The increase in competition of stock exchanges, due mainly to the transformation of the securities markets, has led to mergers, technological agreements among existing exchanges, price wars, takeovers, and the creation of new exchanges, even within the same country. Recently, exchanges have also faced competition from quasi-exchanges, which are also known as ECNs. They not only free-ride on the process of listing given that they generally trade only securities listed on other exchanges, but also on the price-discovery process facilitating members of exchanges to direct trade to them. ECNs are increasingly cannibalizing the businesses of the existing stock exchanges.

The evolution of new financial instruments, the falling monopoly of banks as a source of direct funding to borrowers and of direct investment for investors, the tremendous improvement in information technology, and a greater financial culture among common people as well as the fluctuations in interest, price, and exchange rate due to the oil crises have caused the increasing importance of securities markets in the financial system.

As the capital markets become increasingly globalized, investors have more choices and are demanding better trading facilities, market efficiency and quality from stock exchanges. To meet challenges, exchanges have to accelerate the construction of the market information infrastructure, rivalry among Europe's stock exchanges emphasizes more on cooperation of trading technology than anything else. In Asia, the concept of forming a full financial service group within each market is the main consideration. Exchanges have recognized that faced with the challenge to respond commercially to competitors, they needed to become traded companies themselves.

The underlying assumption is that, in the long run, only the most efficient exchanges should survive, trading stocks from other European countries and offering the most innovative and competitive financial instruments.

Table of Contents

Title Page No.

I Acknowledgements.................................................................. 1

II Abstract................................................................................ 2

III List of Abbreviations................................................................ 5

1. Introduction .................................................................. 6-11

2. Review of Literature

2.1 What is an Exchange................................................................ 12-16

2.2 Globalisation of Financial Markets................................................ 17-20

2.3 Nature of Competition of Stock Exchanges...................................... 20-24

2.4 The Effects of Increasing Competition among Stock Exchanges............. 24-25

2.5 Revolutionary changes of Technology in the Securities Market.............. 26-29

2.6 Integration of Stock Exchanges................................................... 29-30

2.7 Theoretical Influences............................................................... 31-37

3. Methodology

3.1 Aim of the Project................................................................... 38

3.2 Objectives of the Project............................................................ 38

3.3 Why I am Interested in this Topic................................................. 39

3.4 Background........................................................................... 39-40

3.5 The General Approach.............................................................. 40-41

3.6 Data Collection....................................................................... 41-43

3.7 Criticisms of the Sources............................................................ 43-44

3.8 Validity................................................................................ 44

3.9 Reliability............................................................................. 44-45

4. Qualitative Analysis

4.1 Analysis of Industry Dynamics.................................................... 46-56

    1. Case Studies

4.2.1 International Exchange- LSE- A Prototype of Horizontal Merger............ 57-61

4.2.2 Hong Kong Stock Exchange - A Typical Model of a Vertical Merger....... 62-66

4.3 Implications and Discussion........................................................ 66-69

5.0 Conclusion.....................................................................70-72


Appendix 1 - Interviewees & Questions..........................................74

Appendix 2 - Interview Key Points............................................... 75-77

Appendix 3 - Future Strategies of LSE & HKSE............................... 78-80

Bibliography.................................................................. 81-87

List of Abbreviations

ECN's Electronic Communication Networks

ISD Investment Service Directive

EU European Union

iX International Exchange

LSE London Stock Exchange

DB Deutsche Borse

NYSE New York Stock Exchange

PSE Philippine Stock Exchange

PB Paris Borse

SGX Singapore Exchange

TSE Tokyo Stock Exchange

SEC Securities and Exchange Commission

CCASS The Central Clearing and Settlement System

HKFE Hong Kong Futures Exchange

HKSCC Hong Kong Securities Clearing Company Limited

1. Introduction

There are currently about 250 institutions recognized as exchanges in the world, and both individually and collectively they play a critical role in most national economies and also at a global level. They provide cash, futures, options and other forms of derivatives, markets for all major commodities and assets traded in the world.

Competition among stock exchanges, both national and international, is a recent phenomenon. Until some decades ago, it was difficult to think of exchanges as firms that produce and sell goods to customers and compete among themselves. Traditionally, exchanges were seen either as public entities or as formally private bodies, deeply regulated by public rules. In both cases, they were often legal monopolist, given the special nature of their activity that very much resembled that of a public good.

There was an era when exchanges were natural monopolies (Steil, 1996b), yet nowadays they no longer enjoy a monopoly in the provision of many of their services. When its members owned a monopolistic exchange, it did not have the incentive to maximize its profits because members in charge were prohibited from taking any distribution of profits from the exchange. Exchanges increasingly realize that if they have to compete like firms whose goal is to maximize shareholders' wealth, they have to demutualise to turn a member-owned company into a stock company. Exchanges have never been considered as firms, but now they have reformed to become commercially driven corporations. To understand the firm's view of an exchange, it is necessary to redefine what an exchange is, what its products are, where its revenues come from and who its customers and suppliers are. Exchanges are special kinds of firms that provide listing, trading and price dissemination services. Direct customers involve listed companies and those, which desire to go public, information providers and intermediaries that trade on the exchange. Intermediaries trade on behalf of both individual and institutional clients who are indirect customers of an exchange.

Suppliers are network providers. Listed companies have a dual capacity as suppliers of information and shares for trading.

The primary objective of this dissertation is to analyse the competition and integration strategies of stock exchanges like firms.

The dissertation focuses on:

1. Industry dynamics of stock exchanges;

2. Evolution of stock exchange mergers;

3. Integration strategies; and

4. Future consolidation trends.

Advances in technology have further accelerated the globalization trend. In particular remote access to trading systems, implying that the services offered by stock exchanges can now be accessed from anywhere, including firms having their stocks traded on international exchanges while still being easily accessible to local investors. This type of arrangement is likely to develop a competitive environment, where the most efficient exchanges will eventually win the confidence of investors, traders and companies (Cybo-Ottone, Di Noia and Murgia 2000). The structure of the European stock-exchange environment is changing rapidly. Almost every day, there are new alliances between stock exchanges, stock exchange privatizations, Internet exchanges and electronic exchanges, as well as online brokers, etc. appear in the media. The changes are driven primarily by intensified competition, which is related to the deregulation of stock exchanges, technological progress and the increasing internationalization of the securities markets.

Competition takes the form of existing exchanges and electronic communication networks (ECNs).

The increase in competition of stock exchanges, due mainly to the transformation of the securities markets, has led to mergers, technological agreements among existing exchanges, price wars, takeovers, and the creation of new exchanges, even within the same country. Recently, exchanges have also faced competition from quasi-exchanges, which are also known as ECNs. They are parasites on stock exchanges. They not only free-ride on the process of listing given that they generally trade only securities listed on other exchanges, but also on the price-discovery process facilitating members of exchanges to direct trade to them. ECNs are increasingly cannibalizing the businesses of the existing stock exchanges.

Mergers have been one of the most probable strategic interactions among stock exchanges. The concept presented here is drawn upon the network externality literature. Exchanges can be regarded as networks in which an increase in the size of the network leads to an exponential increase in the network's value (Shapiro & Varian, 1999). In other words, larger networks are more attractive to users than smaller ones. Castells (2000) links a network to its connectedness and consistency. When firms decide on a listing exchange, they choose the one that is connected by the largest number of intermediaries and one that consistently provides the greatest liquidity.

In Europe, the pressure for consolidation among stock exchanges has been the arrival of the euro. The full implementation of the Investment Service Directive 1992 (ISD), which allows its members to gain remote access throughout the European Union (EU), further facilitates the financial market integration in the region. The European Securities Forum is promoting the model of horizontal merger. In this model, national exchanges integrate along three functional levels - trading, clearing and settlement, and custody. Each market participant can gain access to a range of pan-European services through a single point of entry.

The proposed formation of International Exchange (iX) from London Stock Exchange (LSE) and Deutsche Börse (DB) and the recent establishment of Euronext (the merged entity among the exchanges of Paris, Amsterdam and Brussels) are outcomes of this model.

An analytical framework will be provided to analyze industry dynamics and integration strategies. The models used include Porter's Five Forces Model, Network Society and Ansoff's Product-Market Matrix. These models are utilized to explain how exchanges determined their merger motives and developed integration and consolidation strategies.

Given the rapidly evolving nature of the industry, a total of 5 interviews were conducted with members of the London Stock Exchange and Hong Kong Stock Exchange, investment banks/brokerage firms. Primary data sources were based on the interviews. Secondary data sources included academic journals, books, newspapers and working papers. The deliverable is this report, which includes the literature review, findings and discussions, and two case studies.

The implementation followed a traditional approach - project specification, literature research, fact finding and investigation, case analysis and evaluation, and finally, report writing.

The first finding from the interviews is that merger is a clear strategic option for exchanges. This strategy can achieve economies of scale, network externalities, improve profitability and enhance efficiency in the decision-making process and order routing facilities. In particular, a cross-border merger between two exchanges is made possible in Europe with the support of the financial markets harmonization.

The second finding is that a merger brings about two patterns of convergence: vertical merger and horizontal merger.

The former depicts that exchanges integrate to form a full financial service group offering the trades of a wide variety of financial products such as stocks, options, futures and other derivative products. The latter describes the merger of specialized exchanges, the outcome of which creates compatibility, a concept in that intermediaries trading in one exchange are offered remote access in other member states, with reciprocity and without further requirements.

The third finding is that the existence of national regulatory regimes, deeply embedded in their corresponding regulators, constrains further inter-exchange alliance or merger. The ultimate goal to have a supranational regulator that imposes its own standards on the globe is unlikely to happen in the near future.

The fourth finding is that the single price and time priority is not an issue in an order-driven market such as Hong Kong Stock Exchange and the London Stock Exchange. In contrast, in a quote-driven mechanism such as Nasdaq, each market maker is itself an execution centre though operating within certain parameters set by the National Association of Securities Dealers (USA). In quote driven or hybrid environments, there creates space for the development of ECNs. The growth of ECNs is gradually threatening to replace quote-driven trading systems.

The fifth finding forms an interesting consensus regarding the motives of investors who choose to trade on an ECN. Investors are not able to differentiate the functionalities of a trading system of stock exchange and that of an ECN as long as they can execute their orders at the best possible price. Competition only on price is inadequate for an ECN's survival. They lack the competencies in attracting liquidity and information dissemination.

This dissertation is organised as follows:

  • Section 1 defines an exchange as a firm;

  • Section 2 analyses the existing competition and integration of stock exchanges in Asia and in Europe;

  • Section 3 uses Porter's Five Forces and network externalities to shape the industry dynamics; then it utilizes Ansoff's Product-Market Matrix to determine the strategic choice of a stock exchange;

  • Section 4 presents the interview framework and cites opinions to analyse the two case studies: London Stock Exchange and the Hong Kong Stock exchange; and

  • Section 5 further develops the findings and links them with the theoretical framework and literature review.

2. Review of the Literature

2.1 What is an Exchange?

A stock exchange has two principal functions. The first is the listing of securities. The stock exchange must approve prospectuses for the eligible securities and also administer the statutory information obligations imposed on the issuers. Secondly, the stock exchange is a marketplace for its members to trade the listed securities. Previously, the brokers gathered physically on the floor where the price was fixed by auction. Today, most stock exchanges have introduced electronic trading systems in some form or other, so it is no longer necessary for the brokers to be physically present at the stock exchange.

