Streetwise Professor

December 3, 2006

Easier Said Than Done

Filed under: Exchanges — The Professor @ 10:58 am

Two weeks ago seven major banks announced their plans to form an electronic stock trading platform to compete with LSE, Euronext, and Deutsche Borse. The seven, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS, have launched Project Turquoise, and will hold shares in the venture. Other reports indicate that the Swiss SWX exchange is willing to provide the technology platform for the venture, and that Swiss group SIS has offered clearing services, although the banks have not had “concrete” talks with either party.

Previous attempts to challenge incumbent European equity exchanges have failed ignominously. Neither Tradepoint in the 1990s nor the LSE’s Dutch equity endeavor generated appreciable volumes. The experience has been similar in derivatives markets, with Eurex’s success in the Bund the exception that proves the rule. The combination of technological differentiation, Eurex’s owners’ control of substantial order flow, and LIFFE’s playing the role of the hare in the exchange adaptation of Aesop’s Tortise and the Hare, allowed Eurex to prevail.

That said, Turquoise has a decent shot at success. Most importantly, the participating banks are responsible for a substantial fraction (an estimated 50 percent) of European equity trading, and hence have control over large order flows. As I argued in my papers “Bund for Glory” and “Upstairs, Downstairs,” the ability to coordinate the movement of order flow to a competing trading venue is necessary (though probably not sufficient) to unseat an incumbent exchange.

LSE, Euronext, and Deutsche Borse shares all fell substantially on the release of the news about the new venture. I expect a period of fierce price competition following Turquoise’s launch. Indeed, to avoid repeating LIFFE’s error of failing to respond to Eurex’s price cuts, it is likely that the incumbent exchanges will cut fees preemptively. This will cost them considerable revenue–hence the stock price declines. In the end, however, I predict that the incumbents will prevail unless they make a serious strategic mistake. Moreover, I predict that exchange fees will rebound when Turquoise exits, just as occurred in the US when Eurex and Euronext.LIFFE surrendered in their challenges to the CBT and CME, respectively.

One further thing of interest in the Turquoise venture: it is essentially a mutual/cooperative, like traditional exchanges that were owned by the brokers and market makers that traded on them, and in contrast to the modern for-profit, investor owned exchanges. Moreover, the participating banks are relatively homogeneous. The cooperative form is a traditional way for homogeneous groups of consumers to circumvent market power; farmer elevator, seed, fuel and fertilizer cooperatives were formed largely to undercut incumbents’ market power in these goods and services. There is a key difference, however. If Turquoise succeeds, due to the nature of liquidity it will supplant one or more of the incumbent exchanges as the (near) monopolist in some segments of the European equity trade. The member banks will capture the monopoly rents from the incumbent’s owners. The successful farmer cooperatives increased competition and undercut existing monopolies, but did not create monopolies of their own. In the event, Turquoise’s entry may actually reduce welfare; the entry will likely not reduce deadweight losses over the longer term (as one monopoly supplants another), but it will utilize real resources in the attempt to capture the monopoly rent. Given the fat margins that exchanges reap, it is a fair bet to spend a substantial amount to create a competing trading platform even if the odds of successfully supplanting the incumbents is fairly small.

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