By Cyrus Sanati
March 2, 2011

Some fear that the proposed tie-up, along with a number of other exchange mergers in the works, could lead to a more volatile marketplace for equities, which they believe could lead to another “flash crash” or something even worse.

But the business of trading has changed dramatically since the NYSE’s heyday. In fact, the NYSE-Deutsche Börse deal has less to do with equity trading than it does with other parts of the business the exchanges need to maintain a competitive advantage: technology and derivatives.

Indeed, the NYSE only trades around 24% of the volume of US equities, down from 70% 15 years ago. That’s thanks to a government directive a decade ago that allowed other exchanges to trade NYSE-listed stocks. There are now over 50 alternative exchanges that can facilitate equity trades much cheaper than the NYSE (NYX).

The margins are so low that even elements in the fragmented world of alternative platforms have started to merge. BATS, one of the largest alternative exchanges, announced last month that it was acquiring rival Chi-X to create an even larger platform. Both have sizable chunks of the equity markets and extremely low overhead, so they may move to offer even lower transaction fees to fight off the competition.

Meanwhile, investors that want to move large blocks of trades out of the sight of the market are increasingly turning to so-called ‘dark pools’ to facilitate their trades. These trading platforms, run mostly by investment banks, trade around 12% of US equities volume. Moves to regulate this space are afoot, but Wall Street continues to turn to these stealth exchanges to cover their activities from the general public.

The exchange of the future

The Big Board has branched out over the years for make up for some of the loss of income from equity volume. It sells its trading technology to other smaller exchanges, like the Qatar stock exchange, and it also sells market data. It’s one of the only areas of growth for the company, with revenues up 22% in 2010 over the same period in 2009. The business represented 16% of the NYSE’s profits in 2010. Fees from listing companies and executing trades, meanwhile, comprised just 13% of the company’s profit for 2010.

While the Deutsche Börse will certainly welcome those revenue streams from the NYSE, the real gem is in the derivatives space. Fees from derivatives trading were up 14% in 2010 to $826 million, comprising a third of the NYSE’s total net revenue ad 40% of its profits. The NYSE owns Liffe, a powerful derivatives platform based in Europe, while the German exchange owns half of Eurex, the largest derivatives exchange in the world, which also focuses on European trades. Unlike equities, derivatives are usually bespoke contracts tethered to exchanges. That means the revenue stream from these trades is somewhat protected from new entrants into the market. The market for derivatives is expected to grow in the coming years as new regulations eventually force most over-the-counter derivatives to clear through an exchange.

The US regulators allowed the two largest futures exchanges in the US — the New York Mercantile Exchange and the Chicago Mercantile Exchange — to merge in 2008 after the two agreed to spin off their metals business. Something similar could happen in Europe, where regulators might want the two to divest part of their European derivatives businesses. That could hurt the deal’s raison d’etre a bit, but it probably won’t kill it.

“A signpost on the road to American decline”
But in the post “flash crash” world, there is a chance regulators could be a bit more sensitive to exchange tie-ups. Making it easier and cheaper to trade could bring more volatility to the market and lead to undesirable market events.

For example, the CME (CME) announced this week that the margin requirements on two of its products, eurodollars and US Treasury bond futures, could fall by 65%, matching a similar move by NYSE’s Liffe exchange. And the cross-margining guarantee that both exchanges are employing with banks will allow traders to make bigger bets with far less money. The increased leverage in the markets could lead to reckless betting by traders and lead to major market volatility.

“More and more, the exchanges, in a kind of rush to the bottom, have to cater to the high frequency traders, and it has become a very low margin business,” Ted Kaufman, the former Democratic Senator from Delaware, who championed for market reform in his two years in office, told Fortune. “It looks like we will have a wave of global exchange mergers, reshaping the market structure landscape again before the SEC can figure out what it thinks about the markets as they existed on,” the day the flash crash occurred.

So far, arguments for blocking the merger have centered on the fear of a large chunk of US equity trading falling into foreign hands. But US government officials have come out and said that the deal probably doesn’t pose a security threat, making it hard for regulators to raise that concern when making their judgment.

“This is about far more than whether ‘New York Stock Exchange’ stays first in the name of the merged company,” says Kaufman, who recently replaced Elizabeth Warren as Chair of the Congressional Oversight Committee on the TARP. “This is a signpost on the road to American decline, if we don’t stop and restore the credibility of our markets.”

But it is unclear if there is anything that can be done to stop mergers in the exchange space. The London Stock Exchange is moving to acquire the Toronto Stock Exchange and the Singapore Exchange is moving to acquire the Australian Securities Exchange. Rumors abound of other potential tie-ups that could see the CME, the parent of the NASDAQ (NDAQ), and other exchanges snap up smaller exchanges. Regulators could put an end to the merger mania but they may have little to hang their hat on at the moment.

Update: An earlier version of this story incorrectly stated that the NYSE makes up about 50% of the U.S. equity trading volume. It controls 24%.

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