Executive Summary Faster, Larger, Riskier: Investing in the Future Global Stock Exchange by Joan E. Foltz The globalization of the world’s stock exchanges is causing structural shifts in the financial industry that have long-term impli- cations for equity markets, regional economies, and individual in- vestors. Recent mergers and acquisitions among the exchanges show acceleration along a trajectory based on the adoption rate of market- based governance across the world. Continuing deregulation accompanies free-market economies, which is enabling a global stock exchange to emerge as a self- organizing system. Risk and rewards will be determined by strate- gies that look at the market as a system restructuring with changing forces. An understanding of how the stock markets will represent the behavioral patterns of their players and how to recognize funda- mental organizational structures will benefit investors in the future. About the Author Joan E. Foltz is a principal of Alsek Research, a socio-economic analyst of global economic development and publisher of Alsek’s Not-So-Daily Update, unbiased mapping of market behavior. Faster, Larger, Riskier Investing in the Future Global Stock Exchange Joan E. Foltz Prognostication of a market-based governance system, one where global development is driven by free-market forces, is sup- ported with the accelerating globalization within the financial in- dustries, particularly the stock exchanges. Emerging as a leader to- ward a unified global system is the projection of what could soon become a Global Stock Exchange made up of either one dominant exchange or two primary exchanges that are restructuring the global stock, commodities, and currency markets. The brisk merger activity among stock exchanges is forming interdependent, global financial markets and creating shifts in the forces within financial systems, most importantly the power struc- tures. These long-term structural changes bring new characteristics and powerful implications that impact not only the global econo- mies, but also corporate strategies and individual investors’ deci- sions, requiring a different way to eye the new landscape emerging in the trading environment. The current phase of rapid consolidation of exchanges was pro- pelled by the New York Stock Exchange when it became a public corporation in 2007. At that time, the purpose of the exchange shifted Joan E. Foltz is a principal at Alsek Research. E-mail firstname.lastname@example.org. 304 Seeing the Future Through New Eyes away from providing an organization supporting its members to max- imizing business profitability by horizontally expanding with the im- mediate acquisition of the Euronext, the European exchange. This propelled a merger and deal mania among competing exchanges and related infrastructure companies scrambling to capture international territory. With the spread of the adoption of capitalism and free-market economic systems, countries with nationalized exchanges will be unable to compete against the behemoths created by the mergers and acquisitions (M&A) that are forming a globally interconnected trading system of powerful networked partners. The vertical and horizontal depth of the M&A activity spreading into other segments of the investment industry advances the efficient infrastructure, which opens a myriad of opportunities for new financial product innovations. However, it also creates structural changes that will al- ter the future of equities’ market behavior. These opportunities at- tract new entities, which in turn will create new challenges as differ- ent major factors surface. Global R each: The chanGinG l andscape M&A activity is forming a global financial landscape layered with intertwined, networked exchanges and affiliated stakeholders servicing the different subsets of companies from large multinationals to small firms, all seeking exposure to international investors. This phase of consolidation, led by the two largest exchanges — the NYSE/Euronext and NASDAQ — is shaping into a few predomi- nant transregional systems. The rate of expansion follows the rate of change made in emerging regions’ regulatory policies as they allow foreign ownership of national exchanges, open to free markets, and form strategic alliances to share trading platforms or other transac- tion-processing systems. Distinct financial centers are arising within the regionally cen- Foltz: Faster, Larger, Riskier 305 tered, interdependent systems, as the competitive race to capture markets in equities and other financial products repositions national players. Since many of the major markets (e.g., the BRICs — Brazil, Russia, India, and China) still restrict foreign ownership, the final Figure 1: World Stock Exchanges alignments culminating into power centers remain unforeseen. In 2004, NASDAQ started competing for the listing business by offering dual NYSE-NASDAQ listings for companies. New ac- counting standards that allowed companies to cross-list on foreign exchanges significantly expanded their access to foreign investors and larger markets. Now, U.S. investors can access more than 420 non-U.S. companies listed on the NYSE and approximately 335 on the NASDAQ exchanges and through American Depository Re- ceipts (ADRs). Companies registering initial public offerings that want the benefits offered by the NYSE, but do not want