Financial exchanges: Shake, rattle and roll

Mergers and competition among exchanges should create new opportunities for customers

MEASURE out a few blue-chip London stocks, add a dash of financial derivatives, mix it all together on one platform using top-notch technology - and presto, a complicated series of trades can be whittled down to a single transaction.

Such was one of the hopes of Deutsche Borse, operator of the Frankfurt Stock Exchange and Eurex derivatives exchange, in bidding to take over the London Stock Exchange (LSE). That effort foundered this week, after Deutsche Borse shareholders called a halt. They want the exchange's stash of cash returned to them, rather than spent on an expensive takeover.

The failure of the bid is a bitter disappointment to Deutsche Borse's managers, but it looks like a mere hiccup in a trend of exchange consolidation and development which is likely, if anything, to accelerate. Exchanges everywhere are considering merging for a variety of mostly good reasons. Even the LSE remains in play. Euronext, the Amsterdam-based bourse that operates several exchanges on the continent, is keen on acquiring it. Euronext needs to name a price and win over its own shareholders to the deal. But that is possible, and the Brits are still taking calls.

In America, too, exchanges are perpetually in merger talks. In January, Archipelago, owner of a pioneering electronic share-trading system, bought a San Francisco-based options exchange. The New York Stock Exchange, which currently trades only company shares, is considering getting back into the derivatives business. It could do so by purchasing an options or futures exchange. The Chicago Mercantile Exchange, which trades financial futures, has piles of cash, and locals never tire of speculating about whether it will buy its cross-town rival, the Chicago Board of Trade, which trades different varieties of futures contracts, or a stock exchange.

Why do link-ups between exchanges make sense? For the owners of the exchanges, the answer is simple. They want to make money. Exchanges used to be members' clubs. Now more and more are publicly held; the list includes the LSE, Euronext and Deutsche Borse (even the venerable NYSE is thinking of selling shares in itself). Expanding distribution networks and adding new revenue streams could boost profits. Trading in derivatives is expanding far faster than trading in shares, so it makes sense for the LSE (like the NYSE) to expand the range of financial instruments it trades.

Users of exchanges can benefit from consolidation too - if regulators keep a sharp eye out for unfair pricing by expanded exchanges, which may enjoy a dominant position in certain regions and in certain financial products. Regulators should make sure that some of the cost-savings from mergers get passed to the exchanges' customers, as well as to their owners. They should also encourage exchanges to raid each other's territories, where that remains possible. Competition, or even the threat of it, has a habit of lowering prices quickly.

Twist and shout

But users of combined exchanges have more to look forward to than just lower trading prices. Also exciting, but sometimes overlooked, are trading innovations. When both financial derivatives and company shares can be traded on the same exchange weird and wonderful things can happen. At the moment, anyone wanting to trade, say, an option on Vodafone shares at the same time as the underlying Vodafone stock - and make a hedge on foreign-currency risk into the bargain - must perform three separate transactions. Combining three into one would reduce the risk of one of those transactions getting delayed or aborted, and could lower trading costs as well. In most of the world the technology is not yet available to make this possible, though it is not far away. Both Deutsche Borse and Euronext have played up the possibility of simultaneous trading in their LSE bids.

Such financial products may sound arcane. And to the average man in the street, they are. But they are also how financial markets innovate, and innovation in this part of the economy can be as important as anywhere else. Bankers point out that they already guarantee simultaneous trades on behalf of their big institutional clients. But if exchanges can offer competing capabilities, as well as an arena for further innovation, so much the better. The result should be more efficient markets, and the chance for a wider range of professional investors - including pensions funds - to manage their risks better. Ultimately, that benefits everyone. And who knows, one day even some enthusiastic individuals may decide to take up simultaneous equities, futures and options trading.

Editorial argues that mergers among European stock exchanges should create new opportunities for customers.

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