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What’s Up With Exchanges?

First it was Philadelphia (Philx) and Boston (BSE), then Chicago, and now it's Cincinnati.

First it was Philadelphia (Philx) and Boston (BSE), then Chicago, and now it's Cincinnati. All of these exchanges recently sold major interests to brokers, hedge funds and/or technology firms. While Citadel and Merrill Lynch kicked it off by putting the Philadelphia Exchange in play a year ago, in August it was the National Exchange's (NSX) turn as Citigroup, Bear Stearns, Credit Suisse, Knight and Bloomberg each acquired 10 percent stakes to own a combined 50 percent of the exchange. So why are exchanges being snatched up like fresh fruit?

First, tempted by the success of the Chicago Mercantile Exchange (CME), Nasdaq, Archipelago/NYSE, the London Stock Exchange (LSE) and others, exchanges are a hot commodity. Over the past two years, the price of the CME has quadrupled while Nasdaq, NYSE and the LSE have merely tripled. Not bad for stodgy, old ex-self regulated organizations (SROs). In today's environment, exchanges have been good investments.

Second, the regional exchanges have been losing tremendous market share. The NSX alone had gone from averaging approximately 13 percent to 15 percent of major market volume in '04 and '05 to below 1 percent once the transaction reporting agreement between Island and NSX ended in January of this year. NSX is not unlike the BSE, Philx or the Amex equity trading business, as the major exchanges (NYSE and Nasdaq) have strained the value proposition of regional exchanges. Without liquidity, regionals are worth little more than their exchange registration.

That brings me to point No. 3. Exchange registrations are expensive; just ask Nasdaq, Archipelago and Island. Nasdaq, the SRO, and the Archipelago and Island ECNs attempted to obtain exchange registrations. It took Nasdaq approximately five years and countless legal fees to obtain its exchange registration. Archipelago figured it was easier to buy an exchange and subsequently purchased the Pacific Exchange. Frustrated, Island gave up and was then acquired by Nasdaq.

While problematic, exchange registrations are valuable. They enable the bearer the ability to monetize market data tape revenue. This was at the heart of the transaction reporting agreement between NSX and Island. While this agreement attempted to compensate Island for its order flow, the rebate scheme was hampered by the SEC, which did not like the idea of NSX rebating tape revenue.

This brings us to Reg NMS, which allows exchanges the freedom to do whatever they want with their tape revenues. This is one of the least known and far reaching attributes of NMS. Under Reg NMS, exchanges that can build up significant order flow and, hence, tape revenue are allowed to do what they want with that tape revenue. And, therefore, they can rebate it back to its owners or its major trading partners - who naturally are brokers or ECNs (not unlike Bloomberg's Tradebook).

The Story Begins to Unfold

In addition, since the regional exchanges no longer have significant liquidity and the majority of ECNs have been acquired or fallen by the wayside, exchange power has centralized into two major entities - Nasdaq (SuperMontage, Instinet, Island and Brut) and the NYSE Group (NYSE and Archipelago). Brokers do not like having limited options, especially in regard to the exchanges that they can use. Buying a regional exchange gives the brokers trading/matching options unavailable to those locked into the Major's duopoly.

So, to summarize, exchanges are a hot investment. Exchanges have consolidated, leaving only two major governing bodies (NYSE and Nasdaq) and centralizing exchange power in limited hands - which also have become profit-seeking entities. Regional exchanges are faring very poorly, making them inexpensive; however, obtaining a new registration is very expensive. In addition, brokers investing in exchanges under Reg NMS can leverage them to obtain market data rebates as well as use them as a threat against the major exchanges so they don't try to raise rates or stop innovation. Combine these issues and there are at least a dozen reasons to buy an exchange. Anyone making an offer?

Larry Tabb is founder and CEO of Westborough, Mass.-based TABB Group, a financial markets strategic advisory firm. [email protected] Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based research methodology of "first-person knowledge" he developed, TABB Group ... View Full Bio

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