Stock exchanges can be seen as a market, not too much different from the one that fruits and vegetables are traded on. They operate according to the laws of supply and demand and the most successful, whilst having reasonable regulation, will be constantly changing and developing their market operations. Domowitz has given a comprehensive definition, stating: An exchange is a trading system that must:

  • Provide trade execution facilities

  • Provide price information in the form of buy and sell quotations on a regular or continuous basis

  • Engage in price discovery through its trading procedures, rules or mechanisms

  • Have either a formal market-maker structure or a consolidated limit order book or be a single price auction

  • Centralize trading for the purpose of trade execution

  • Have members

  • Exhibit the likelihood, through system rules and/or design, of creating liquidity in the sense that there be entry of buy and sell quotations on a regular basis, such that both buyers and sellers have a reasonable expectation that they can regularly execute their orders at these quotes

An exchange is generally described by regulatory authorities as an organization, association, or group of persons that provides a marketplace for exchanging securities between purchasers and sellers. Traditionally, an exchange is owned by members who are also intermediaries. Under a member ownership structure, members did not have the incentive to invest in the exchange infrastructure including technology and trading facilities because returns from these investments could not be distributed to them. The lack of motivation undermined the profitability of an exchange and hence its competitiveness. In addition, intermediaries trading on a monopolistic exchange were subject to higher prices.

They passed the increased costs of operations onto their customers. Therefore members were reluctant to vote for an increase in transaction levy. Hansmann (1980) notes that:

The nonprofit producer, like its for-profit counterpart, has the capacity to raise prices...without much fear of customer reprisal; however it lacks the incentive to do so because those in charge are barred from taking home any resulting profits.

As time has gone by, exchanges have had to compete in the global market to attract quality companies to list and intermediaries to trade; many of them have converted their member ownership structures into a stock company by means of demutualisation. Under the plan of demutualisation, members are issued shares of the exchange. They become shareholders of the exchange and therefore can be eligible for profit distribution. Since then, exchanges have reformed to become commercially driven corporations whose goal is to maximize shareholders' wealth.

2.1.1 Products

Stock exchanges cannot only be perceived by the function they fill in an economy, they can also be viewed as a firm, producing a product. The product is the creation of a market in financial instruments, thus leaving the property of the price information produced with the stock exchange. More specifically the products a stock exchange offers encompass: listing, trading, price-information services and clearing & settlement, the percentage of which are shown in Table 1. The distribution of revenues from these various offerings shows that the focus lies mostly on listing and trading, as other services are not always part of the offering.

Table 1

Fees Europe % N. America %

Listing 19.3 32.1

Trading 45.1 39.7

Services 24.4 22.6

Other 11.2 5.7

The 'firm' view focuses on the production and profitability of an exchange. Mulherin et

alii (1991) defines a financial exchange not as a market, as it normally is, but as a firm that creates a market which is characterized by the use of financial vehicles.

Lee (1998) suggests that a security market be regarded as a firm that produces goods: listing, trading of securities, clearing and settlement services, price information dissemination, and research. In this dissertation, the aspect of the provision of settlement services is omitted because many of the exchanges either dismiss it or do it by a separate entity.

The dissertation considers the exchange as a producer of listing and trading services, given that the network externalities' effects created by listed companies and intermediaries are the main focus.

2.1.2 Revenues

The revenues from listing and trading are in general fees, both initial and annual. Services include Settlement & Clearing and price-information services. Thus the trading services offered by a stock exchange can be ...structured in three parts: the object traded (issued by some entities that generally pay a fee to have it listed), the means of trading (trading facilities, computers, a computerized floor, settlement) and price dissemination.

The listing and trading and related services can be segregated and tagged as the front-end of stock exchanges. Clearing and settlement is the unglamorous bit after equities or bonds are traded on an exchange. A clearing house ensures that buyer and seller have the cash and securities to do the deal; a securities depository settles the trade by moving the securities from one account to another.

The profitability of an exchange establishes the extent to how successful it is in attracting order flow and in attaining the ability to generate revenues (Lee, 1998). Order flow implies the liquidity of the market and the trading volume that includes the number of trades over a specified period and the total value of the shares traded. It directly and indirectly generates revenues for an exchange. The direct effect comes from an exchange's receipts for transaction services, which are dependent on the number of trades it executes. The indirect effect exists because the trading volume reported on an exchange is regularly used as a marketing tool to attract new listings to the exchange.

2.1.3 Customers

An exchange has direct and indirect customers:

Direct customers include listed companies and those which desire to go public; both pay for their use of listing services. They also include intermediaries who pay to be admitted to trading; and information providers who pay to have terminal access and the right to disseminate price information.

Indirect customers are individual and institutional entities that send orders to intermediaries for execution on an exchange. They can either trade through an intermediary or via the Internet. In both cases, they take into account the quality of the exchange, price factors and transaction cost. Market microstructure, such as liquidity, price discovery, or immediacy, and reputation and fiscal regulation all influence their choices. Other income includes share registration service fee income arising from initial public offerings.

2.1.4 Suppliers

Listed companies are also suppliers because they provide the information and the shares for trading. Another type of suppliers is the network provider who provides physical connectivity services on an exchange infrastructure.

The above describes an exchange as a firm; globalization of financial markets and competition of exchanges have caused the transition of an exchange from a market to a firm.

2.2 Globalisation of Financial Markets

Since 1980, cross-border securities transactions have grown very rapidly. A quarter of stock market trades worldwide involved either a foreign security or a foreign counterparty by 1988 (Howells and Bain, 2000). Between 1989 and 1995, estimated global turnover in foreign exchange more than doubled.

With the formation of the European Union, cross-border trading in Europe is growing in popularity. The introduction of the euro and a wider acceptance of equity as a financing tool are encouraging investors in Europe to engage in more cross-border transactions in search of profit-making opportunities. Yet despite the appeal of cross-border trading, most stock exchanges in Europe are national institutions that trade only local, country-specific stocks.

This market structure appears to be changing, however, as an increasing number of stock exchanges are attempting to operate across national borders. A Transaction Survey done by Hong Kong Stock Exchange in 2000 indicated that overseas investors (mainly institutions) had significantly increased their participation in the Hong Kong market. In Europe several ambitious initiatives have been undertaken of late to create, through mergers or other consolidations, pan-European exchanges that offer trading in stocks from many European countries. The establishment of these exchanges will likely lead to important benefits for the financial markets. For example, a standardization of trading platforms across exchanges, an increase in market liquidity, and a reduction in market fragmentation potential by-products of consolidationcould help minimize the costs and problems associated with cross-border trading in Europe.

Despite the persistence of protectionism and restrictions to free trade, markets for goods and services are becoming increasingly globalized (Castells, 1996). Financial institutions are extending their activities either by developing new products or by penetrating new markets in response to growing competition. They are also widening their customer base to benefit from economies of scale and scope.

Expansion occurs both within national boundaries, and also across borders to establish presence in international markets. Globalization of markets has been made possible in the late twentieth century by new communication and transportation technologies allowing for more efficient delivery of information, goods and services.

2.2.1 Europe: Vision to Become a Pan-European Financial Market

The concept of harmonization of financial regulations to establish a single financial market across the EU was brought out since the 1957 Treaty of Rome when it established the European Economic Community (EC) (Howells and Bain, 2000). Extensive liberalization of financial markets was seen in the 1960s regarding direct investments, commercial credits and the acquisition of securities on foreign stock exchanges.

A genuine single financial market across the EU extended to include the securities markets and the insurance services industry. In 1979, the Directive Co-ordinating the Conditions for the Admission of Securities to Official Stock Exchange Listing allowed companies to list their shares or raise capital on other EU stock exchanges. The ISD, based on the Single European Act principles, applied the single passport principle to non-bank investment firms, removing barriers to both provision of cross-border securities services and the establishment of branches throughout the EU for all firms. It also liberalized the rules governing access to stock exchanges, and financial futures and options exchanges. Mutual recognition and home-country control for all security firms and banks performing investment services were shared among all member states.

As with other financial services, the insurance industry saw the promulgation of certain directives; all established the right for companies to operate in other member states.

The Euro launch as a common currency on 1 January 1999 by 11 European nations has been considered a step toward Europe's economic convergence. Euro facilitates to establish shared, centralized accounting and administrative systems dramatically reduce currency exchange costs and increase price transparency for the member countries. Even non-members dealing with member countries may also benefit from greater price transparency when dealing with one, rather than a number of different, currencies (Geradine, 2000).

As discussed above, globalization has become a major driver of change, which was confirmed by rapid growth in cross-border portfolio investment and cooperation of markets

2.2.2 Asia: Evolution of Strategic Alliances and Cooperation

Asia Pacific saw the frantic pace of exchange alliances and cooperative arrangements.

Most recent examples include:

On 1 February 2000, HKSE jointly agreed with Nasdaq to launch the NASDAQ AMEX Pilot Programme for the trading of seven global securities (Amgen, Applied Materials, Cisco Systems, Dell, Intel, Microsoft and Starbucks) in Hong Kong. These shares can be traded and settled in Hong Kong dollars following the standard T+2 (the second trading day following the transaction) settlement period.

Memorandum of Understanding among various countries were signed to facilitate information sharing and cooperation of regulatory matters: examples are Jakarta Stock Exchange and the Amsterdam Exchange; The Singapore Exchange and the Australian Stock Exchange; The Stock Exchange of Thailand and the Tokyo Stock Exchange.

In Japan, The Osaka Securities Exchange signed a Business Cooperation Agreement with Nasdaq Japan Inc. to establish the Nasdaq Japan for acceptance of listing applications on the Nasdaq-Japan market. Another collaboration accord was signed between The Tokyo Stock Exchange and the Korea Stock Exchange for the effective management of their operations and better investor protection, which allowed for useful information swap regarding promotion of stock investment and supervision of market activities.

2.3 Nature of Competition of Stock Exchanges

The evolution of new financial instruments, the falling monopoly of banks as a source of direct funding to borrowers and of direct investment for investors, the tremendous improvement in information technology, and a greater financial culture among people as well as the fluctuations in interest, price, and exchange rate due to the oil crises have caused the increasing importance of securities markets in the financial system, both as regulated exchanges and over the counter (OECD, 1996). New theories of financial intermediation (Allen and Santomero, 1996; Allen and Gale, 1997) underline the importance of the markets in such a way that all intermediaries (banks, mutual funds, etc.) perform a risk-management activity in between borrowers and lenders on one side and markets on the other, providing a kind of risk insurance. In spite of that, banks and markets can still coexist (Boot and Thakor, 1997).

The evolution and transformation of securities markets and of information technology is becoming an important issue in Europe and in the U.S. for another reason: it makes exchanges comparable and more integrated. The borders of the irrelevant market that investors face are blurring. In this way there is an increasing competition among the stock exchanges (Pagano and Steil, 1996) and among exchanges and automated trading systems (Domowitz & Lee, 1996).

Rivalry exists among the exchanges in pursuit of the same goal to attract order flow. The market is fragmented mostly because no single exchange dominates in the economic arena, or because each of the exchanges is individually too small to affect the prices but they are reluctant to act in concert to condense their market power (Lee, 1998). Both suggest that different law and regulation may be the obstacles that constrain them to undertake the same activities. ECNs have been put in place, the marginal cost of additional transactions is, in effect, zero. Its arrival that can automatically search out the lowest-cost market for investors adds to the pressure. In the subsequent sections, each of the issues of rivalry, fragmentation and competition from ECNs is analyzed.