to pay the costs incurred when registering as a U.S. offering, can go through Euronext, a branch of the NYSE. In the future, as the exchanges continue to merge and share infrastructure, the trading landscape will likely morph into one in- 306 Seeing the Future Through New Eyes terconnected exchange, where trades will be accessible to any inves- tor on a centralized trading platform. The listing exchange and regulations will be transparent to the trader. Until then, the primary driver of the industry’s consolidation will be competition for the po- tential surge of liquidity found in new emerging markets. Both regulatory changes and advancements in electronic trad- ing systems have enabled exchanges to go global. NASDAQ, which started as an electronic exchange, always had a strategy to build an international trading service based on an online-trading system. Since the 1990s, NASDAQ has built a foreign presence through various alliances, starting with a joint Internet information service with the Hong Kong Stock Exchange and its launching of the NASDAQ Canada in 1999. On the European front, the Paris, Brussels, and Amsterdam exchanges formed the Euronext in 2000, which also acquired the Portuguese Lisbon exchange. In 2007, as soon as the NYSE became a public corporation, it proposed a merger with Euronext, which was finalized in 2008 to form the world’s largest stock exchange, valued at more than $20 trillion. The NYSE takeover of Euronext triggered a rush for stake claiming. However, bidding wars emerged when the NASDAQ, a 15 percent stakeowner in the London Stock Exchange, made a bid to acquire the remaining LSE shares in 2006. The offer was re- jected. Moreover, the aggressive move to take over the third-most- active exchange pulled Borse Dubai, a United Arab Emirates ex- change, into negotiations, which caused a significant change in the landscape of global financial centers. The ongoing fight to acquire the LSE ended with a shuffle of convoluted ownership structure. Borse Dubai settled with a 28 per- cent stake of the LSE purchased from NASDAQ’s shares. NASDAQ became the principal commercial partner of Dubai International Financial Exchange in exchange for the Borse Dubai taking 19.99 Foltz: Faster, Larger, Riskier 307 Table 1: Top 10 Stock Exchanges Market Value Total Share Turnover Stock Exchange (US$ trillions) (US$ trillions) NYSE Euronext $20.70 $28.70 Tokyo 4.63 5.45 NASDAQ 4.39 12.40 London 4.21 9.14 Shanghai 3.02 3.56 Hong Kong 2.97 1.70 Toronto 2.29 1.36 Frankfurt 2.12 3.64 Madrid 1.83 2.49 Bombay 1.61 0.26 Source: Wikipedia. percent stake in the NASDAQ. And Borse Dubai took the NASDAQ branding name. While the LSE fights to maintain its independence and ward off takeovers, the NYSE and NASDAQ continue to build their global networks. In 2008, NASDAQ and the OMX (agglomeration of Stockholm, Helsinki, Copenhagen, Latvia, Lithuania, and Esto- nia exchanges) will merge into the NASDAQ /OMX, pending ap- proval by Sweden and other Nordic and Baltic jurisdictions. The agglomeration of the various NASDAQ mergers and alliances will cultivate the first exchange that will span the United States, Europe, and the Middle East regions. The emergent organizations do not clearly define territories or differentiating regulations. Dubai has plans to become a major fi- nancial center servicing the Asian region between East Asia and Europe. Singapore, already an established financial center for the 308 Seeing the Future Through New Eyes Asian-Pacific region, is a prime target for M&A activity as that re- gion develops. In 2007, Tokyo purchased 5 percent of the Singapore Exchange, SGX. Rumors say the Tokyo Stock Exchange (TSE) plans to take a major stake or acquire SGX. That could expand the products and technology the TSE already shares with the LSE. However, targeting the Asian region is already part of the NYSE Euronext and NASDAQ expansion strategies. Aggressive-deal making activity is not limited to any city or country, but surfaces in all areas that enable foreign participation. NASDAQ long ago established an office in India, and NYSE Euronext already purchased the maximum allowed foreign owner- ship of 5 percent in India’s Mumbai exchange, the National Stock Exchange. The NYSE also made headway into China with the first registered representative foreign exchange office. However, the ad- vantage of any leading exchange may change as restrictions on for- eign ownership are lifted in the emerging regions. As globalization of the industry opens opportunities, the pres- sures to perform as a publicly traded company will fuel further con- solidation necessary to achieve efficiencies of the integrated tech- nologies and to exploit the massive global market. Small, regional, and single-platform exchanges will be unable to compete. new FoRces in The Global exchanGe sysTem’s sTRucTuRe As a revolutionary exchange structure emanates, new power- ful forces will impact directions of the global economy and wield enough power to influence regulatory policies governing regional economics and foreign trade. Electronic trading systems, coupled with a new massive market composed of different players, could cre- ate significant shifts in the distribution of global capital formation. Also, both infuse different behaviors into trading systems. Information technology has leveled the playing field by pro- Foltz: