Exchanges are no longer private clubs with privileged access to a select few. Today exchanges around the world and across asset classes are restructuring their businesses to become for-profit global enterprises. Operating as public companies, exchanges are looking to expand their business franchise globally to find new growth opportunities and to increase revenue. Exchanges earn a majority of their revenue from the volume of trades on their platform. Exchanges can simultaneously increase volumes and reduce average costs by adding new products. In the new world, adding new product lines is fairly inexpensive—a few new servers and a little programming. So any new volume from the new products contributes directly to the exchange's bottom line. With exchanges being increasingly stockholder owned and publicly traded, an easy way to add products is by simply acquiring or merging with other exchanges. We expect these mergers to continue and for exchanges to get larger. Mergers between publicly traded companies are much easier than between member-owned organizations.

Exchanges across all asset classes have been merging with other exchanges to capture more market share and to expand product offerings, including new asset types. In 2007 there was approximately $39 billion worth of mergers and acquisitions. ¹ Some long-established exchanges, in different asset classes and even different countries, have joined forces to compete with other exchanges and the new electronic trading platform. These transatlantic mergers include such venerable names as Nasdaq-OMX, NYSE-Euronext, and ISE-Eurex. The largest derivatives merger was the CME-CBOT-NYMEX merger during 2007 and 2008. The past few years have been pretty busy for exchange consolidation, and the trend is likely to continue. A majority of the mergers in recent years have been in North America and Europe. The rest of the world is just beginning to enter the global markets. As the financial markets continue their journey toward globalization, exchanges will continue their trend toward further consolidation. Consolidation allows exchanges to combine their product suites onto a single technology platform, thus reducing their infrastructure costs. The financial community will see further consolidation among exchanges to gain market share in different countries.

The financial community will merge multiple asset classes together to capture additional volume and market share. The trend of consolidation across asset classes has already begun with Nasdaq's acquisition of the third largest option exchange, the Philadelphia Stock Exchange (PHLX), in November 2007. ² The acquisition of PHLX will allow Nasdaq to compete in the options market, which has grown more than 30% annually since 2003. ³ Established exchanges will find partners in other areas with fast-growing volume. With the growing popularity of OTC markets and the competitive threat they pose to exchanges, there will be a number of acquisitions of these OTC platforms by the established exchanges. CME's purchase of SwapStream in 2005 to capture the market for credit swaps and ICE's purchase of Chatham Partners to expand into the market for natural gas options are recent signs of established exchanges expanding outside their standard exchange-listed products. ⁴

There are significant opportunities for further consolidation in global financial markets, including in North America and Europe, where consolidation has already been under way for several years. Australian markets had undergone some consolidation with the Australian Securities Exchange's (ASX) merger with the New Zealand Stock Exchange and the Sydney Futures Exchange. Established markets in Asia will need to consolidate to compete with larger exchanges such as NYSE and CME, which have several acquisitions already under their belt. The Tokyo Stock Exchange bought an almost 5% share of the Singapore Exchange, the most allowed without the approval of the Monetary Authority of Singapore. ⁵ NYSE Euronext invested 5% in the National Stock Exchange of India, and Deutsche Börse invested 5% in the Bombay Stock Exchange. ⁶ Asia, by and large, has not seen a large number of mergers and acquisitions due to stricter regulation and closed financial market policies.

As the established markets in countries such as Hong Kong, Singapore, and Japan look to expand their territories, there will be a growing convergence between the East and West. In addition, markets in India and China are growing quickly and will likely use partnerships to expand into markets beyond their countries. Similarly, markets around the globe such as Brazil, Dubai, and South Africa have seen double- and triple-digit growth in recent years. As the world of financial markets becomes more flat and more open, these growth rates will further fuel mergers and acquisitions around the world. Exchanges will no longer be a single asset class isolated within one region. Instead, they will be multi-asset markets spanning multiple continents.