2.3.1 Rivalry among Exchanges

Rivalry is a contest among different exchanges in pursuit of the same goal. The primary goal of all exchanges and trading systems is to attract liquidity. To compete, an exchange must be able to provide a marketplace for exchange of assets at the minimal transaction cost. Direct costs include exchange fees and brokerage commissions. Indirect costs are characterised by the absence of liquidity (Lee, 1998) implying that purchase and sale of an indefinite amount of the assets cannot be traded at the same time without delay and at the same price. Furthermore, deregulation of brokerage commission implies that the source of income from trading is being threatened. To improve profitability, an exchange must attract more companies to list and more intermediaries to trade.

Examples of competition among exchanges are not new at all, especially in the

U.S. They can be found, for example, from the initial years of the NYSE. In 1885 the Consolidated Stock Exchange3 decided to trade NYSE-listed stocks, charging lower commissions due to its lower costs because it used the NYSE quotes and did not incur the costs of establishing the price-discovery mechanism (Mulherin,1991). Blume and Goldstein (1997) analyze empirically the integration of the U.S. equity markets in recent years.

In more recent times, the London Stock Exchange, deeply reformed in 1986, decided unilaterally to trade on its international segment (SEAQ International) the most important European stocks. It gained such a significant market share in other European securities listed on national exchanges that they had to quickly update their markets. Nowadays, the LSE must face the national competition of Tradepoint. After its entry into the market in 1995 and the shift to it of the trades of three out of four Inter-dealer markets, the LSE recently slashed its fees by more than 60% to undercut Tradepoint. Meanwhile, the LSE decided to move from a quote-driven system to an order-driven system for the FT100 Index leading shares, to better compete with the order-driven European exchanges.

Exchanges are facing even stronger competition from quasi-exchanges, like automated trading systems (ATS), where it is possible to trade securities generally listed on exchanges. ATS compete with exchanges even if their nature is not clear from a regulatory point of view.

2.3.2 Fragmentation

Fragmentation describes a divided market in that no single participant dominates in the market. Exchanges within the same country desire to have one exchange in which a single exchange operates with a single order execution mechanism to concentrate all securities trading, and with a single data dissemination centre to consolidate all news releases. Otherwise, liquidity will be impaired; resources will be duplicated on staff and technological investments.

The Philippine Stock Exchange (PSE) has previously objected to the proposed establishment of a Small and Medium Enterprise Securities Exchange to cater for the needs of small and medium enterprises that do not meet the listing requirements of the PSE main board. This kind of proposal, if it had materialized, would have fragmented the market and impaired liquidity.

As discussed above, a fragmented market is one in which there exists more than one trading system, and no formal linkages are created between their market architectures.

2.3.3 Competition from ECNs

From an economic point of view, an ECN can be seen as a special kind of exchange, which specializes in producing trading services without producing listing services, and generally trades securities already listed on regulated exchanges. ECNs are low-cost, for-profit distribution channels competing largely on price and exploiting a perceived lack of service from quote-driven markets such as Nasdaq. ECNs account for approximately 30% of Nasdaq volume and over 15% of the total US orders (Baker, 2000). The largest ECNs,

Instinet and Island, account for 13% and 12% of the Nasdaq market respectively.

Some ECNs have applied to the SEC to become full stock exchanges to avoid paying trade reporting and quotation fees to Nasdaq, further lowering their operating costs, thus intensifying head-to-head competition with stock exchanges.

From an investor's perspective, connectivity and sophisticated order-routing software enable broker-dealers to trade at the best price and in the most cost-effective trading and settlement environment (Butler, 2001). The more technology enhances connectivity between market participants, the more likely it is that sufficient liquidity will remain in the system even in the face of greater market fragmentation. ECN software vendors have succeeded in creating a virtual marketplace.

If users can get the best available prices in the market, they will not bother where the order is executed. This is because on one hand, investors are increasingly driven by the need to minimize trading costs; on the other hand, they inevitably gravitate towards the most liquid platform that gives price transparency.

From an exchange's viewpoint, ECNs are fragmenting the market because they are drawing liquidity away from the exchanges. However, they are also consolidating liquidity because the price transparency they are bringing makes it easier to identify prices (Butler, 2001). In the US, the rise of ECNs is regarded as a direct response to market dissatisfaction with the pricing advantages enjoyed by the members of floor-based exchanges. To survive and develop successfully, exchanges must be able to provide the right products and services to the market in the most efficient way and at the most competitive price.

ECNs have the same economic function as exchanges (Britton, 2000). They seem particularly strong with a primary focus on order matching and execution at the most competitive price.

2.4 The effects of the increasing competition among Stock Exchanges

The effects of the increasing competition among exchanges are difficult to evaluate in terms of the future market structures in Europe. On one hand, in the long run, only the most efficient exchanges should survive, trading stocks from all the other European countries and offering the most innovative and competitive financial instruments (especially derivatives). As Steil (1996b) notes, the existence of three dozen European stock exchanges almost all of which are operating with the same basic trading mechanism (the continuous electronic auction) is, at the very least, duplicative and wasteful of resources. The expansion of remote membership access after 1996 will undoubtedly go a considerable way towards facilitating cost-effective cross-border trading, and thereby eliminate significant barriers to creating a common and expanded pool of equity market liquidity.

A single European currency would serve to integrate the market even further. The first model in this paper is consistent with this explanation; only one exchange (but not necessarily the most efficient) should survive.

On the other hand, it is possible that a unique exchange will emerge only for highly standardized and/or traded products, especially after the introduction of the Euro (like government bonds, derivatives, and stocks of the biggest firms). In fact, remote access makes useless any competition among the different exchanges at least if they are at the same technological level; furthermore, the informative advantages on national firms (especially small and medium-size firms) by their national exchanges and intermediaries will remain important. Finally, all the past projects or attempts to create a unique European stock exchange (PIPE, Euroquote, etc.) were unsuccessful. In any case, the rationale for a coexistence of many markets, in different nations, trading the same stocks, could easily be given by different trading systems (as continuous auction favors transparency and market making favors liquidity).

The stock-exchange market is characterised by increasing internationalisation. The technology has made cross-border trading possible and simple, while deregulation has provided the basis for exploitation of these opportunities. The EU Investment Services Directive, ISD, has provided market participants with the opportunity for remote membership of stock exchanges abroad and the stock exchanges can now establish electronic access abroad.

The demand side has also driven the internationalisation of the stock-exchange environment, in particular via the investment behaviour of institutional investors. In view of the growing volume of pension savings the role of the institutional investors is of increasing importance to the development in the stock-exchange area. Investors' portfolios are subject to greater diversification with a view to higher returns.

The introduction of the euro has acted as a strong catalyst for this development since investors can now spread their investments on several countries without assuming any exchange-rate risk. This has been particularly important to institutional investors which are typically subject to placement rules restricting the volume of investments denominated in foreign exchange.

2.5 Revolutionary Changes of Technology in the Securities Markets

In several respects the development of information technology has had a decisive impact on changes in the securities trading area. Firstly, complex orders can now easily be processed in the electronic trading systems. Secondly, the systems can accommodate a virtually unlimited number of participants, in contrast to e.g. traditional floor trading where the number of participants is physically limited. Thirdly, IT development has eroded geographical borders. In principle, all that participation in an electronic trading system requires is the installation of a terminal/PC and a link to the system.

As detailed in section 2.2, the world is experiencing a dramatic increase in the context of economic globalisation. International trade and capital flows, foreign direct investment, migration all have increased substantially over the last twenty years (Holland, 1987; Dunning, 1992, 1993). A corresponding globalisation is said to have occurred in social, cultural and political life, impacting on local communities, and lowering ties of national identity, citizenship, and political sovereignty (Held, 1991; Robertson, 1992). The generation and diffusion of technological innovations made this economic and social globalisation possible.

2.5.1 Evolution of Online Brokerage Firms

Archibugi and Michie (1997) wrote about technological globalisation as Global exploitation of technology. Firms are exploiting their innovations on global markets eitherby exporting products, which embody them, or by licensing the know-how. This implies thatfinancial institutions have exploited the Internet and new digital technologies to developacross the borders to lower operation costs, reduce the need for intermediation, and widenchoice and awareness. Online brokerage firms are developed as new channels to reachcustomers, diverting growing volumes of trading away from established exchanges andfrom the exchanges' traditional member firms respectively.

Online brokerages with new business models have evolved to compete with exchanges' traditional member firms (Weber, 2000). According to a survey done by the Securities

Industry Association (SIA), on-line trading would account for 50% of retail stock market trades by 2003, up from 37% in 1999. The SIA also estimated that 18% of stock buyers and sellers were now using the Internet, compared to only 10% a year ago. According to the US Banker, there are now around 150 brokers offering Internet trading. The average number of on-line trades per day has increased five fold since 1997, and now exceeding

500,000. Today 3 million households invest online, up from 2.2 million a year ago

(Haggin, 2000).

E-brokerage is a direct electronic market access that allows investors to bypass the middleman and trade directly with buyers and sellers (Tunick, 2001). In some circumstances, some exchanges act as a catalyst to allow investors to disinter-mediate the middleman and trade directly within the execution destination of their choices. The New

Zealand Stock Exchange, for instance, plans to introduce a wireless securities trading system, which allows investors to trade securities without passing through a broker. Under such plan, investors can be connected to the exchange's WAP server through their Internet service provider using a WAP-enabled phone or palm computer.

2.5.2 Impact of ECNs

Computer technology has led to the birth of new MONSTERS (Market-Oriented New Systems for Terrifying Exchanges and Regulators) (Lee, 1998). ECNs emerged as an incremental innovation to sustain established trajectories of performance improvement to the existing trading systems. This gives rise to regulatory competition between ECNs and regulated exchanges, for example, Instinet versus New York Stock Exchange (NYSE). The competition issues of ECNs have been described in section 2.3.3.

2.5.3 The network effect - the advantage of being first and largest

Technological development and increasing internationalisation have intensified competition in the stock-exchange area, while the advantage of being first/largest in the market has probably served as an impediment to competition.

Generally, it is an advantage to the users of a trading system that it has several participants. This is because the liquidity in the system is assumed to increase with the number of participants. This means that investors can trade at lower spreads, buying and selling without the price of the securities being adversely influenced from the point of view of the investor. Thanks to the positive effect of many participants in the same system (network effect), the investors tend to use the large, well-established marketplaces.

The traditional stock exchanges have enjoyed the advantage of being first in the market. At the same time, substantial establishment costs have impeded competition. In view of these conditions the traditional stock exchanges have not always had any great incentive to introduce new technology and to develop in accordance with customers' requirements. For example, the largest stock exchanges were the last to introduce automatic trading systems to replace floor trading. On the largest US stock exchange, the New York Stock Exchange, floor trading continues to be an important element in trading.

It is possible to think of an application of the network-externalities literature to financial intermediation and exchanges. The application of network externalities to finance is a relatively new topic but has developed substantially in the last years. Regarding stock exchanges, they can be seen as networks where the more traders (drawn from the same distribution of uncertain endowments) enter the market, the more market uncertainty (measured by the variance of market prices) is diminished (Economides, 1993).