Faster, Larger, Riskier 309 viding access to information and electronic trading to individual retail traders with the same detail as professional traders and institu- tions. However, the expanded base of traders also introduces new investment strategies, trading styles, and intentions, often with con- flicting goals. Many new traders and investors making the market are from regions that only recently adopted open markets and capi- talist economic structures, where individuals may not be protected from market fluctuations. The dynamics of matured trader groups intermingled with novice entrants, whose understanding of market behavior is based only on current market conditions, could incite volatility both in the trading arena and in the economies of specific regions — if shifts of fast money constitute instability. Conversely, a more risk-averse group of global players could add stability or induce new agents that would balance short-term speculative progression. Spread of Risk and Governance The expansion of the market adds liquidity, which fuels more economic opportunities. The diversity of players that comes with an international market also changes along with the shift in large hold- ings. Institutions, such as insurance companies, pension funds, and corporations, utilize different avenues to invest large pools of capital with minimal impact to any particular stock or market. However, foreign institutions are now composed of large sovereign funds that often trade on the open markets and impact certain sectors and in- dividual stocks. Concerns regarding their intentions, or at least their ability to have control over stocks, industrial sectors, and regional economies, are heightened by the lack of regulation, accounting standards, and transparency of the foreign entities. Escalating numbers of pension funds spread across the world, along with economic growth in the emerging regions, should miti- gate any intent to manipulate a targeted stock or economy by a sov- ereign entity. As the dispersion of foreign investments widens, the 310 Seeing the Future Through New Eyes sovereign fund could expose its own country’s downturn risks through the fund’s other investments. Any sovereign fund concen- trating financial activity to a specific target will likely trigger inter- vention before any significant event occurred. The integrated connectivity of the pan-global exchanges, as mapped in the NYSE and NASDAQ expansion, provides the means to spread risk and leverage accumulated wealth, which is likely to be of more value to any fund in a global economy than begets a coun- tervailing force. Intentionally threatening a global imbalance would provoke protectionist policies that could reduce capital flow to that country. Hence, impacting capital formation would likely be avoided. However, capital infusion could be used to influence countries’ and corporations’ decisions that indirectly impact the trading environ- ment. The trading environment is a large, interdependent system, so the emerging structure will likely develop into a self-correcting, bal- anced system that is less overpowered by waves of momentum and speculative trading. However, the probability of forces threatening the system’s performance rises if foreign markets overadjust with regulatory policies that impact the integrated global market as these countries learn market-based economics. The formation of regional financial centers, such as New York, London, Dubai, and Singapore, plays a key role in global stability. This is a step forward in the globalization transition, which leads to international regulation and has the potential to undermine the powers of nation-states. Eventually, the global exchanges will have to agree to a set of international standards. Without those, the practices of all players may not be in the best interests of any particular country. An ex- ample is speculative commodity prices driving up inflation, which could hurt economies that cannot absorb the costs. Another exam- ple is the 2007 subprime mortgage crisis, which started in the United Foltz: Faster, Larger, Riskier 311 States and rippled throughout the foreign exchanges due to foreign participation in the derivatives, yet alleviated some of the risk to the United States. Risk will increase as countries deregulate to partici- pate in the global market. Competing financial instruments will propagate new investment opportunities, which will continue until creative financing is exhausted or the ramifications from regional regulatory regimes pose predatory or protectionist repudiation. The most significant benefit of a global market is that risk is spread across the world. The decoupling of investment banking from commercial bank- ing regulations has opened the doors for developers of creative secu- ritization that has embedded unregulated financial instruments in the complex integrated systems; such moves expose innocent recipi- ents to unknown high levels of risk and insecurity. Without a set of international accounting standards, the exploitation of unregulated securities by passing them through regulated funds will become harder to track as the portfolio of investment products inflates choices. The geographic diffusion of shocks no longer depends on the epicenter of the shock or the periphery. The spatial dislocations are now more dependent on the linkage between the participants in the arbitrage. Episodes that cause economic crisis to a particular coun- try will receive pressure from agents in the trading system. The cor- recting mechanism will come from the periphery (countries) that will impart controls on the market, which is more prone to organiza- tion based on human behavior. The free-for-all speculative trading that some fear could lead to a gambling market should evolve into a global institution with universal ideologies. Decision making will shift from the financial institutions, broker/dealers, and traders as the center of gravity to a universal world order. Organization will not be based on ideologies, but on risk management of an integrated economy. 