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Page last updated
February 15, 2003




Will stock exchanges survive?


Twenty years ago, such a question would have seemed stupid and those who posed it considered candidates for certification - in paper form, of course.

Everyone knew what stock exchanges were and what they did: they provided a physical marketplace where shares were traded; they stamped a seal of approval on the companies whose shares were traded; they often gave investors security against broker failure through a compensation scheme; they sometimes controlled the settlement process; they were frequently trade associations (and disciplinary bodies) for their members and usually the only source of information about what trading was taking place and the prices at which deals were being done.

Far from this steady state, today almost every exchange in the world is under threat to its very existence, or at least facing a questioning of its role. New (usually electronic) methods are replicating what the exchanges used to provide. Software houses are developing systems which challenge the old ways of doing business. Electronics are making physical proximity irrelevant. Worldwide securities houses are making 24 hours a day trading a reality, passing control of their trading books around the world in a continuous securities trading relay - and probably praying that nobody drops the baton en route.

Until a few years' ago, stock exchanges were generally larger than the sum of their individual parts. Today, that is no longer the case. World-wide securities houses themselves can now dominate the individual national markets.

So do stock exchanges still have a role?
To try to answer that question, we need to ask ourselves a further one: what is the nature of an exchange? What, in essence, does it do? By answering these questions we may get some answers to the larger question of their future.

So what are an exchange's essential functions? In a nutshell, exchanges are 'places' where participants can trade risk: with both parties buying or selling a security in order to take in, or offset, financial risk, according to their own preferences. The role of an exchange is to minimise all the 'outside' risks: that the buyer or seller may get the 'wrong' prices; that the seller will fail to deliver stock; that the buyer will not produce the money; that an intermediary will fail while the transaction is still open; that the trade will take too long to settle. And these are just a few of the risks.

Until recently, an exchange provided a physical market where buyers and sellers came together to do business face to face. Today electronics provides a trading platform where buyers and sellers come together in 'virtual reality'. Meeting the needs of buyers and sellers remains the fundamental raison d'etre of every market, whether in stocks and shares or fruit and vegetables. The more business comes to that market, the better the price which both sides will get.

A market also needs to build the confidence of its users: buyers must know that they will get what they paid for; sellers that they will get their money; both must be sure that the price they have agreed is a fair one. A market therefore needs integrity. That need used to be provided by 'Club rules' which all members had to subscribe to. Today an electronic system provides the functionality of transacting trades and providing a full audit trail for them. Ultimately, however, real integrity remains a human value and as such cannot be replicated by a machine - yet.

A user of securities and derivatives markets has today developed a number of 'must have' demands, which in the past did not seem so necessary, when you literally met your opposite number every day on a market floor. First of these relates to market counterparty risk. Providing a central counterparty, rather than simply relying on the probity and good name of the person with whom you have dealt, has become almost essential nowadays, with the exchange itself or another well-financed organisation taking on the responsibility for settling all deals. An exchange used to be in a position to undertake this task, but the size and globalisation of deals, means that other, non-exchange-based organisations are now taking this role on.

Providing information of all sorts to the market is another role which used to be an exchange prerogative which has now passed to more specialised information vendors whether this is general news, company information or prices of securities.

Any trading system must provide all relevant information to one place. This used to be a trading floor, but these are now largely irrelevant, as the London Stock Exchange and LIFFE have both found out - and as NYSE may yet discover.

One of the arguments for a stock exchange used to be the provision of a 'central market'. The argument that an exchange in which all business was transacted, could provide the greatest possible liquidity and therefore the finest prices to both buyers and sellers is unanswerable. However, this does not mean that one single organisation has to provide that formalised central market as an institutional monopoly.

The modern concept of a central market is that a whole series of prices is brought together on a single screen so that dealers are able to transact business with whichever supplier is providing the best price. Meanwhile the investor is guaranteed a 'best execution' price and the best possible flow of business - liquidity - is assured.

Settlement, again once considered an essential part of a stock exchange's functions, is now, by and large, provided by others and increasingly on an international basis.

In the United Kingdom, although less so in other countries, the stock exchange has been the body which grants listing of shares to companies. Even in the UK, this function has now passed to the Financial Services Authority. While exchanges still decide whose shares they will trade on their market, this is a function which could - and is - carried on by electronic market providers; it is not unique to an exchange.

In conclusion, the fundamentals of a stock exchange can now be undertaken by electronics and software companies, information providers and statutory regulators. Stock Exchanges therefore no longer have the unique role they have had in the past. Only if exchanges embrace the new technologies and take other partners are they likely to survive and even then, not in the form we

have known them. How long before the NYSE floor is a multiscreen complex showing Star Wars?

Stuart Valentine
Director of Membership & Public Affairs
The Securities Institute



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