The consolidation of exchanges always raises concerns of exchanges becoming a monopoly, which could lead to stagnation in innovation and potential increases in trading cost. However, the recent emergence of new upstarts tells us that the established exchanges will continue to face pressures from new electronic platforms that will keep the overall trading cost low and innovation healthy. There are a growing number of electronic platforms, called multilateral trading facility (MTF), that are already challenging large exchanges in both the equities and the derivatives world. Chi-X, now owned by Nomura, has brought fierce competition to Europe. As of October 2008, it already owned 22% of FTSE 100 trading and 15–18% Dutch AEX, French CAC 40, and German DAX 30. ⁷ Chi-X claims to provide order execution 10 times faster than major European exchanges and to offer trading services significantly cheaper. The annual license fees associated with market data redistribution are zero at Chi-X compared to £44,000 at LSE and 36,750 at Euronext. The trading fees are considerably lower as well, with Chi-X charging only 0.05 basis points for DMA trade volume. By comparison, Euronext, the LSE, and Deutsche Börse charge 0.50, 0.51, and 0.57 basis points. ⁸

Of course, the competition doesn't end with Chi-X. A number of other players have already launched or are planning to launch MTFs to compete with the established exchanges. Turquoise, another MTF, was also launched in the last year. Turquoise, backed by large global banks, has also made inroads and captured almost 5% of the FTSE 100. A more recent entrant has been BATS Trading, which will also compete with established exchanges such as the LSE as well as other MTFs. Plenty of other MTFs are already under development, such as Equiduct, majority owned by Börse Berlin; Burgundy, a Nordic venture backed by banks in the region; and Nasdaq OMX Europe, backed by Nasdaq OMX. ⁹ Whether all of them will be successful or not is yet to be seen, but one thing is for certain: Competition will remain healthy in coming years. The established exchanges have already begun responding to the threats of emerging MTFs by cutting fees and upgrading their technology to match the ultra-fast platforms offered by these upstarts.

Trading on the floor was loud and chaotic. Physical stature mattered. The louder and taller you were, the better your chances of getting your orders filled. Electronic trading changed all that. Today traders are accessing markets around the globe through a single screen. Orders for an exchange come from around the globe electronically. The financial community can access all the information it needs to make trading decisions directly on computers. Players around the world can access the same information in real time. Electronic trading puts the focus on accessing information and submitting orders as quickly as possible. The focus has been shifted from physical stature to the stability, reliability, and speed of the trading infrastructure. These are the criteria that financial players use when developing or purchasing components to implement the trade cycle. Already in its short lifetime, electronic trading has seen significant adoption within the financial markets. According to TowerGroup, over 38% of buy-side order flow in 2008 will be pushed through algorithmic trading. ¹⁰ An IBM study estimates that over 40% of LSE trades are generated through black boxes around the world. ¹¹ It is predicted that over 80% of equity market flow in the U.S. and Europe will be generated through automated trading applications. ¹²

The rise of automated trading as well as the globalization of financial markets has produced a tremendous surge in volume across all asset classes. The increase in volume and the number of new listed products have also increased the amount of electronic information sent to and from the exchanges. Exchanges around the world have been updating their electronic trading platforms to provide fast and reliable systems to clients. The connectivity requirements at the exchanges have been increasing year after year to handle the growing message traffic. To maintain a low-latency connection to CME, the bandwidth requirement is 40 mbps, ¹³ which is four times faster than a typical cable modem. NYSE recommends a bandwidth of 20 mbps for optimal performance. ¹⁴ These bandwidth requirements have been steadily increasing as the exchanges' message traffic increases. TABB group predicts an increase of 140% in market data, rising from 4 billion messages per day in 2006 to 130 billion messages per day in 2010 in global equity and options markets. ¹⁵ Exchanges have been spending a significant amount of time and resources to continually upgrade their systems to efficiently support the electronic trading models and to gain a competitive advantage. The LSE spent £40 million and four years to launch its upgraded trading platform to handle and process the increasing volume. ¹⁶ The upgraded platform improved execution speed from six to three milliseconds, and it processes 20,000 messages per second, well above the previous 10,000 messages per second. ¹⁷ After suffering a number of failures due to its unstable technology platform, the Tokyo Stock Exchange spent over $500 million to upgrade its infrastructure to improve its reputation as well as prevent market share loss to competitors such as the Osaka Securities Exchange. ¹⁸

