Global stock exchange consolidation may just be starting

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In the span of nine hours Wednesday morning, the global financial markets ushered in a new era.

As the heads of the TMX Group Inc. and London Stock Exchange Group Inc. sat together in Toronto to unveil their $7-billion merger plan, Deutsche Boerse AG and NYSE Euronext Inc. confirmed that they too are in talks to create a vast new exchange company that would combine the New York Stock Exchange with Germany's main market. The Deutsche Boerse-NYSE plan would create what would be the world's biggest market operator by revenue.

The deals mark the resumption of a wave of mergers that in the past decade has seen exchanges unveil more than 600 purchases worth $94-billion (U.S.), according to Thomson Reuters. More than half that activity has been via cross-border deals as the industry has gone from one where each country had one or two major exchanges to one where transnational conglomerates dominate.

The burst of merger activity - and the astonishing speed of the announcements - shows that exchanges once again believe that bigger is better after taking a break during the financial crisis.

People involved with the LSE-TMX merger said the fresh consolidation craze is being driven by two factors: Investors' increasingly global view as they seek opportunities in all markets, rather than just at home, and fierce competition from alternative trading systems (ATS), which is putting pressure on the revenues of traditional exchanges. In the United States, for example, there are now about 50 different venues to trade stocks. In Canada, there are about half a dozen, and they have taken about a 30 per cent market share away from TMX, which once had a virtual monopoly.

The current deal-making frenzy isn't likely to end with Wednesday's transactions, since trading in public markets is being concentrated in the hands of far fewer for-profit companies. There is at least one more potential deal in the pipeline, as Kansas City-based BATS Global Markets, which runs the third-biggest U.S. stock market and the second-biggest alternative trading system in Europe, is in exclusive talks to acquire Chi-X Europe, the largest electronic ATS in Europe.

"Everybody's jockeying to become the one true global provider of trading services," said Mike Pagano, a professor of finance at Villanova School of Business who studies financial markets. "Nobody's there yet, but everybody is scrambling in that direction."

For NYSE Euronext and Deutsche Boerse, a combination would mean significantly lower costs and greater heft in global trading.

Unlike in the past, when exchange operations depended heavily on human traders, today they're dominated by highly sophisticated and automated trading systems. "When you merge companies, you don't need two technology platforms, so there are a lot of cost synergies," says Richard Repetto, a principal at Sandler O'Neill & Partners in New York.

NYSE and Deutsche Boerse have large European derivatives trading businesses that can be combined to generate savings.

The ambitions for Toronto and London are different. There are few costs to cut as there is little overlap, but there is an opportunity to create new products and offer new services, like the ability for TSX-listed companies to easily list their stocks also in London where there is a larger community of investors, said TMX Group chief executive officer Tom Kloet.

The hope is also that TMX and LSE together can compete for the listings of some of the new companies that are being created in emerging markets to tap the capital of investors in developed economies.

"Our industry is getting more competitive, and the critically important listings business is also on a global basis very competitive," LSE CEO Xavier Rolet, who has been tapped to head the combined company, said in an interview. "Together we will be in a unique position to enhance our competitiveness and attractiveness for the large flow of very, very large listings, and some not quite as large, that will be coming out of the emerging world over the next 10 to 20 years, looking for ideal places to raise capital."

There's speculation that a Toronto-LSE merger is only a step on the way to a much bigger company.

"I think that once these mergers get digested, the next logical step is to think what can we do in Asia," said Prof. Pagano. "Could it be London-Toronto-Australia? That would be a very interesting combination."

The latest round of exchange consolidation started in October, when the Singapore Exchange, where Mr. Kloet was once CEO, announced a $8.3-billion offer for the ASX, the operator of the Australian Securities Exchange.

However, the scale of these mergers is now creating the risk that politicians will step in, not just in Canada where it's expected that the TMX-LSE deal will face close scrutiny.

Australia has blocked foreign takeovers in the past, mostly in the resources sector, and the Singapore-ASX deal immediately ran into political and regulator problems.

"The pushback against this is there's some political risk," Mr. Repetto said. It will be difficult, although not impossible, for U.S. regulators to see the New York Stock Exchange - still the flagship brand of American financial markets - effectively acquired by a European entity. At the same time, European authorities may bristle at a combination that would create a dominant player in the region's futures markets.

The mergers also show that exchanges are positioning themselves for an improving macroeconomic climate. "[This year]won't be a bang-up year, but people are more confident that the exchange business will see a bounce," says Jamie Selway, managing director at Investment Technology Group, Inc. in New York. If exchanges "can take out costs in preparation for that [uptrend] it's a good time to do it."

Experts caution that the size and regulatory complexity of such transactions mean they can be long, drawn-out affairs. The last explosion of merger activity three years ago also showed there's a good likelihood some deals won't be consummated. Deutsche Boerse reportedly discussed acquiring NYSE Euronext back in 2008, for example.