A paper that explicitly applies network externalities to exchange competition is

Domowitz (1995). Though not analytically described, he uses network externalities to set up a game among exchanges where two technologies (floor and automated trading) are available for traders and network externalities are, in trading terms, the liquidity effect, as the more traders are in a market, the more liquid it is. It is argued that increased network externalities offered by electronic exchange structures will... encourage and provide the vehicle for implicit mergers, which is something that is already happening in reality with various agreements, especially among derivatives exchanges.

2.6 Integration of Stock Exchanges

In Asia, most recently saw the merger between the demutualized Stock Exchange of Singapore and Singapore International Monetary Exchange Limited in 1999. In 2000, the

HKSE and HKFE demutualised to become subsidiaries of Hong Kong Stock exchange. The Hong Kong Stock Exchange has increased its competitiveness in terms of regulatory efficiency and effectiveness, liquidity, economies of scale, settlement risk management and customer service. Further consolidation is expected in the region to cope with the increasingly complex and competitive global environment.

Traditional exchanges under competitive pressures are forging mergers or strategic alliances across borders. The attempt to consolidate Europe's stock exchanges did not come to a halt following the collapse of the proposed merger between DB and LSE in 2000. Euronext tied together in 2000 the exchanges of Paris, Amsterdam and Brussels (Zwick, 2001). The introduction of the euro and the advent of more sophisticated trading technology have fueled the momentum. Euronext was able to consolidate an annual equity trading volume of more than $1.5 trillion, far exceeding either the German or London Stock Exchanges. This unified system for trading, clearing and settlement, using state-of-the-art technology, which makes trading more efficient and less expensive, accounts for exactly what stock exchange customers clamor for.

Talks with some other smaller exchanges such as Lisbon are in progress. Paris Börse predicted that only three or four western European stock exchanges down from sixteen would remain in a few years.

The evolution and transformation of securities markets and of information technology is becoming an important issue in Europe and in the U.S. for another reason: it makes exchanges comparable and more integrated. The borders of the irrelevant" market that investors face is blurring. In this way there is an increasing competition among the stock exchanges (Pagano and Steil, 1996) and among exchanges and automated trading systems (Domowitz and Lee, 1996).

International cooperation is emerging. Nasdaq formed a joint venture in Europe in May

2000. It has also formed affiliations with stock exchanges in Japan, Hong Kong and

Canada. More recently, Nasdaq's greatest rival, NYSE, has been exploring the feasibility of a global equity market that can link exchanges in many countries including Japan and

France. The goal of having a single 24-hour market in which the shares of the world's biggest blue-chip firms can be traded cheaply and efficiently is being urged to be viable.

2.7 Theoretical Influences

2.7.1 Industry Dynamics

Figure 1 Porter's Five Forces Model

The simple model of the analysis of the competitive structure of the stock exchange dynamics is the Porter's Five Forces model. This model is used because of its dynamic interaction of the forces between one another. The five dimensions in the context of a stock exchange are: existing competition in the stock exchange industry, the threat of new entrants, the relative bargaining power of suppliers, the relative bargaining power of the buyers, and the threat of substitutes. They are not of equal strength within the stock exchange industry. Their relative strength may change over time. For instance, Internet technology allows business transactions to be conducted via open networks based on the fixed and wireless infrastructure (Amit & Zott, 2000). In view of the Internet influence, Porter (2001) incorporates this new element into the model.

If stock exchanges can view the Internet as a complement to, not a cannibal of, traditional ways of trading, then they can leverage electronic trading as a key element in their business strategies. The Internet increases operational efficiency because orders can be received based on price and time priority. Bid, offer and transaction prices are instantly disseminated, providing the highest level of trading efficiency and transparency. Other forces such as the current rivalry, the threat of new entrants or the threat of substitutes are essentially of a dynamic nature and are based on expectations, whereas the bargaining powers of suppliers and buyers are more static and reflect current realities. The strength of each of the five competitive forces is determined by certain factors, some of which are listed in Table 2.

An assessment of market attractiveness depends on the assessment of the strength of these factors.

Table 2

Competitive Force

Strengthened by:

Current rivalry

Low growth of industry, high fixed operating costs, low product


Power of suppliers

High (supplier) switching costs to buyers, non-availability of substitutes,

supplier concentration

Power of buyers

Buyer concentration, low cost of switching

Product substitution

Low relative price of substitute, buyer propensity to substitute, low

switching costs to buyers

New entrant

Low level of entry barriers, e.g. scale of economies, capital requirements

Determinants of the strength of the five competitive forces

The Porter model is used in this dissertation for strategic situation analysis. Strategic situation analysis is self-examination of a corporation's existing strategic exposure, so as to discover the strength of a portfolio of businesses. Such an examination enables the stock exchange to assess its competitive strengths (S) and weaknesses (W), and to match these against the opportunities (O) and threats (T) put forward by the five forces. The SWOT analysis helps reveal a mismatch between the stock exchange's present capabilities and those that are needed to create, sustain or strengthen a competitive advantage in the market.

The mismatch creates a need for the stock exchange to proceed to the strategic choice analysis, which is a forward-looking, scenario-building approach to its future strategic posture. There are generally three alternatives of strategic choices: organic growth, mergers or strategic alliances. A stock exchange's choice depends on:

1. Level of competition in the host market;

2. Availability of organizational resources for organic growth; and

3. Ability to appropriate potential added value.

Competitive force Strengthened by

If level of competition in the host market is already high and there is excess capacity, building new capacity will invite retaliation from the existing players. Under these circumstances, merger with an existing stock exchange will reduce such risk.

Moreover, the stock exchange may not possess all the necessary resources and capabilities to compete effectively in the host market. Merger or strategic alliance enhances faster access of these resources and capabilities. Merger is the quickest means of achieving synergies. The challenges are mainly post-integration problems.

Network Society

The rationale behind merger is to consolidate liquidity. Liquidity is important and is created by network externality. Network externalities describe the effect that larger networks are more attractive to users than smaller ones (Federal Trade Commission, 2000). Network externalities have two main effects on both the old and new economies (Shapiro and Varian, 1999). The old industrial economy was driven by demand-side economies of scale, given that the more attractive a product is, the larger is the number of consumers who will use that product. This shapes the future success of competing products in today's choice. The new information economy is driven by the economics of networks. The key concept is positive feedback, which makes the strong strengthen, and the weak weaken. It is a more potent force in the network economy than ever before; this has also been covered in 2.5.3.

Positive network externalities arise when a good is getting more valuable to one user; more users realize the network's attractiveness and tend to use the same good. Applying this concept in the context of the exchanges: allows more stocks to migrate to a single exchange, the largest pool of liquidity will form there and benefits existing trades at more competitive prices. The more intermediaries who execute more deals in one exchange, the more the other intermediaries/companies that want to go public will be likely attracted. Thus complementarily, compatibility and coordination are the essential components of a network.

Domowitz (1995) explicitly applies network externalities to exchange competition by setting up a game among exchanges where two technologies (floor and automated trading) are available for traders. Network externalities create, in trading terms, the liquidity effect, in that the more traders enter in a market, the more market uncertainty is diminished and the more liquid it is.

A company decides on an exchange, which can derive the highest utility, primarily because a greater degree of trading orders can be consolidated, and more intermediaries trade to give more liquidity. This is the concept of cross-network externality (Noia, 1998). Utility derives from an increase in consumption of a good belonging to the same network. Investors anticipate that the higher the liquidity, the more they are aware of the company's securities, and the more efficient the market is in terms of the speed of information dissemination and immediacy of order execution. In general, markets, which are characterized by high connectivity, a focus on transactions, and high reach and richness of information, are said to have cross-network externality effect.

There also exists a direct-network externality when a company prefers a listing exchange where many other firms choose to be listed (Noia, 1998). Companies anticipate that such exchange signifies high market quality, and enhances fairness, transparency and accountability enforced by good corporate governance practices. Moreover, the bigger the exchange, the better services such as clearing and settlement, and information dissemination can be provided; and the more products the exchange can afford to be developed. Most importantly, when more intermediaries appear on the same exchange, the volatility of such market may be lower than of the one, which consists of a relatively smaller number of listed companies that are highly correlated (Hull, 1998).

2.7.2 Integration Strategies

The immediate objective of an acquisition is self-evidently growth and expansion of an acquirer's assets, sales and market share. A more fundamental objective is to maximize shareholders' wealth through acquisitions and create sustainable competitive advantages for the acquirer. A merger adds value only if the two companies are worth more together than apart (Myers, 2000).

It is assumed that mergers are undertaken to cut costs, add revenues or create growth opportunities and ultimately to achieve synergies in human resources and the decision making processes. The disadvantages of mergers are change of control and ownership. Very often, new assignments for the top management are included as a part of the merger agreement.

Mergers are often categorized as horizontal, vertical or conglomerate. A horizontal merger is one that takes place between two firms in the same line of business. A recent example is the proposed formation of the iX. A vertical merger involves companies offering different products in the same market. Companies, which adopt this strategy, desire to expand backward toward the supplier of raw materials or forward in the direction of the ultimate consumer along the supply chain. A conglomerate merger involves companies in unrelated lines of business. Its major objective is to expand the range of the product offerings.

Ansoff's Product-Market Matrix

The strategic choice made by the stock exchange determines the type of merger it undertakes (Sudarsanam, 1995). As Table 3 suggests, market penetration strategy aims to increase market share of a firm in its existing markets. Market extension strategy involves selling of existing products across borders. It can be a horizontal merger given similar organizational architecture. It creates values when both firms can share complementary resources. Product extension enables a firm to sell new products related to its existing products in its existing market. A vertical merger can achieve this. In a diversification strategy, the target is in an unrelated business resulting in a conglomerate merger.

Ansoff's product-market matrix captures the rich complexity of factors which determine the competitive environment of markets, or factors which constitute a firm's competitive strength. Case studies of the London stock exchange and the Hong Kong Stock Exchange exemplify the mergers including elements of horizontal and vertical mergers respectively.

Table 3 Ansoff's Product-Market Matrix

Existing Product



Market Segments



Market Penetration

- Aims to increase market share in existing markets.

Product Extension

- Aims to sell new products related to existing ones in present markets.



Market Extension

- Aims to sell existing products in new geographical markets.


- Aims to sell new products in new markets.

Source: Sudarsanam, 1995

3. Methodology

3.1 Aim of Project

The aim of this project is to show the current and future developments of stock exchanges. They were once regarded as public entities, but have now developed into profit maximizing corporations, with increased integration and mergers occurring between stock exchanges. To show why they have changed and taken more of a competitive and integrated strategy.

3.2 Objectives of the project

The primary objective of this dissertation is to analyse the competition and integration strategies of stock exchanges like firms.

The dissertation focuses on:

1. Industry dynamics of stock exchanges;

2. Evolution of stock exchange mergers;

3. Integration strategies; and

4. Future consolidation trends.

3.3 Why I am interested in this topic

My interest in this topic was brought about by my previous work experience at a stockbroker as it enhanced my interest in stock exchanges and their development, with many people (particularly traders at the company) reacting to their changing competitive strategy and the continuing introduction of new technology. I wanted to develop my knowledge and understanding in this subject area and to see if the trend has occurred further than Europe.