Other financial players such as trading firms, brokers, market data vendors, and other technology providers have also been focused on improving their technology to gain a competitive edge in this rapidly changing marketplace. As the exchanges improve their technology to handle and process more data, the financial players continue to push the limits of their trading systems to trade more and trade faster. Technology players used the open exchange APIs to develop direct exchange connections to provide their clients with real-time market access. Market data providers such as Wombat and Hyperfeed gained market share by providing fast market data feeds to their clients, forcing established market data vendors such as Reuters and Bloomberg to follow a similar path to remain competitive. ¹⁹ Brokers are investing in technology to develop and improve their trading infrastructure to provide their clients with the speed and transparency that has become the cornerstone of electronic trading. They are focused on developing and acquiring technology to provide innovative and customized applications to their clients. For example, Credit Suisse is positioning itself as a full-service broker offering clients its proprietary algorithmic engine, CrossFire, ²⁰ as well as the trading infrastructure required to get direct market access.

Transparency and speed will continue to dominate the trading world. In the coming years these two factors will reshape the financial markets and change the business models of many players. Trading firms will need to adjust their strategies and invent new trading styles to compete in a transparent world. They will build or buy applications that provide direct and fast connections to the exchanges to compete in electronic trading markets where a millisecond advantage could result in a better trade and a better price. Brokers will no longer have the advantage of privileged information and will need to reinvent their model to compete for trade execution business through value-added services, such as automated trading or a trading infrastructure that is faster than their competition. They will need to find new revenue sources by entering new markets and establishing their technology arm. Exchanges will need to provide a solid and scalable trading platform that can handle the increasing growth in volume. Technology players will need to continue to develop innovative products. More specialized technology players will emerge with innovative products that promise to provide a competitive advantage in a world where everyone has equal information. For example, Vhayu specializes in providing quality tick-by-tick information that is crucial for automated trading. Automated trading systems rely on massive, detailed market data information for markets to analyze, which help trading firms find and take advantage of new strategies and anomalies. ²¹

To gain an edge in a fast, transparent world, technology will continue to play a crucial role in the coming years as financial markets develop the trading platforms for the next century. Exchanges have been pursuing partnerships in recent years to capture additional market share and reduce expenses. Similarly, significant numbers of vendors have emerged, offering applications to support various functions of the trade cycle. These vendors are all trying to increase market share and increase growth. We will see them develop specialized applications to differentiate themselves in the marketplace. They will forge strategic partnerships to gain a competitive advantage while reducing their technology expense. We will see strategic partnerships between these vendors and brokers as both continue to attract the trading community of hedge funds, proprietary trading funds, and other trading players.

Trading firms are building complex trading strategies covering all asset classes. With the increasing use of smart order routing, technical analysis, new order types, and new trading strategies, firms are demanding more services from brokers and vendors alike. To earn business from these trading firms, brokers and vendors will need to align themselves to provide unique services. Alliances between these two players will be increasingly important to meet the complex demands of trading firms. We will see brokers depending on vendors such as Cinnober for low-latency solutions for market data dissemination, Tethys Technology for multi-broker platform, Ullink for FIX solutions, and Quanthouse for algorithmic trading solutions. There are plenty of vendors offering specialized solutions in these spaces. The brokers will gravitate toward vendors that offer the most unique application or solutions to the latest problem, and, more important, they will forge alliances with vendors that are favored by the customers.

We will also see increasing dependence on software providers who offer networking solutions such as hosting facilities. As the customers become more computer savvy and adopt more automated trading applications, the need for speed will be increasingly important. To provide a fast, reliable solution to their customers, vendors will look to partner with other vendors such as Trading Technologies, which offers trading applications built for speed along with a high-speed hosting solution. The role of brokers is likely to change in coming years as they move to scour the lists of vendors to offer specialized services to their sophisticated client base. The vendors will continue to invest in research and technology to find new trading solutions and building systems to offer services in every component of the trade cycle. In the end, customers will benefit greatly through these strategic relationships between the brokers and vendors who will continue to offer customized solutions to meet specific needs of their customers.

As we have explored in this book, clearing is an integral part of the trade cycle. Every trade executed on exchanges around the world must be cleared through a central counterparty clearinghouse. The U.S. equities markets have long had one central clearinghouse, DTCC. However, the derivatives markets and the European equities markets have had a number of clearinghouses. The clearing landscape is at the beginning of transformation. We expect to see a new wave of both mergers and competition in the clearing area as the exchanges continue to expand their territory by acquiring exchanges around the globe. The clearinghouses also will see new opportunities as the OTC market such as credit default swaps come under the spotlight.

