Entertaining grand dreams of becoming a for-profit stock exchange is difficult in a bear market.
So have pity on the shellshocked customers in these hard times.
Bear market or bull, the customers of these would-be profit-conscious exchanges will pay the butcher's bill: Their trading costs will go up if these misty dreams become a reality.
Experts say there is one side of stock exchange demutualization – the switch from private membership to public ownership – that is often overlooked: Making money for shareholders.
Business schools teach that companies should aim to make a profit margin of at least 15 percent to satisfy the folks holding equity ownership in a company.
That rule, applied to demutualized exchanges could, for example, force new cost pressures on Nasdaq, should it go ahead with its planned IPO. That's not a given if the bear market continues.
But these higher fees and charges, difficult to imagine amidst pre-IPO talk of raising hundreds of millions while aligning investors and management's interests, are a fact of life in the sometimes painful transition to a for-profit status.
Indeed, the Chicago Mercantile Exchange, which recently became the first U.S. market to go public, has since increased its monthly fee for live data on its successful E-mini stock indices. Fees are increasing from $10 to $15 a month, starting in April. The CME attempted to take the sting out of the increase by reducing live data fees on all its contracts from $63 to $53.
But, as exchange watchers note, stock index traders don't use Eurodollar or currency contracts. By contrast, fees for live stock quotes from the New York Stock Exchange, which itself personifies the private members only trading club, are just $1 a month.
As a public company, exchanges may have to charge customers more for faster fills and fancy new technology unless they can generate more volume, according to experts. That's because, as a public company, exchanges are serving shareholders, a restive group that will dump its stock whenever it is not in the black.
Despite the bear market and other spiraling cost concerns, demutualization is still popular. "Demutualization is pretty much a world-wide trend," said Peter Clifford, director with the World Federation of Exchanges (WFE) in Paris.
WFE is a voluntary group that represents the interests of 56 exchanges. The group accounts for most of the world's stock market capitalization. Of the WFE's members – which handle exchange traded funds, options, bonds and listed investment funds – only 18 percent are still exclusively member-owned structures. Several of these are even in the process of demutualizing.
Cohesive Strategy
Exchanges, bitten by the demutualization bug, are taking strides to distinguish more clearly between the exchanges' owners and customers, hoping to find a cohesive management strategy.
Some 70 percent of "seats" in the U.S. are owned by speculators, notes Meyer "Sandy" Frucher, chairman of the Philadelphia Stock Exchange. These business people lease seats for the income. This is similar to the way a property owner rents an apartment for profit.
These Philly speculators are not interested in brokering or trading stocks. Not surprisingly, Philly has announced it plans to join the shareholder-owned for-profit model.
A demutualized exchange, proponents say, is better suited to access capital for future needs and can enter alliances for expansion at home and abroad.
But the principal motivation is technology. "The idea of electronic order entry for cash markets, for instance, clarified the idea of exchange ownership because it questioned the value of trading seats once remote access became standard," Clifford said. "Some exchange members cashed out in the demutualization process."
As with so many other institutions in society, exchanges had to keep up with the pace of technological change, said one securities lawyer.
"In the end, it
was technology that changed the exchange business model," said Kevin O'Hara, general counsel for Archipelago.
For instance, Eurex embraced electronic order entry to become the world's largest futures/options exchange – eclipsing both the CBOT and the CME. On many exchanges, the advanced technology that enables officials to handle increasing volume is costly. Demutualization is one way to pay the bill.
However, some say demutualization is not the only way to survive in a dog-eat-dog trading world. "Some exchanges adapted to the drivers of this world-wide trend without demutualizing," said Clifford at the World Federation of Exchanges. "Failure to demutualize will not necessarily put an exchange behind the curve."
Over the past ten years, trading costs for many private membership exchanges have dropped in line with the dramatic growth in trading volumes. At the same time, revenues exploded.
Indeed, the NYSE, which spends heavily on technology – and toyed with demutalization – still has some 80 percent of the market in listed trading business. NYSE Chairman Richard Grasso says "public ownership for this institution at this juncture is not being considered." However, the NYSE is perhaps already de facto demutualized because half its 27-person board is made up of outside members.
Floating an IPO is problematic for the NYSE. One issue is costs: State and local taxes are rising.
"The other is that the SEC saw exchanges as a kind of utility, but sensed that privatized exchanges should perhaps spin off their regulatory arm to avoid conflicts of interest," said O'Hara, who is a former SEC official.
Nasdaq is awaiting approval on its application as a stock exchange. Nasdaq says it could abandon that application if the SEC requires it to make certain changes as a pre-condition. One controversial issue is internalization which accounts for some one third of Nasdaq's flow of business. If the application is to succeed, the SEC might force Nasdaq to curb the ability of members to internalize.
Private Placement
But Nasdaq is ready on another front. It is quasi-public – at least on the OTC Bulletin Board – following the expiration of lockup provisions in which stock that Nasdaq sold in a private placement is trading for around $10 a share. That's several dollars a share lower than the price at which the shares were sold to a group of investors. All told, 2,900 investors ponied up $516 million; another $240 million was invested by Hellman & Friedman which purchased a 9.8 percent stake.
But even if Nasdaq eventually has an IPO of its own shares, it does not mean it will take back the huge volume of trading siphoned off by competitive ECNs, according to analysts. A sudden cash hoarde may buy advanced technology, but it does not guarantee the magic bullet of success.