3.4 Background

As time has gone by, exchanges have had to compete in the global market to attract quality companies to list and intermediaries to trade; many of them have converted their member ownership structures into a stock company by means of demutualisation. Under the plan of demutualisation, members are issued shares of the exchange. They become shareholders of the exchange and therefore can be eligible for profit distribution. Since then, exchanges have reformed to become commercially-driven corporations whose goal is to maximize shareholders' wealth.

With the formation of the European Union, cross-border trading in Europe is growing in popularity. The introduction of the euro and a wider acceptance of equity as a financing tool are encouraging investors in Europe to engage in more cross-border transactions in search of profit-making opportunities. Yet despite the appeal of cross-border trading, most stock exchanges in Europe are national institutions that trade only local, country-specific stocks.

Rivalry is a contest among different exchanges in pursuit of the same goal. The primary goal of all exchanges and trading systems is to attract liquidity. To compete, an exchange must be able to provide a marketplace for exchange of assets at the minimal transaction cost. Direct costs include exchange fees and brokerage commissions.

Indirect costs are characterised by the absence of liquidity (Lee, 1998) implying that purchase and sale of an indefinite amount of the assets cannot be traded at the same time without delay and at the same price. Furthermore, deregulation of brokerage commission implies that the source of income from trading is being threatened. To improve profitability, an exchange must attract more companies to list and more intermediaries to trade.

3.5 The General Approach

The general approach of a study is affected by the researcher's frame of reference, which refers to one's overall knowledge, norms and values (Wiedersheim-Paul and Eriksson, 1997). The approach of this project is based upon the frame of reference, which works as an individual scale. The applied theories and models themselves affect the individual scale of the research. Therefore, it is important that the researcher maintains an objective approach. To achieve objectivity I have studied a wide range of theories and literature in the field of my study. However, an entirely objective approach is difficult to achieve as a large part of the literature and articles themselves contain interpretations and opinions that may influence me.

There are two types of approaches that you can take on, when conducting a research project. One is a deductive approach, in which you develop a theory and hypothesis and design a research strategy to test the hypothesis, or these is the inductive approach, in which you would collect data and develop theory as a result of the data analysis. I have chosen a deductive approach as the research is based mainly on articles as I am looking at the development of stock exchanges and the changes in their strategy over the years. I will test the empirical findings with existing literature and models.

3.5.1 Choice of Method

A method can be either quantitative or qualitative. A quantitative method is formalized, structured and is characterized by selectively as well as a distance from the source of information (Holme & Solvang, 1996). The approach centralizes on numerical observations and aims at generalizing a phenomenon through formalized analysis of chosen data where statistics indicators play a central role. On the other hand, a qualitative method is formalized to a lesser extent is directed at testing if the information is generally valid. The approach is characterized by the use of verbal descriptions instead of purely numerical data and aims to create a common understanding of the subject being studied.

In order to achieve the purpose, I have chosen to apply more of a qualitative method but have incorporated aspects of a quantitative method. The qualitative method refers to the survey I have implemented in the form of an interview, which is directed at active investors, brokers and members of two stock exchanges. Through the interview, I strive to determine whether mergers in Europe are more productive than overseas, examples being the London Stock Exchange and the Hong Kong Stock Exchange. Also how each exchange is competing and how technology and other factors are affecting the increasing competition strategies of exchanges. The quantitative method has been used when analyzing the results of the interviews.

3.6 Data Collection

Data for my study was primarily collected through an interview as well as through research based on existing material concerning the competition and integration strategies of stock exchanges.

3.6.1 Primary Data

Primary data refers to data, which is collected for a specific purpose and which is required in order to complement secondary data (Widersheim-Paul & Eriksson, 1997). The primary data in this project consists of an interview directed at a private client broker, an investment bank and members of two stock exchanges. Two interviews were conducted at Brewin Dolphin Securities Ltd, a private clients brokers', one is from UBS, a Swiss Financial Services Corporation. I have also interviewed members of two stock exchanges, the London stock Exchange and the Hong Kong Stock Exchange. The interview was conducted over the phone with 3 of the participants and 2 preferred to carry out the interview via email. The interview was conducted and answered voluntarily by all 5 participants.

The questionnaire consists of 9 questions concerning whether stock exchanges merging is beneficial for all parties, whether this phenomenon is just occurring in Europe or more further a field, such as Hong Kong. Interview questions covered macro-environment, integration strategies, competition and partnership issues, impact of technology on stock exchanges, bargaining power of both buyers and suppliers, and future consolidation trends.

The project was managed and implemented using established project management and consultancy techniques (Cope: 2000), (Maylor: 1996). This was considered essential given the rapidly evolving nature of the industry. The names of the participants and the interview question can be seen in Appendix 1. Appendix 2highlights the key points of interviews.

The framework of industry dynamics and integration strategies detailed in section 2.6 were deployed to analyse and evaluate the qualitative data (Grant: 1998), (Doyle: 1998). Finally, the choice of merger strategies and challenges of mergers were induced (Hart, 1998).

3.6.2 Secondary Data

Secondary data refers to the existing collected and summarized material of the subject in question. This data originates from such sources as databases, literature, journals and the Internet (Wiedersheim-Paul & Eriksson, 1997). The secondary data used in my research refers to the existing literature written on the subject at hand, particularly articles in journals and Internet data sources. The emphasis was on finding material on the relatively new and changing area of competition and integration strategies of stock exchanges.

Most of the literature was found in the Coventry University Library and search engines on the Internet. I also used books from the library, but were not that useful as they were dated and did not contain information that I needed.

3.7 Criticisms of the Sources

Both the primary and secondary sources of data may contain factors influencing the quality of the research. Furthermore, one must also consider the validity and reliability of the research in order to establish the overall quality of the study.

3.7.1 Criticisms of Primary Data

The interview which I conducted, is advantageous as the data collected is unique and contemporary in nature and the questions may be formulated to specifically correspond to the area being researched. However, the interview is susceptible to the subjective opinions of the respondents. When asking about previous and future events, the responses are exposed to their subjective ability to recollect specific past events. The respondents may also have changed their opinion or been influenced by other people of specific past and future events.

Therefore the answers given by respondents can be biased toward what their opinion is on the specific matter. In addition, brokers answering the same questions as members of stock exchanges will have a different viewpoint. The members of the stock exchange were biased towards the interests of their own business and therefore did not give entirely true answers, this along with some respondent's time constraints; a lack of interest and confidentiality did create limitations.

3.7.2 Criticisms of Secondary Data

The theories and literature written on the competition and integration strategies of stock exchanges is relatively new and therefore literature on this subject is subject to many interpretations. I have endeavored to take an objective perspective on stock exchanges. The majority of the secondary data is obtained from articles and is contemporary in nature. Therefore I consider my secondary data to be highly pertinent.

3.8 Validity

A research has a high validity if the study only contains what one wants to study and nothing else (Thuren, 1991). Validity refers to how well the data collection and data analysis of the research captures the reality being studied. The data I have collected both primary and secondary in my opinion is very valid to the subject area of the competition and integration strategies of stock exchanges.

3.9 Reliability

Reliability demonstrates that the operations of a study, such as the data collection procedures, can be repeated with the same outcome. In my case I have interviewed brokers and members of the London and Honk Kong Stock Exchange. I consider that the same procedure is easily applicable to another similar set of interviewees in the same field of work. Therefore, I believe the study fulfils the reliability criteria. However, the answers obtained are exposed to subjectivity dependant on the area of work they are in and their opinion of mergers in Europe and in Asia. A certain amount of hindsight bias may also distort the responses.

4. Qualitative Analysis

4.1 Analysis of Industry Dynamics

The industry dynamics is shaped in the framework of Porter's Five Forces Model, as illustrated in Figure 1. An exchange is in a very precarious position due to a competitive market, powerful suppliers (listing companies) and cautious buyers (intermediaries and eventually investors), weak substitutes, and high barriers to entry.

4.1.1 Industry Dynamics in the Porter's Five Forces Model

Source: Porter, 2001

Threat of Substitutes

Inefficient Substitutes: ECNs

  • Low-cost, for-profit distribution channels.

  • Compete largely on price

  • Exploit a lack of service from a quote-driven market but yet to succeed to consolidate liquidity.

  • Parasites on stock exchanges.

  • The proliferation will not create new substitution threats in both Europe and Asia Pacific.

Barriers to Entry

High barriers to entry

  • Trading alone is difficult to keep proprietary from new entrants such as ECNs.

  • Capital intensive.

  • High costs to maintain good corporate governance practices and an orderly market.

Bargaining Power of Suppliers (Listed Companies / Network Providers)

Listed Companies

  • Proliferation of competitors widens the choice of a listing exchange and shifts the power to listed companies.

  • The Internet provides an e-brokerage channel for listed companies to reach investors, reducing the leverage of intervening stock exchanges

Network Providers

  • Provision of connectivity services.

  • Strong bargaining power in terms of bandwidth and technical skills

Buyers Bargaining Power of Channels / End Users

Cautious customers (Investors)

  • More selection, less loyalty.

  • Increasingly lower switching costs.

Effective Online Brokerage Channels

  • Eliminates powerful member brokers or improves bargaining power over traditional channels

Rivalry Among Existing Stock Exchanges

A competitive market for stock exchanges

  • Competition intensifies with lower brokerage commissions.

  • Many players offer similar propositions and standardized products and services.

  • Dual listing eliminates geographical boundaries.

  • Demutualisation leads to increasing pressure to maximize shareholders' wealth.

  • Transfer of the listing function to another authority resembles and ECN.

4.1.2 A Competitive Market

Competition takes place on many grounds, such as the provision of immediacy, price discovery, price volatility, liquidity, transparency and transaction costs. The opinions I have collected suggested that there were two major reasons leading to competition. Firstly, technological innovation has made it possible for faster and cheaper delivery of services via connectivity to regulated stock exchanges. Secondly, the rising influence of retail investors is driving the desire for more cross-border trading. There are also region-specific reasons. A member of the Hong Kong Stock Exchange anticipated that the deregulation of brokerage commissions would further intensify competition in Hong Kong.

Regulators came to a consensus that demutualisation was the most effective way to link profitability to members who were also shareholders of the stock exchange. This gives them the incentive to maximize shareholders' wealth and therefore to increase the stock exchange's competitiveness. Investment banks/brokerage firms were most concerned with transaction cost and liquidity.

Investment banks/brokerage firms were most concerned with transaction cost and liquidity. If an intermediary must choose which market to trade in the absence of information asymmetry, everything being equal, they choose the lowest-cost market. An intermediary will find an exchange more attractive when other intermediaries exist because the more intermediaries are attracted to the exchange floor or computerized system, presumably the higher is the liquidity. Higher liquidity also attracts even more intermediaries. This agrees with cross-network externality literature. Liquidity attracts companies regardless of the differences in listing requirements and securities regulation. Companies prefer to be listed on an exchange where many other firms are also listed. This is in consensus with the direct-network externality.

Utility derives from an increase in the consumption of a different good belonging, in a sense, to the same network. Many empirical studies show that liquidity has a sizable impact on securities value. Listing on a major exchange can attract many investors, as Pagano et alii (1995) by acting as an advertisement for the company.

Merton (1987) has captured this point in a capital-asset-pricing model with incomplete information, showing that stock prices are higher the greater the number of investors aware of the company's securities." At the same time, firms may prefer to be listed on an exchange where many firms are listed (direct network-effect), as it may be a sign of quality of the market, or because they anticipate that more intermediaries will be there and the variance of such a market may be lower than of an exchange with a very small number of firms highly correlated. The value of being listed for a firm is higher the more listed firms and the more intermediaries trading on the same exchange. A firm will prefer, with other conditions equal51, to be listed on high-quality exchanges where many other firms are listed (the market is more liquid with 100 listed firms than ten) and many intermediaries can send trading orders.

