Article

The most prominent feature of the changing securities markets landscape today is consolidation. The New York Stock Exchange and Euronext — itself the product of the merger of the Amsterdam, Brussels, Lisbon and Paris exchanges — completed their merger earlier this year (NYSE/Euronext), and that was after the NYSE merged with Archipelago, an electronic market. In the derivatives arena, the Chicago Board of Trade and the Chicago Mercantile Exchange finalized their merger in July, while the Deutsche Bourse has purchased the International Securities Exchange.

Can we expect an ever-diminishing set of exchange acronyms, or are such mergers temporary aberrations?

A key to assessing the viability of the consolidation trend is understanding an exchange’s output. The exchange provides an arena in which market participants transact, producing a sequence of transaction prices. The specifics of the trading rules determine the nature of the competition among market participants. The prices themselves are important outputs of the exchange, because they tell the rest of the world the consensus value of the securities. In return for this information, an exchange collects transaction fees and sells access to the prices determined in its markets.

If communication is costly, then the advantages of a single exchange are clear — for example, if you want to sell shares of IBM at the best price, you should send your sell order to the exchange where there will be the most competition to buy those shares. As others do likewise, the trend will be toward concentration of trading on a single exchange. Of course, communication today is not very costly; in fact, prior to this era of consolidation we saw a host of new competing electronic exchanges and a corresponding concern about order-flow “fragmentation” as price determination occurred in various milieus.

But my research demonstrates that competition among participants in a single electronic market is essentially identical to competition among multiple exchanges. It is efficient, therefore, to organize trading on a single exchange because traders need not have multiple exchange interfaces and markets need not duplicate resources to provide optimal competition. Thus, even a small communication cost can lead to concentration.

This is not, however, the whole story. The preceding argument suggests why we might see trading on IBM on only one exchange, but not why IBM and ABN Amro need to be traded on a combined NYSE/Euronext exchange. The issue is still one of communication cost.

With consolidation, we will see trading-platform uniformity, which will allow traders to reduce their investment in software and communication. This suggests that we should see even more consolidation and also points to the merger of equity and derivative (futures and options) markets.

We may well see “NYSE/Worldnext,” but we will see something else as well. Despite the economic forces that might favor a single exchange, the giants of Wall Street and elsewhere will ensure that at least two exchanges survive to prevent a monopoly.

The economics of the exchange industry tells us that the consolidation is not an aberration. The question now is how will capital market regulation evolve in response to global exchange ownership. Will there be a regulatory “race to the bottom”? Will governments reject foreign ownership of national exchanges? These and other legal questions are just now being studied.

Lawrence R. Glosten is the S. Sloan Colt Professor of Banking and International Finance at Columbia Business School. Beginning this fall, he and Merritt B. Fox of Columbia Law School share the Nasdaq Chair of the Law and Economics of Capital Markets.