Does It Matter That a German Exchange May Control the NYSE?

Filed under: Investing, Investing Basics, NYSE, Market News, Investment

Capitalism has many ways of dealing with failure. If a company is small enough to fail without bringing down an entire industry or economy, it files for bankruptcy. If such a failure seems to threaten wider economic stability, the company gets a government bailout. And if it fails moderately but still has some assets with value, it gets acquired.

This last form of failure comes to mind in the case of NYSE Euronext (NYX). In 2005, it handled 80% of all trading in the stocks it listed. Today, that share is down to 23%, according to Bloomberg. New competitors have hacked away at its market share by offering superior service at a lower price.

And, as I reported in a DailyFinance article in June, the NYSE has been trying to offset some of the lost revenues by selling high-speed access to the NYSE's computers so hedge funds can trade a fraction of a second ahead of regular customers -- a practice that skims $3 billion out of investors' pockets each year. Now, Germany's 18-year-old Deutsche Boerse (DBOEY) wants to buy 60% of the combined companies for $10 billion in stock.

Considering that the NYSE is a storied American institution -- founded back in 1792 by traders standing beneath a buttonwood tree -- it's not unreasonable to ask whether the U.S. should allow a German company to control it. But the reality is that the luster of NYSE's name and history is far greater than its competitive position today. If Germany ever decided to close down the NYSE, nimbler U.S. exchanges would jump in immediately, eager to pick up the slack.

Computerized Competitors: Faster, Better, Cheaper

Investors don't decide where to trade based on an exchange's address: They want fast, inexpensive trade execution. And thanks to regulatory changes regarding what exchanges can charge, and an evolution of the industry structure that made room for new, computerized exchanges, that's what they get. A decade ago, it cost 6.25 cents to execute a 100-share trade. Today that cost is down to a penny.

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And unlike the NYSE, which still has a few costly specialists whose job is to match up buyers and sellers for a specific stock, the 50 computerized exchanges -- up from 20 in 2000 -- don't. So exchanges such as Getco, Bats Global Markets and Direct Edge can make money -- with margins as high as 55% for trading derivatives -- while offering low prices and fast execution, reports Bloomberg.

The NYSE has been going downhill for at least 40 years. The competition really got going in 1971 when the Nasdaq was formed to provide computerized trading and price quotes. In 1984, I consulted to the NYSE -- analyzing the competition it faced in the then-lucrative business of selling those price quotes. The business of charging for such quotes has essentially gone away.

Two scandals -- a 2003 flap over then-CEO Dick Grasso's $140 million compensation package and 2005's revelation that 15 NYSE specialists had manipulated prices to steal $19 million from clients -- tarnished the NYSE's remaining luster. In 2006, a reverse merger with Archipelago Holdings took the member-owned NYSE public.

A Decade of Merging for Leverage

If the Deutsche Boerse-NYSE Euronext merger goes through, it will be one among many similar marriages that have taken place over the last few years -- $95.8 billion worth since 2000, reports Bloomberg. The reason is simple: Once you build a computer system that can execute trades, the more trading volume you pump through the system, the higher your profits. This is bad news for people who work in the exchanges in jobs like sales, marketing and computer support. But it's better news for shareholders because mergers reduce costs.

If the two exchanges combine, they'll dominate the futures market. The Futures Industry Association estimates that the merged exchanges would be the top-ranked global futures trader, controlling 11 derivatives markets in the U.S. and Europe with 4.8 billion in contracts (based on last year's numbers). That's 55% more than 2010's futures leader, CME Group (CME).

For all the patriotic chest-thumping that might ensue over the idea of letting a German company control the NYSE, the truth is that the NYSE has been falling behind for decades. This merger is a way to rescue a failed company while it still has some salvage value.

As long as the U.S. can keep innovating in the creation of computerized exchanges, the price and speed of execution that investors want will keep improving -- and trading market share will shift to those innovators.

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Source: http://www.dailyfinance.com/2011/02/10/nyse-deutsche-boerse-merger-stock-exchange-germany/

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