4.1.3 Bargaining Power of Suppliers

Network Providers

Network providers are leveraging their competencies to offer physical connectivity services to an exchange. An exchange depends on them to build the infrastructure of the trading system. They have strong power in terms of bandwidth and technical skills. Initial investments are huge. They are able to lock in stock exchanges that need them for future upgrades of software and regular maintenance of trading systems.

Listed Companies

Listed companies are weak suppliers. An opinion shaper in the securities and futures market mentioned, Initially companies prefer to list domestically because they are better understood by their customers and suppliers. Regulators, investment banks/brokerage firms agreed that the bargaining power of firms was low in choosing primary listing exchange; but their power increases when they come to choose their secondary listing exchange, which agrees with literature. They will consider an exchange, which has:

  • A critical mass;

  • The reputation for market quality and efficiency; and

  • The ability to attract liquidity.

Apart from the above, investment banks/brokerage firms are in a better position to understand companies' needs, as they are particularly concerned with listing and subsequent disclosure requirements, securities regulation, and investor protection.

The weak bargaining power of companies was further strengthened by literature that mentioned that dual listing was duplicative and not feasible because listed companies had to comply with two sets of regulatory requirements, accounting standards and securities regulation, thus increasing their indirect costs.

4.1.4 Bargaining Power of Buyers


In an order-driven market, investors are not able to distinguish a monopolistic exchange or an ECN as long as the same order is automatically matched and executed at the best possible price. The broker firm emphasized, Investors do not choose a particular exchange if the stock they desire to buy only list there.

Brokerage firms concluded that the crucial determinants for an investor to choose a broker included simplicity of execution, low transaction costs and availability of market information provided by the brokers.

Financial intermediaries of various kinds perform more and more risk management activities (Allen and Santomero, 1996), which are profitable and can substitute other forms of revenues that are drastically falling (like the net interest income), due to the transformation of financial markets. Changing regulations and new technologies allow them to trade (directly or through subsidiaries) on stock exchanges as broker dealers.

Intermediaries can choose nowadays where to trade. They may find more interesting an exchange with more financial products listed because it is more attractive for diversifying their own portfolios and their customers'.

At the same time, despite competition in commissions and spread, intermediaries may find more attractive an exchange with many more intermediaries, as they should give liquidity to the market, There are six factors that influence an intermediary's decision where to locate. They are the brokerage commissions, trading objectives such as immediacy and accuracy, legal impediments, economies of scale, network externalities, and enhancements in order routing facilities. Like listed companies, intermediaries want to trade on an exchange comprising many more intermediaries that can increasingly provide liquidity to the market. This agrees with positive network externality literature.

This is also beneficial to an exchange as an exchange competes to attract more intermediaries on the floor or in its computerized system, the more intermediaries create more connection fees and a greater customer base also enhances more trading commissions. Exchanges attract the greatest possible number of intermediaries for the purpose of efficiency and quality, and recognition and reputation. The former enhances scales of economies in the provision of transaction services while the latter attracts more companies of even greater market capitalization to be listed in a more liquid market.

New Channels

Recently, online brokerages have evolved to compete with traditional brokers. Their growth occurred in the absence of severe competition from traditional brokers, especially during a period of rapidly booming stock market activity, stagnant growth of customer base, and evolution of Internet channels. Consequently, the majority of active self -directed investors have already migrated to the Internet for their trading. Therefore, a multinational corporation's director was of the view that a traditional broker had to differentiate to compete in different market segments. One segment would be the retired who valued a combination of personalized services and physical locations over stand-alone delivery of products and services; another could include the middle twenties to late thirties who were not financially sound but had high potential growth of income in the future. The traditional powerhouse brokerage firms are fast waking up to the potential of direct retail brokerage services and are aggressively pursuing on-line strategies. And many are doing so on a global basis.

European investment banks generally agreed that new online brokerage channels have significantly increased buyers' power in Europe, but brokerage firms in Asia claimed that the turnover via e-trading was minimal. To meet various clients' needs, brokers have to combine Internet and traditional methods. They can make use of on-line financial portals.

They can also tailor the services to certain segments, for example, research delivery, online financial planning, extended-hour trading, portfolio management tools, and automated advice.

4.1.5 Inefficient Substitutes

Table 4compares the functionalities of an ECN with that of the existing electronic trading system. From an intermediary's perspective, these are well-established alternatives to the exchange proposition. However, the interviewees generally perceived that the ECN resembles a low-end outsourcing trading function as shown in Figure 2.

The benefits of outsourcing can easily be offset by increased transaction costs due to a lower level of liquidity (Teece: 1986). In effect, the savings in IT staff and equipment can be small compared to trading volume and monitoring costs (Williamson: 1985).

Moreover, most of the opinions I have collected seemed to agree that the business model resembled that of an order-driven market, which is the case in Europe and most East Asian countries. In these countries, uptake was almost stagnant. Acceptance had been lower than anticipated because investors were cautious due to uncertainty and trust. They had concerns regarding the quality of service and value. Investment banks/brokerage firms were concerned with the lack of price transparency and the ECN's ability to attract liquidity.

Table 4 - ECN versus Traditional electronic trading platform

ECN with sophisticated


Traditional electronic trading


Market Model

  • Multiple markets

  • Single market

Trading Method

  • Automatching

  • Single price auction

  • Automatching

Order Types

  • Order Types

  • Auction order

  • Limit order

Trading Request

  • By phone / in person

  • Over the Internet

  • By mobile phone

  • By phone / in person

Product Offerings

  • Trading services only

  • Issuers services: listing

  • Broker services: trading

  • Information dissemation

Order Modification and Order Status Enquiry

  • Done by brokers

  • Through Internet or by phone

  • Done by brokers

Order Confirmation

  • Done by brokers

  • Sent to investors automatically by email or mobile phone

  • Done by brokers

Note: New functionalities are highlighted in italic.

Figure 2 - Ansoff's Product Matrix

4.1.6 High Barriers to Entry

The notion of a national stock exchange as a natural monopoly has become obsolete. Stock exchanges are no longer public utilities they are moneymaking enterprises. If an ECN desires to become a recognized exchange, it must satisfy several requirements, among other things, sufficient financial resources, and rules and practices to ensure an orderly market and afford investor protection.

New entrants have taken the form of alternative trading mechanisms, new exchanges and established exchanges seeking to attract listings and cross-border trading to their markets. All interviewees agreed that in the long run, only the most efficient exchanges should survive, which allow trades in stocks from all countries in the globe and offer the most innovative and competitive financial vehicles. Academics reckoned that stock exchanges, which were operating with the same basic trading mechanism, are duplicative and wasteful of resources. This was especially the case in Europe where the expansion of remote membership access after 1996 could undoubtedly facilitate cost-effective cross-border trading, and thereby eliminate significant barriers to create a common and expanded pool of equity market liquidity. A single European currency would serve to integrate the market even further. However, continuing differences in law and regulation were great obstacles towards mergers, both national and international, and eventually form a supranational exchange. Academics claimed that the regional merger between LSE and DB has encountered ongoing arguments, most notably in the disagreement of a single set of regulation between them.

4.2 Case Studies

4.2.1 International Exchange - London Stock Exchange: A Prototype of Horizontal Merger

In the U.K., trading of shares began as soon as in 1760 when 150 brokers who were previously members of the Royal Exchange formed a club at Jonathan's Coffee House to buy and sell shares. In 1773, members voted to change the club's name to Stock Exchange. Securities trading in the UK underwent a major upheaval in the 1986 Big Bang. The main consequence ended single capacity trading and allowed firms, known as market makers, to operate in a dual capacity. In single capacity trading, brokers bought and sold securities on behalf of clients whereas jobbers held stocks of securities from which they bought and sold to brokers. After 1986, market makers could take the role of jobbers and simultaneously dealt with investors bypassing an intermediary broker.

Minimum scale of commission was abolished. Trading moved from the floor to being performed via computer and telephone from separate dealing rooms. In 1997, Stock Exchange Electronic Trading Service was launched to enhance greater speed and efficiency to the market. The settle meant service was removed from LSE to CRESTCo, the new electronic share-settlement service provider. LSE became a public limited company in 2000 and went public in July 2001.

In Germany, The Frankfurt Stock Exchange was established 223 years ago as a private institution operated by a number of merchants. Frankfurt is today Germany's leading stock exchange with a total volume of around euro 5,200 billion in 2000. DB combines the entire spectrum of services and system applications ranging from securities and derivatives trading through clearing and provision of market information to systems development. In particular, the Xetra trading platform has made DB the second-largest fully electronic cash market in the world.

The proposed merger is examined to form iX is examined from LSE's perspective. Table 8 summaries the SWOT analysis of LSE.

Table 5 - SWOT Analysis of LSE


  • Liquid secondary markets.

  • Internationally respected regulatory standards.

  • Well-established market position.


  • More scalable technology required


  • Harmonisation of financial markets in Europe.

  • Euro enhances settlement in a single currency.


  • Intense competition, other exchanges are building alliances.

i) Merger Motives

Building Market Credibility

To continue building its market credibility, LSE was seeking more alliances with its counterparts in Europe and other regions and to eventually create a Pan-European stock exchange. This is in line with the EU policy that aims to liberalize market access and create a single financial services market in Europe.


The number of cross-border transactions is increasing as a result of the changing investment patterns of institutional and retail investors towards a sectoral rather than geographical investment focus. LSE aimed to consolidate trading volume in the fragmented European market for equities, increase liquidity and price transparency.


LSE planned to undertake mergers to enhance efficiency by forming a single trading platform that allows for better order routing facilities. In addition, a merger could enable sharing existing technology and thus reducing transaction costs.

ii) Merger Strategy

The merger between the LSE and DB to form a new company to be called International

Exchange or iX was first announced on 3 May 2000. The merger talk was traced back to

July 1998 when LSE and DB began considering a relationship in response to the increasing competition and customer demands. LSE aims to form a common trading platform with DB with the support of harmonisation of the European markets and facilitation of a single passport license. iX would be headquartered in London with major operations in Frankfurt.

LSE chose a horizontal merger to resolve the mismatch between the resources, capabilities and opportunities available to both exchanges and attempted to create sustainable competitive advantage. Duplicate use of resources including the trading infrastructure, research and development and surplus operating capacity can be greatly eliminated. Other resources appearing in the form of strategic assets such as market power and entry barriers such as the experience curve or size can be further enhanced.

An exchange's distinctive capabilities, which include its architecture, capacity for innovation and reputation, can create sustainable competitive advantage.

iii) Merger Challenges

London Stock Exchange (LSE) and Frankfurt Deutsche Boerse said they would merge in 2000. The pair were to partner with Nasdaq to form an exchange, to be based in Frankfurt, for high-growth European stocks.

The merger threw a glaring light on LSE's technical problems, which damaged its reputation and was one of the main reasons they failed to complete the integration.

LSE's problems go back several years. Two years before the attempted merger, it and Deutsche Borse tried to establish a common European trading platform but they failed to deliver. LSE's outgoing Chief Executive Gavin Casey has been criticized in European newspapers for failing to implement a stable electronic trading system--two multi million dollar attempts at electronic trading failed--and for not raising the exchange's profile in the face of more intense competition.