The clearing space saw the beginning of consolidation in 2003 when the merger between the London Clearing House and Clearnet provided a European clearing counterparty, the common clearing link between Chicago futures exchanges was formed, and a proposal to form a Global Clearing Link was floated around through the partnership between Eurex and the Clearing Corporation (CCorp). The Common Clearing Link provided significant saving to customers through margin efficiencies. It was estimated that approximately $1.7 billion in capital was saved, and free capital means trading firms have more trade, resulting in greater volume at the exchanges. The Global Clearing Link by Eurex and CCorp offers to provide clearing for both U.S. products and Eurex products through one clearing structure. This was originally prompted when Eurex launched its U.S. subsidiary, EurexUS, to compete with Chicago markets.

The clearing landscape today is undergoing a new wave of transformation. The derivatives exchanges, such as ICE, are starting their own clearinghouses to gain added revenue in clearing fees. Following on ICE's footsteps and also due to the threat from MTF, such as Project Rainbow, LIFFE recently announced its intention to leave LCH.Clearnet and move clearing of its products in-house. ²² Whether the derivatives exchanges will continue to maintain their own clearing organizations is still up for debate. Recently the U.S. Department of Justice findings claimed that the exchanges controlling their own clearing and settlement process inhibit competition and called for the separation of the clearing function from the futures exchange. ²³ The new upstart MTFs coming into the picture to compete with these exchanges have also complained of challenges they face due to the fragmenting world of clearing in derivatives markets.

The pendulum has been swinging between consolidation and fragmentation in the clearing space. With recent announcements by the exchanges such as LIFFE and ICE to launch their own clearing service, the derivatives landscape has been leaning toward fragmentation. In addition, the recent emergence of MTF and growing regulatory pressures from initiatives such as MiFID have led to two new clearinghouses, EuroCCP and European Multilateral Clearing Facility (EMCF). EMCF, a subsidiary of Fortis, plans to provide clearing services for many of the MTFs. ²⁴

As the exchange consolidation continues and new platforms emerge, the clearing landscape will continue to evolve, where partnerships between clearinghouses will be formed to provide links between them. The most recent announcement between DTCC and LCH.Clearnet to form a single clearinghouse perhaps is a sign that the pendulum will be swinging toward consolidation. The DTCC and LCH.Clearnet merger will provide a single clearinghouse for a wide range of asset classes such as equities, fixed income, derivatives, and OTC products such as interest rate swaps, credit default swaps, carbon emission, and freight forwards. ²⁵ The combined group promises to provide the financial community clearing services at cost²⁶ and enhanced cross-margining among products, which would save users capital similar to the benefits achieved by the common clearing link between CME and CBOT.

The clearing process will see further growth as they look to enter the OTC market. The recent turmoil in the global financial markets was largely attributed to the credit derivatives market. A market with $58 trillion in notional value was traded by the trading community with essentially no central clearing counter party. The risks of this were painfully endured by the financial markets, with large investment banks such as Lehman and Bear Stearns falling and the rest getting significant bailout package from the government. By the time this book goes to print, we are likely to have not one but a couple of clearinghouses providing CCP services for the credit derivatives markets. NYSE Euronext is planning to support the credit derivatives markets on its BClear system that already process over $7.5 trillion of OTC equities derivatives markets. ²⁷ LCH.Clearnet is planned to be the clearing service for the CDS contracts that processes through the BClear system. In addition, Eurex, the first exchange to list CDS on its platform, is also planning to provide clearing services for CDS contracts. Finally, CCorp is also looking to support CDS contracts by building a partnership with DTCC, which currently holds more than 3 million outstanding CDS contracts. ²⁸

We are a long way away from a true global marketplace where every component of the trade cycle is connected seamlessly. There is still a tremendous amount of work to be done to achieve straight-through processing, where the trades pass through front-end trading systems to the settlement process without any manual intervention.