312 Seeing the Future Through New Eyes Globalization has shifted traders’ awareness from regional centers to the core of financial centers. Economic concerns that im- pact overall exchange performance arise from adverse shocks to as- set sectors. Political or economic instability at the periphery usually remains insignificant, discounted with little impact on markets. This global mind-set versus a regional mind-set will prevail in a pan- regional marketplace. Capital Formations and Shifts in Distribution A global stock exchange platform makes the opportunity for asset accumulation available to more people. Inequalities in capital formation can accrue in open markets if governments are left out of the distribution architecture. As countries adopt market-driven gov- ernance, more people will be pushed toward participating in pen- sion funds and other types of private investing in a system that used to be exclusive to the wealthy and countries with stable exchanges. The self-organizing system will increasingly expose retail traders to a complex array of investment choices and schemes. “Smart money” and institutional traders moving into assets that require an under- standing of sophisticated asset management to yield the higher rates of return will leave individual investors to lower-return assets, thus perpetuating the increasing gap between wealthy capitalists and in- vestors attempting to generate pensions. Investments maximizing returns by chasing emerging regions and innovations can infuse significant amounts of capital into a region or sector without having a long-term commitment. The risk of oscillat- ing and massive withdrawals exposes regional development to the vul- nerabilities of market sentiments. Any increase in volatility or instability created by the diversified pool of investors could cause governments to change policies regulating foreign ownership and investments. If systemic problems in the global exchange become unpre- dictably chaotic, investors and institutions will decouple from the Foltz: Faster, Larger, Riskier 313 public exchange and migrate to alternative trading platforms, such as the emerging private exchanges, to invest among a more efficient market in a lower-risk environment. These exchanges could draw the liquidity, often called “dark liquidity,” from the private equity firms and major markets as companies look for some regulation, plus the necessary liquidity to facilitate large transactions. These alternative trading platforms could disrupt the financial landscape and the structured network of exchanges by aligning with partners from other segments of the financial industry, such as banks, service, and technology providers. Depending on the forma- tion and allocated resources and alignments, each exchange offers differentiating services suitable to the goals of large block traders. In 2007, NASDAQ announced its PORTAL Market, a closed trading system available to brokers and institutions trading 144A securities (unregulated securities restricted to qualified institutional buyers worth more than $100 million). The trading platform in- creases the liquidity by enabling foreign investors and other quali- fied parties to conveniently participate in private sales of 144A secu- rities through an efficient execution network. Private exchanges operate not only with minimal regulation, but also with no transparency. Qualified investors that can absorb risk are invited to trade large blocks in Project SmartPool, an elec- tronic block trading market accessible to European sell-side firms, a partnership between the NYSE Euronext and investment bankers NP Paribas and HSBC. Parties will be able to trade without disclos- ing their identity or the bid/ask prices or size of trade. Minimal in- formation will be required pre-trade, and information will only be posted after settlement. Alternative exchanges are outcomes of regulations, such as MiFID in Europe and Reg NMS in the United States, which take the investing environment from a highly controlled regulatory struc- ture to a free-market system. The flood of new products and plat- 314 Seeing the Future Through New Eyes forms for trading and investing that comes from deregulating the industry will continue to change the landscape as interacting par- ticipants produce a collective structure. These dark-liquidity trading platforms are estimated to already process more than 5 percent of the trading volume in the United States. chanGes in invesTmenT sTRaTeGies The evolving exchanges present dynamic and fluid options to the individual trader, brokers, and corporations. The changes in the trading environment’s system structure will likely