The vision of a pan-European market never really took off due to political barriers and conflicting interests among the partners. A member of the LSE claimed, Firstly, political barriers are immense. National regulatory parties were reluctant to share or give up their powers and well-defined national jurisdictions. Literature confirmed this by saying that countries would prefer not to give up their stock exchanges of established prestige and revenue base.

Secondly, every stock exchange had its clearing and settlement system, operating in its own jurisdiction even though all the settlements could be done in euro. This implies that any extra delay of settlement would result in an extra cost of financing.

Thirdly, from an economic viewpoint, stock exchanges are investment-intensive businesses in that they require a lot of investments in technology. Economic synergies that can be synthesized from the merger are not guaranteed.

Costs to LSE

A broker I interviewed believed that the low offer price resulted because LSE was undervalued. Even if the merger had occurred, LSE would have incurred high transitional costs to link up with Xetra, the proposed German trading system after the merger. As the member of LSE explained that the market size that could be increased by merger per unit effort was very minimal. He also claimed, LSE is so big that it will find it difficult to merge with another stock exchange of comparable market size. LSE accounts for 55% of the equity trading volume in Europe. If it merges with the major active European stock exchanges, LSE can gain at most 9% from Switzerland, 7% from Italy, 5% from Spain and 3% from Sweden. Such a difference is not significant to the LSE.

Regulation and Compliance

Arguably, the merged entity might not necessarily streamline the process of listing and flotation, but threaten a quantum leap in regulation and compliance. Academics reckoned that whether a cross-listed company should be subject to the regulatory requirements of either its country of origin or both was not yet resolved. DB proposed any company that planned to list its shares on the LSE would only be required to comply with the German standards. The Financial Services Authority strongly objected to this proposal, requiring trades in any shares in the UK had to be subject to the UK standards regardless of the origin of original stock exchange. As discussed above, the iX merger proposal was officially withdrawn in the wake of concerns over regulatory harmonization and the potential level of operating costs.

4.2.2 Hong Kong Exchanges and Clearing Limited: A Typical Model of Vertical Merger

Reports of securities trading in Hong Kong dated back to the mid -19th century. The first formal market, the Association of Stockbrokers in Hong Kong, was not established until 1891 and it was re-named as the Hong Kong Stock Exchange in 1914. In 1921, a second exchange, the Hong Kong Stockbrokers' Association was incorporated. In 1947, these two exchanges merged to form the Hong Kong Stock Exchange, which aimed to re-establish the stock market after World War II. Rapid growth of the economy of Hong Kong led to the evolution of three other exchanges - the Far East Exchange in 1969; the Kam Ngan Stock Exchange in 1971; and the Kowloon Stock Exchange in 1972.

In 1980, HKSE was incorporated to strengthen market regulation and unify the four exchanges. The new exchange commenced trading through a computer-assisted system on 2 April 1986. As of September 2000, the Hong Kong stock market was the 10th largest in the world by capitalization, and the second largest in Asia.

The HKFE was established in 1976 to provide efficient and diversified markets for trading futures and options contracts for more than 130 participant organisations, including many that are affiliated to international financial institutions. Derivatives market under HKFE operates futures and options markets on a broad range of products, including equity index, stock, interest rate and foreign exchange. It operates rigorous risk management system, which enables participants and their clients to meet their investment and hedging needs in a liquid and well-regulated market place.

The HKSCC was incorporated in 1989. It created The Central Clearing And Settlement

System (CCASS), in 1992 and became the central counterparty for all CCASS participants. Share settlement is on a continuous net settlement basis by electronic book entry to participants' stock accounts in CCASS, following the mechanism of T+2 (the second trading day following the transaction).

The merger is examined from HKSE's viewpoint. See Table 6:

Table 6 - SWOT of HKSE


  • Strong presence in Asia.

  • An order-driven market with central limit order books, a trading system which is more suitable to retail investors.

  • Recently implemented electronic means for subscription of initial public offerings and allotment of shares.

  • Showing marvelous marketing opportunities in the Far East.


  • Lack of product diversification.

  • Once a big named player in Manchester United is sold sales go down affecting the brand image. For example David Beckham.


  • The Opportunity of new investors investing Manchester United. For example Glazer US billionaire. Could possibly increase brand awareness in America.

  • Could increase brand awareness by buying new quality players.


  • Possible new competition as other football teams are performing better on the pitch and selling their products abroad.

  • Duplicate resources, which were spent on two trading platforms, lowered its competitiveness.

i) Merger Motives

Before the March 1999 declaration of the securities and futures market reform by the

Financial Secretary of the Hong Kong Government, HKSE, HKFE and HKSCC were responsible for the stock trading, derivatives trading, and settlement and clearing services respectively. Hong Kong, once claimed to be the region's financial flagship, was seriously impaired by the Asian financial crisis of 1997-98. In August 1998, hedge funds attacked the peg of Hong Kong Dollar to the US Dollar and managed to build up huge positions in both the stock and futures markets. This went unnoticed by the regulators and government officials because HKSE and HKFE were independent of each other. They were self-regulating companies that rarely exchanged information and data on transactions. While the government was attempting to cover the short positions in the stock market intervention, it realised that inconsistencies were found in the settlement policies. Shares traded on HKSE were settled by T+2 (the second day following the trading day) whereas HKFE required the settlement of derivatives on a T+3 basis (the third day following the trading day). Such incompatibility ended in extra costs of financing.

In addition to aligning policies of both, the following summarises other drivers of the


Acquisition of liquidity pool

Regulators, brokerage firms and literature strongly believed that a liquid exchange could attract high quality companies. This agrees with positive network externalities in that more quality firms attract more intermediaries because more orders will be consolidated for execution.

Commercially driven business

The government's aim, as explained by a HKEx member, was to resolve the structures of fragmented markets traditionally run as cozy brokers' clubs, but towards merged national markets managed by shareholder-owned companies.

Elimination of inconsistency in product development

A conflict arose between HKSE and HKFE in the development of new products. For instance, warrants, which are normally traded on futures exchange, are products of HKSE because they are highly correlated with the underlying shares. HKSE and HKFE are basically not rival markets since the only difference is the product. The product is divided artificially but the operating system is identical.

Economies of scale

The government aims to achieve economies of scale on research and development and eliminate duplicated investment costs spent on computer and trading systems. This is important if Hong Kong has to strengthen its position as an international capital formation centre for Mainland China.

ii) Merger Strategies

The government mainly drove the merger. This vertical merger aims to combine the exchanges and share their resources to achieve common objectives:

  1. Eliminate inconsistencies in the application of policies in settlement and better coordination of product development.

  1. Minimize duplicate use of resources in serving overlapping markets.

  1. Consolidate market power to become the Asian time-zone pillar in the global securities and futures markets; and

  1. Become the preferred Asian partner for major exchanges seeking to build global alliances.

Under the reform, HKSE, HKFE demutualized and together with HKSCC and two other clearing houses, merged to form HKEx. The merger was completed on 6 March 2000 and

HKEx listed its shares by introduction on the stock exchange on 27 June 2000.

iii) Merger Challenges

Initially, market reforms were slow because local brokers (those comprising a few hundred clients form the majority of brokerage firms in Hong Kong) were severely damaged by the 1997 stock market crash due to unrecoverable margin financing borrowings. They resisted to any change, which might further endanger their business.

In addition, merging two trading systems was the hardest given its labor-intensive nature and huge capital involved in implementing user acceptance testing and rollout activities.

4.3 Implications and Discussion

i) Strategic Choice

Both cases imply that merger is a clear strategic choice to achieve the above objectives. While the process of strategic analysis is rather generic, country or regions specific factors are the key determinants of strategic choice.

For example, rivalry among Europe's stock exchanges emphasizes more on cooperation of trading technology than anything else. In Asia, the concept of forming a full financial service group within each market is the main consideration.

Exchanges have recognized that faced with the challenge to respond commercially to competitors, they needed to become traded companies themselves. DB was now listed and traded. London has previously demutualised and went public in July 2001. HKEx subsumed HKSE, HKFE and clearing-houses and went public in June 2000. All interviewees come to a consensus that fewer operations of clearing and settlement systems shall prevail in three to five years, but not necessarily fewer trading systems.

ii) Barriers to Consolidate

The analysis provided some national and regional aspects of consolidation, but the concept of consolidation does not seem to extend globally because:

1. Technology has enabled intermediaries to service investors at much lower cost without

being constrained by national boundaries.

2. Regulators emphasized that every stock exchange caters for the needs of different

markets, it will be costly to reconcile various interests of different market user groups.

In particular, cross-border merger requires reconciliation of regulation under different


3. The main cost of transaction attributes to the delay in settlement because the cost of

capital can be huge. Transaction levy does not matter significantly because investors

will be able to trade at more competitive prices after the deregulation of commission.

Seeing a potential opportunity, exchanges are building infrastructure links to facilitate

mergers or alliances at the back end.

4. A stock exchange is a national asset. Political parties will not compromise to give up

its dominant position in a merger or share a set of rules and regulation of different


iii) Merger Patterns

LSE and HKSE have responded to increasing competition by implementing strategies of horizontal merger and vertical merger respectively. Europe was in a phase of intense competition between two models of convergence. The developing formation of a pan-European marketplace with a common currency has convinced many market participants that nationally organized financial markets were outdated and not competitive. The European Securities Forum is promoting the model of horizontal merger. In this model, national exchanges are replaced by a more open architecture along three functional levels - trading, clearing and settlement, and custody. In this way, each market participant can gain remote access to a range of pan-European services through a single point of entry.

The underlying assumption is that, in the long run, only the most efficient exchanges should survive, trading stocks from other European countries and offering the most innovative and competitive financial instruments. Another model is one of vertical merger where exchanges, clearing companies and the depository within one country merge. This approach generally appeals to traditional exchanges. They desire to form a full financial services group because they realize that trading alone does not generate sufficient revenue to compete with other cheaper Internet-based alternative trading systems. Moreover, exchanges and clearing houses are no longer the only market where buyers and sellers trade or clear transactions.

Unlike in Europe, there has not been any consolidation across borders in Asia primarily due to the lack of facilitators such as a common currency. Furthermore, the argument that a merger will significantly attract liquidity is not very persuasive given the relatively thin trading volume in most of the Asian countries.

The above uncertainties or obstacles have not deterred HKEx or LSE from meeting the demands and challenges. They are more conscious than ever to implement their strategies in various aspects. Appendix 3 highlights these strategies.

5. Conclusion

The research has revealed a very dynamic and rapidly evolving industry of stock exchanges. Competition among stock exchanges is a new phenomenon since only recently have they become more like firms than legal, public or private, monopolies. Competition takes the form of ECNs, established exchanges and new exchanges in pursuit for the same goal: to attract liquidity. The findings have several implications.

Firstly, exchanges shape the globalization of capital markets through technology links and partnerships. Stock exchanges intend to grow their existing businesses and extend the reach and scale of its operations through business development initiatives and mergers, acquisitions, joint ventures and alliances where appropriate. Among these, a merger is considered the most feasible strategic option for stock exchanges. It is not only the quickest means of entry into a new market, but also confers a strategic advantage when 'time to market' is important. The merger can realize any anticipated synergy when two value chains are reconfigured to create or improve the competitive advantages for the merged entity. The reconfiguration process may involve change of one or both of the value chains, most notably in the change of the organizational structures and new management assignments.

