Worldwide markets continue to evolve from the open outcry system. While regulators globally are trying to devise new policies for the changing landscape, traditional exchange operators are looking to consolidate to restore their profitability. Some of the recent failed merger attempts, such as the NYSE Euronext and Deutsche Boerse merger and the LSE and TSX merger, clearly demonstrate the pressures these exchanges face. But what is causing them to consolidate and what does that mean for other industry participants?
Exchanges operate with massive infrastructure overhead and rely on the volume of shares traded on their platforms to cover these costs. Their revenue streams, however, continue to decline as other players step in to steal their market share. These alternate venues, collectively known as alternative trading systems (ATS), include crossing networks, electronic communication networks, and dark pools. They rely on certain services to help institutional traders achieve “best execution,” a duty they owe to their clients. These services include anything from abundant liquidity in certain assets to anonymous trade execution to facilitating certain algorithmic strategies. Popular alternative venues include Chi-X Global, Instinet, and ITG’s POSIT.
Major exchanges have also started offering their own alternative venues to serve sophisticated institutional investors, but these alternatives have been relatively slow in gaining market share. Recent research shows that ATSs continue to take away market share from traditional exchanges, stepping up the pressure on the exchanges to transform.
Other industry participants are also affected by these developments. Although this poses new policy challenges for regulators, increased competition in the industry and declining transaction costs are encouraging. For issuers, the listing process becomes less strenuous: they can focus on meeting the reporting requirements for getting their stock listed at the lowest cost, and be confident that ATSs will step in to provide liquidity and continuity of their stocks. In other words, listing one’s stock on an exchange with the highest volume — a measure of liquidity — is no longer relevant.
The availability of ATSs is also beneficial to institutional investors because of the diverse trading needs they can satisfy. However, reaping the full advantages of the availability of these venues requires sophisticated technologies and systems. This gives technology service providers and vendors an opportunity to provide innovative products and services that allow investors to execute trades on multiple platforms and integrate them with standard back-office systems and processes. Some service providers are clearly ahead of the curve in this area, but opportunities for more innovative solutions still exist.
Execution management systems (EMS) have begun to fill this gap. In contrast with order management systems (OMS), EMSs take the orders generated by an OMS and shop the various ATSs available for execution. This aggregation of trading analytics and execution is crucial to take advantage of the availability of multiple trading venues in addition to traditional exchanges. ITG’s Triton and Goldman Sachs’ REDIPlus are prime examples of such EMSs, along with Bloomberg’s EMSX for options trading. In addition to stand-alone platforms, some OMS providers offer extensions that include various EMS functionalities, such as smart order routing.
As developments continue in this area, new services and products that further streamline trading operations should become available. It will be interesting to see how industry participants transform to take advantage of these developments. As opportunities and challenges proliferate, trading fragmentation seems to be forming the future of capital markets, paving the way for further transformation of the industry.