But the past two decades have seen some tremendous changes in the financial markets. Technology has allowed exchanges to shed regional and physical boundaries and move into the global world. They have shed their member-owned model and transformed themselves into stockholder-owned companies. Through mergers, acquisitions, and partnerships, financial players are connected across asset classes and continents. The software vendors are playing an integral role in connecting exchanges, brokers, and the trading community. For example, integration of Bank of New York's proprietary algorithmic engine with Bloomberg's Execution Management System (EMS) reaches 260,000 financial users in 125 countries. ²⁹

These vendors will continue to develop new applications in all three areas of the trade cycle: the front office, the middle office, and the back office. There has been significant innovation in the front office. Numerous vendors offer trading screen, charting, and analytical tools; pre-trade risk management tools; exchange connectivity; and market data engines. We will continue to see innovation in the front-office to meet the changing needs of the trading community. We also believe that there will be greater innovation, collaboration, and standardization in the middle and back office. Just as FIX has become the standardized protocol for the front office, the vendors are depending on SWIFT as the standard protocol for the back office. There is a tremendous amount of fragmentation in the back-office area where firms are handling multiple interfaces for back-office tasks such as trade reporting, end-of-the-day price reporting, and collateral reporting. The standardization in the back-office area will lead to new applications to move the financial markets another step closer to STP.

The recent transatlantic mergers such as NYSE-Euronext, ISE-Eurex, and Nasdaq-OMX have certainly given these exchanges greater share of the global financial markets. As we have explored in this book, these mergers have helped capture new products and increase volume. They have also helped achieve economies of scale by merging technology and operating expense between the exchanges. NYSE-Euronext hopes to achieve a $250 million reduction annually in its operating expense and deliver a single trading platform across asset classes. NYSE-Euronext wants to build a single platform to connect its seven options markets between the United States and Europe (Amsterdam, Paris, London, Brussels, and Lisbon in Europe and Arca and AMEX in the United States).

By providing one platform, ³⁰ the exchange hopes to increase volume by having its European customers trade the U.S. markets, and vice versa. To provide a single global platform, NYSE-Euronext knows it has to provide a consolidated market data feed and a solid infrastructure for connectivity. And it is on its way to achieving that in next couple of years. With its recent purchase of Wombat, a company specializing in high-speed delivery of market data, NYSE will provide new market data feeds across all asset classes supported by NYSE-Euronext. To provide global connectivity, NYSE-Euronext has rolled out the Secure Financial Transaction Infrastructure (SFTI), which will allow its members and vendors to connect to all NYSE-Euronext services. The SFTI is already available in the United States and, with access centers in London, Paris, Amsterdam, Brussels, and Lisbon now set up, NYSE-Euronext's European base will be able to connect to all the NYSE-Euronext services. ³¹

Similarly, the Eurex and ISE partnership is also looking to build a common trading and clearing platform to provide its global customer base cross-border access to its products. Eurex-ISE plans to provide clearing links through the Options Clearing Corporation. With this link established, Eurex members will have access to the 2000 ISE products and will be able to trade these products through its existing Eurex connectivity. The common clearing link will allow these members to trade ISE products and still be able to clear these products through their existing Eurex Clearing setup. ³² The common trading and clearing platform will be crucial to the success of the exchanges that have merged in recent years and for the financial community to experience a truly global financial market.

As in so many other industries, the computer revolution has upended financial markets. Though face-to-face interactions between traders worked for centuries, it was swept away in a few short decades by computers and telecom networks. Where traders once shouted orders on a trading floor, they now tap them into a computer. Where traders were once limited to the suite of products available in their pits, they can now scan products and markets across the globe. Where private regional exchanges once handled local products, profit-seeking exchanges now cross national borders to reach a broad audience of global traders. Vast quantities of data travel at the speed of light around the globe to new markets with new products. The flowering of fresh competition in every component of the trade cycle has led to rapid innovations and radical changes in the markets. All this change and turmoil in financial markets is just a side effect of the computer revolution.

The future of financial markets will surely be as tumultuous as its recent past. The transformation from the floor to the screen is only half the revolution. Most OTC products have yet to move to electronic exchanges. Many back-end operations still rely on ad hoc communications, such as text files, emails, phone calls, and faxes. Until markets agree on an API, these components will be a drag on market efficiency. Regulators will need to catch up to the new realities of a fast-moving global marketplace. Though the leading exchanges will try to dominate different markets, new platforms will pop up quickly to undercut their monopolies. The next wave to hit financial markets will come from new players that invent new business models to help markets move closer to straight-through processing.