Secondly, different value creation objective drives different types of mergers. Following its strategic situation and strategic choice analyses, a stock exchange should be able to specify a target exchange, which will help achieve its strategic objectives and create value. HKSE utilized the vertical merger to significantly minimize the infrastructure costs of both exchanges and share use of resources. LSE attempted to use a horizontal merger to extend geographically, with facilitation by a single passport in Europe and a common currency.

However, a further consolidation seems beneficial, as stock exchanges can capture economies of scale, heighten liquidity in the markets and attract further investors.

But in the current economic climate, a vertical integration following the focus of investors on their domestic markets appears to be a well functioning strategy. Once a stable economic outlook can be established, merger talks will soon be commenced.

The end game could include one global stock exchange for blue chips with specialized markets for other segments on national level. But first, Europe has a long way to go in providing the necessary harmonization of rules and regulations.

Thirdly, all the opinions I have collected form an interesting consensus, most notably in their disagreement with the literature on the future of the consolidation of stock exchanges. In particular, there is a common understanding that more technological agreements and strategic cooperation of the clearing and settlement systems will prevail. An exchange of strong market power will never look for agreements with one of lower market power. This agrees with regulator's argument that LSE prefers incompatibility because on one hand, LSE has already possessed a large network to create its own liquidity and therefore it is reluctant to give up its dominant position to other exchanges in a merger.

Since consolidation amongst institutional investors and investment banks has generated greater demand for transnational access to exchange facilities, it should be deduced that consolidation amongst exchanges would follow. However, political considerations prohibit the compromise to form a single set of regulatory standards. A cost cut at the front end - transaction levy - is unlikely especially after the deregulation of brokerage commissions. Therefore, consolidation is expected to continue in the form of cooperation among the clearing and settlement providers and strategic alliances in technological developments, as exchanges seek to realize economies of scale.

Fourthly, the growth of ECN's has been a largely US phenomenon. European and most

Asian exchanges argue that the US exchanges, particularly Nasdaq, have not developed central limit order books, which concentrate liquidity and thereby minimize execution costs. These exchanges in switching to electronic trading in recent years have built order auto-matching mechanisms and have thereby declined incoming ECNs. Moreover, these established exchanges have already controlled largest pool of liquidity. Competing only on price is insufficient for ECNs' survivals, especially after deregulation of brokerage commissions.

Finally, from an investor perspective, an ECN's functionality does not differ from an order-driven trading system. These crossing networks are though the cheaper way, from a broader perspective of capital market efficiency, they pose certain risks. Liquidity declines if intermediaries switch their trading from exchanges to ECNs. A decreasing proportion of the overall market will affect a growing proportion of securities transactions by value. It is inevitable that, if the prices determining trades become fewer, smaller trades result; liquidity will decline and prices will become increasingly erratic. As a result, the cost of equity capital and risk will rise.

This dissertation raised many issues where answers were not obvious and more instrumental judgment would be required. These areas, amongst other things, will require further understanding and may be left as deeper research subjects:

  1. The reasons for the existence of two different mechanisms, order-driven and quote-driven, whether one can supersede the other, and if so under what circumstances.

  1. The costs and benefits of consolidation at the clearing and settlement levels.

  1. The probability of forming cooperative arrangements or strategic alliances with ECN's.


Appendix 1

Interviewees and Questions


1. Paresh Jansari Broker Brewin Dolphin Securities Ltd

2. Eben Allen Business Development Brewin Dolphin securities Ltd

3. Hubert Matheison Business Development UBS Warburg

4. Janie Greenson Corporate Strategy London Stock Exchange

5. Lee Fok Business Development Hong Kong Stock Exchange

Interview Questions

  1. Do you think rivalry exists among stock exchanges exist, if yes what factors do they compete on?

  1. What do you think are the major reasons leading to competition between stock exchanges and why?

  1. What are the effects of this intensified competition

  1. Stock exchanges are receiving competition from ECN's, are they a popular alternative?

  1. Are the barriers of entry high or low for competition such as ECN's to enter the stock exchange market?

  1. Do you think the bargaining power of buyers, in this case, investors, high?

  1. Is the bargaining power of supplier, listed companies, high? & what type of exchange do they prefer to be listed on?

  1. What are the possible advantages and disadvantages of stock exchanges merging?

  1. What will be the future of stock exchanges? Is consolidation the next step?

Appendix 2

Interview Key Points

Key points

Stock Exchanges

Investment Banks/Brokerage Firms


Industry Analysis

  • Recently, there has been a change from a member-owned structure into a stock company by way of demutualisation

  • More technological agreements or strategic cooperation will be seen among stock exchanges.

  • In theory, one supranational stock exchange should be formed to provide one-stop shop services.

  • In reality, political barriers are immense, differences in legislation persist, and national boundaries remain high.

  • Consolidation of stock exchanges in the globe is difficult

  • It may not be as cost effective as anticipated if stock exchanges merge to a single entity.

  • Technological innovation has made it possible for faster and cheaper delivery of services.

  • Many companies, formerly state-owned, were privatized to become standard corporations; thus, increasing the demand for equity issuance and greater need for the more sophisticated marketplaces for equities.

  • Consolidation, both regional and international, is more likely to occur at the back end, the clearing and settlement systems.

  • Globalisation of financial markets is the major driver for change in stock exchanges.

  • Competitive pressures force stock exchanges to respond, to keep transaction cost low, to provide better services and to attract liquidity.

  • Differences in trading and clearing and settlement systems persist.

  • A global monopoly that comprises all exchanges in the world is unlikely to occur.

Integration Strategies

  • Merger within the domestic boundary brings about synergies in human resources and operational efficiency.

  • No significant disadvantages arise from mergers.

  • 24-houring does not necessarily consolidate liquidity, but rather liquidity is spread throughout the entire trading period

  • Major benefits attribute to a wider customer base and the sharing of IT technology.

  • Disadvantages mainly involve the practicality to align both regulatory standards.

  • Technological advances enhance more efficient communication and international cooperation

  • Advantages of mergers include synergies and lower cost of transactions.

  • Disadvantages are mainly cultural constraints, and different levels of compliance and disclosure requirements.

Rivalry Among

Existing Stock


  • There is no intense competition in Asia.

  • No political parties want to give up or at least compromise the sharing of their national assets.

  • More strategic partnerships in technology should be formed, but do not necessarily lead to consolidation of stock exchanges.

  • There is no substantial competition among stock exchanges within the domestic border.

  • Stock exchanges compete on the market size and turnover.

  • They also compete on the market quality and efficiency, and reputation.

  • Stock exchanges compete in technological innovations.

Competition from


  • An ECN business model resembles that of an order-driven market.

  • Different exchanges cater for the needs of different markets.

  • ECNs lack the credibility to safeguard price-sensitive information.

  • An ECN will never be able to offer price transparency as an exchange normally does.

  • ECNs are still at an underdevelopment stage

  • ECNs lack personalized services.

  • Due to geographical proximity, to locate a broker is not difficult. Therefore, ECNs are not popular at all in Asia.

  • ECNs are not user-friendly to investors.

  • There is space for developing a niche market, however, ECNs will not be able to replace stock exchanges in terms of consolidation of liquidity and price transparency.

Barriers to Entry

  • ECN can enter the market easily.

  • Though competing on low cost, liquidity is not centralised but rather fragmented among several ECNs in an order-driven market.

  • Barrier to entry is low.

  • ECNs operate no more efficient than an exchange's trading system.

  • ECNs are active in the quote-driven markets but the concept is untested in an order-driven market.

Bargaining Power of

Buyers (Investors)

  • Individual investors remain major users of domestic markets.

  • Investors tend to trade on an exchange, which can offer the highest liquidity.

  • Investors choose the stock they want to invest and the brokers, they do not choose the trading systems.

  • The differences of trading between an ECN and a stock exchange are normally not distinguishable among investors.

  • The choice of a stock and a broker is the first priority.

Bargaining Power of

Suppliers (Listed


  • Companies to be listed first prefer the its domestic exchange to be the listing stock exchange.

  • Companies that want to be listed prefer a stock exchange that offers the maximum exposure and the greatest investor protection.

  • Companies first choose their domestic markets because their customers, suppliers, analysts as well as investors better understand them.

Appendix 3

Future Strategies of London Stock Exchange and the Honk Kong Stock Exchange

Key features

Hong Kong Stock Exchange

London Stock Exchange

Market Operation

  • Continue to develop electronic means for subscription and allotment of shares

  • Establish electronic means to replace traditional hard copies of annual reports and documents.

  • Build infrastructure links to facilitate retail cross-border trading.

  • Continue to pursue opportunities to attract new domestic and overseas investors and issuers to the markets in order to deepen pools of liquidity.

  • Introduce a new settlement network to the retail community.

  • Seek to promote open and more competitive markets in the UK and Europe.

Market Regulation

  • Reconcile the interests of different market user groups: wholesale, retail and professional.

  • Further enhance liquidity and improve the quality of price information.

  • Continue to improve the provision of reliable, real-time information services.

  • Continue to promote regulation and good corporate governance practices.

  • Believe they have much to gain from a stronger enforcement of competition rules.

Investor Education

  • Continue to promote retail participation.

  • Increase investor education regarding investment decisions.

  • Made some modifications that will enhance corporate governance e.g. charging investors a premium for the security of issuers.

  • Work to remove stamp duty on UK equity transactions, as stamp duty on share transactions remains one of the major barriers to more efficient share trading and to greater investment by UK companies

  • Continue to improve investor protection.


  • Continue to build global alliances with major equity and derivatives exchanges.

  • Aim to become a leading full financial service market in Asia.

  • Seek to become the Asian time -zone pillar in the global securities and futures markets.

  • To enhance competitiveness, they have extended trading hours.

  • Commission rates are now in place, with brokers and clients negotiating freely, as they believe its in the best interest of investing public and the Hong Kong market.

  • Admit new products to trading, such as Exchange Traded Funds, covered warrants and other non-equity products.

  • Expand the number and geographical diversity of its customers.

  • Competition among providers would help create more choice both for investors to diversify portfolios and for European companies over where they list, cutting their cost of capital substantively in the process.

  • Pursue mergers, acquisitions, joint ventures and alliances.

/Technological Development

  • Introduce Multi-workstation System and Broker Supplied Systems at broker offices.

  • Introduce new order types: Enhanced Limit Orders (ELOs) and Special Limit Orders (SLOs).

  • Revision of trading parameters:

1.Change of price spreads from 4 to 8 to match with ELOs and SLOs.

2.Enlarge board size from 400 to 600.

3.Increase number of outstanding orders per broker from 800 to 2,000.

  • Enhance Order Routing System and channels for investor access.

  • Considering mutually beneficial business cooperation with other exchanges.

  • Continue to support a range of trading mechanisms on an efficient and flexible technology platform.

  • Utilize the LSE network to provide connectivity between market participants, for example, to provide a CREST network to allow member firms to access to both LSE's markets and CREST via a single link to the LSE network.

  • Using their extensive database of financial market information, they are developing a suite of new data products within a Corporate Data Warehouse, and aim to become the definitive global numbering standard with our new SEDOL products

Source: Annual Reports 2003, Hong Kong Stock Exchange and London stock Exchange.

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