stock options, the SEC actually wanted it this way. The problem was that had there been multiple listings of each option, for example, both CBOE and AMEX listing IBM, there was not a practical way to ensure that a customer wanting to buy a specific IBM call would have his order filled at the exchange offering the best price. Communication systems were simply not good and fast enough to have exchanges communicate with each other on every order for every one of the many strikes and expirations being offered. The bandwidth of the 1970s was simply not sufficient. So it was best, the SEC thought, to have each company option at a single exchange.

Though the SEC formally eliminated the practice of listing new options only on a single exchange in 1990, each options exchange still chose not to list those options in which significant liquidity had been established at another exchange.

We explained earlier in this book how technology has been a fundamental driver in the morphing of exchanges during the current era. We also explained how all exchanges are trying to make their way down this steeply falling cost curve, to minimize the cost per share or the cost per contract traded. And, of course, the only way to move down the cost curve is to have more shares or contracts traded at an exchange. Aside from increasing business in existing products and listing new products, the only way to bring more trades to an exchange's platform is to capture business from other exchanges. And there are really two ways to do that. You can capture business by essentially attracting an existing exchange's business to your own exchange, essentially killing the other exchange in the process. Alternatively, you can purchase that business from the other exchange via a merger or acquisition. We turn to the issue of expanding business through mergers and acquisitions in the next chapter.

When pursuing the “kill the competitor” approach, exchanges first tend to go after other exchanges within the same country. Only after that approach has been exhausted do exchanges tend to jump borders and attempt to capture business from exchanges in other countries. And the kill-the-competitor approach works best when the attacking exchange is electronic, and the target exchange is still floor-based. So there's a relatively brief transitional period in the history of exchanges where this approach could work, and that is where electronic and floor-based exchanges exist side by side.

The new global competition has been more prevalent in derivatives than on the equity side of the street. So we start with global competition in derivatives.

As we have seen, there has been some global competition in the equities market going back to 1927, when the first ADR was created, and in the derivatives markets going back to 1984, when SIMEX was founded on products from other jurisdictions. But the pace has quickened as we have moved into an era of electronic trading, and the need to expand the scale has been heightened. The big attempt at cross-border competition in derivatives failed (the Eurex subsidiary in Chicago), but the event did drive the Chicago exchanges to swiftly shift their trading to screens, resulting in some pretty low exchange fees, at least for a while. The very active cross-border competition in European equities should continue to heat up for a few years, pushing down trading fees in Europe just as they have been pushed down in the United States.