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The ambiguity of exchange consolidation

by Robert Teitelman | Published February 11, 2011 at 12:04 PM

Ever since the financial crisis broke, criticisms have been lobbed at financial journalism (among others: regulators, economists) for their failures to predict and somehow stop the conflagration. Indeed, there's a book just out that argues that very point: "Bad News: How America's Business Press Missed the Story of the Century." (OK, so the century was only eight years old.) I'm not anxious to argue that point again here, as I have in the past, except to note that none of the contributors to that book, even Columbia University economist and Nobel prizewinner Joseph Stiglitz, exactly won the lottery by accurately predicting themselves what was about to befall us all in 2008; or at least, they were no closer to the mark than many more obscure financial commentators and reporters. But no matter.
Instead, let's turn to the future, which is considerably murkier than the past. Let's ask ourselves a question that is simpler than whether problems in subprime mortgages would race through the global financial system and nearly melt it down: Are mergers of global exchanges a social good or a social bad? Does the consolidation of exchanges that has been going on for over a decade represent a race to the top or a race to the bottom? Is innovation in this sphere reckless or bountiful? In short: Are we heading for a more efficient global capitalism or a meltdown?

Think about it, get back to me.

Times up. This isn't some sort of trick question. After all, the spate of exchange mergers of late, including a possible merger between the Deutsche Borse in Frankfurt and the venerable New York Stock Exchange, has generated a lot of comment. The advantages of many of these deals, particularly for investors, are clear: greater liquidity, more efficient and faster technology, lower transaction costs. Indeed, given the ruthless competitiveness of this arena, anyone that fails to produce these virtues might as well hang it up, particularly as new high-tech, cutting edge rivals keep popping up, offering everything from faster execution to dark pools. In a business where liquidity attracts liquidity, and size means capital and greater resources to develop new technology, consolidation seems to be the only route to survival for the larger, more established exchanges, and thus arguably good for shareholders.

This scenario lays out the race to the top. Competition drives innovation and provides customers more efficient, more customized execution at lower costs.

Of course, there is a darker side, which, in all the teeth gnashing about national competitiveness, including this free-trade-or-die editorial in the Wall Street Journal, has not been widely articulated. Exchange consolidation produces all sorts of regulatory questions, particularly because most of these deals are now cross-border. In a world still sorting itself out after the failure of financial deregulation, considerable differences exist worldwide on how we oversee exchanges, clearinghouses, payment systems, not to say all the various instruments that trade (or in some cases don't) on them: commodities, options, derivatives, foreign exchange, stocks and bonds. This is a Balkanized regulatory world within many countries - look at how the Securities and Exchange Commission and the Commodities Futures Trading Commission share derivatives regulation in the U.S. - not to say across many borders. It is thus prime territory for regulatory arbitrage. Indeed, given the intensity of the competition and the narrow differences between success and failure, the regulatory environment may well turn out to be a determining factor in how these deals unfold. In short, the easy venue wins.

And there's more. How far do we go in encouraging the creation of greater liquidity, efficiency and ease of trading? And why? Institutions, which have been profiting from better technology, easier regulation and lower commissions since 1975, have, for all the good they have done, also created a world in which they have refused to truly participate in active corporate governance, have driven volumes way up as transaction costs have fallen, thus creating much shorter-term markets, or, through indexing, spawned large, passive pools of essentially dumb money. All of these tendencies, as Tuft's University professor Amar Bhide argues in his new book, "A Call for Judgment: Sensible Finance for a Dynamic Economy," have been enabled and encouraged by the deep belief that more liquidity and greater execution efficiency is always better; they are, in short, a consequence of various reforms of the past. Will another round of consolidation further encourage greater speculation as opposed to investment? Even murkier, will the merger of exchanges with specialties - the NYSE's equities, DB's derivatives - create the kind of large, integrated, global operations that may prove to be vectors of systemic risk rather than buffers? This scenario is the race to the bottom.

Let's face it; these are difficult questions. After all, investors, both institutional and retail, have long been treated as a favored interest group (certainly by the SEC), a sort of proxy for the people, particularly in an age of privatized defined-contribution retirement plans. And exchange consolidation clearly works to their favor. Moreover, the lessons of deregulation suggest that in a globalized world, protection not only produces high costs, but is a recipe for anachronism and failure. A cosseted exchange system in the U.S. might leave us the worst of both worlds: high costs, lousy execution, crappy liquidity and poor risk management. We would be at a disadvantage; money would flee; and the attempt to produce more viable exchange-utilities might produce the same consequences as the deregulation of U.S. commercial banks, which represented an attempt to help them against less-rigorously regulated rivals. Or perhaps not. As Bhide argues, by reducing the effect of large, deep markets we may well allocate capital more effectively and swing the equation more toward long-term investment.

So what do we do? What does the future hold? I have to frankly admit, at the risk of sounding like I've been captured by an evil Wall Street gang, that I can't see the future clearly. The issues are, at their heart, ambiguous, tradeoffs between good and bad, but without any certainty of the evolutionary path. Even the argument that we need stronger regulation and enforcement doesn't really help, because of the global context for regulation and technology that really can be located anywhere. Of course, you can - as many will - pick one side of this or the other, defend it vigorously, and claim that your choice is an obvious race to the top or a rapid descent to hell. But that will only work if you claim godlike prescience and ignore the valid arguments of the other side, which in a way is a definition of ideological thinking.

I can't wait for the answers. - Robert Teitelman

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