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Competition and Integration of Stock Exchanges

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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 (Jump to)


I Abstract................................................................................ 2

II 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.


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