The End of the Road for the Exchange?

As the next step in the Deutsche Börse and NYSE Euronext merger draws near, I have been thinking about the future of the exchange business model and wondering whether it has reached its logical apex.

Looking at the largest global players, the common characteristics appear to be a diverse revenue stream derived from trading multiple asset classes in multiple geographies, market data licensing, listing operations, technology and services.

According to David Easthope, a research director with industry analyst firm Celent, the technology business will become a more important revenue stream for exchanges in the future. He sums up the current exchange environment quite nicely in his latest whitepaper Exchange 2.0: The Evolution of Exchange Technology in the Cash Markets.

It is not surprising that most exchange operators look to diversify their business as quickly as possible. At the very basic level, exchanges are transaction-based businesses. If they had monopolies on liquidity, this would not be a problem. But since most North American and European exchanges are competing with at least a handful of local competitors, it is a race to the bottom in terms of exchange fees. When you include the spiraling technology investment the exchanges need to make in order to keep the high-frequency traders happy, it is not a good business model. There are lower profit margins from competition, higher technology costs and a reliance on fewer clients – the high-frequency traders ─ to produce that revenue.

Is this what the markets were thinking when they decided to demutualize most exchanges? Yes, selling shares allowed the exchange operators to modernize the trading system and perform some much-needed upgrades. However, it has also pushed them to find as many new revenue streams as possible to support the core business.

Now the industry is seeing mergers based on cost synergies, or simply cost cutting. How viable are long-term business plans that focus simply on trimming the fat?

If the European regulators let the transatlantic exchange merger take place, it will be interesting to watch it play out.