require adjust- ments in strategies to include more risk assessment and more sophis- ticated methods to identify opportunities to generate capital gains. As integrated pan-global exchanges open foreign markets to more investors, the systemic complexity will only grow. Analysis of any market will require an international mind-set, a global view, and a whole-system understanding. Investors — cor- porate, institutional, and individual — will have to be able to assess opportunities throughout the world, not necessarily by regions, but by individual stocks. With an interconnected system, a company of any size need not depend on its economic success being linked to a country or region, but rather on its competitive position in the world market. The complexity of understanding the expansive landscape saturated with a myriad of financial products and equities could have a residual effect that slows down the capital distributions while the system finds stability. Likewise, the risk and volatility from an open-market system could push private investors to seek stability in funds or drive out players from the market, which will reduce liquid- ity and cause further downturn. Corporations may opt to list with exchanges that are less regu- lated to avoid stringent reporting rules such as Sarbanes-Oxley re- quirements. Likewise, other companies may seek a regulated envi- Foltz: Faster, Larger, Riskier 315 ronment for stability. In a global financial system, companies have the option to choose the best match for their strategies, whether it is a foreign listing or a cross-listing. This makes a market of conflicting goals. A corporation that wants a market with the liquidity and abil- ity to handle large IPOs, which would typically seek to be listed on the New York Stock Exchange, could list on a European exchange if the terms are more beneficial. The interdependent exchanges pro- vide the option to raise capital and receive the securitization in mul- tiple locations without dislocating the company’s central operations. Threats from listed companies to move to another country will limit the ability of the SEC and other regulators to impose their will. These threats could be mitigated if investors prefer to keep their trading within a regulated framework for increased protection. Overall, the structural changes in the globalization of ex- change systems bring advantages such as an expanded market and opportunities for corporations. However, challenges could become disadvantageous for individual traders. A rise of private exchanges could leave the NYSE and NASDAQ to be the aftermarket for individuals, which would result in these exchanges becoming a gambling system functioning more on be- havior and computerized algorithms than on investments. Those characteristics could become more pronounced than the skeptics al- ready perceive. Individual traders could be shut out of the lucrative IPO market if initial offerings migrate toward private exchanges or other instruments where there is less volatility. This could lead to only high-risk IPOs that are more likely to fail or be insignificant to debut on one of the major exchanges (NYSE, NASDAQ, LSE). The decoupling of the large block institutional traders from the public exchanges would grossly affect stock market performance. Left to individual players, the market would become more of a be- havior and sentiment indicator than an economic barometer. Fads, 316 Seeing the Future Through New Eyes bubbles, and momentum could dominate strategies. Timing the market would become a prevalent tactic rather than short- and long- term investing. This would leave less-active traders disadvantaged in a constantly fluctuating market. Protection will be needed for individual investors who have to rely on investments for retirement, particularly if Social Security becomes privatized or there are other disruptions in pension assets. However, the massive aging population could force alternative safe havens to be offered. Demand is expected only to increase with the growing aging population around the world. But it is the role of the industry to provide options for security. The conflict will be between a global exchange, which has a purpose to maximize opportunities fueled by liquidity, or secure programs for asset protection and sub- scribed payout. FuTuRe ouTlook Globalization of exchanges will continue to evolve and revolu- tionize the financial industry as new economic theories are explored. Products for creative securitization will be tested. And the role of global exchanges will be scrutinized as they struggle to improve their competitive position versus providing options that are in the best interest of investors. The solidity of the entire global financial system will likely re- quire somewhat of a regulated architecture. Else, national econo- mies run a risk from potential spillover effects resulting from events in other regions. Being on the periphery of an interconnected system does not provide any safeguards from the core’s behavior. In an open market, government policies will be less influential than traders’ behavior. Exchanges will become more representative of a gambling environment than an investment platform. And even though the stock market has been long compared to a casino, that strategy will dominate until an event disrupts the fundamental Foltz: Faster, Larger, Riskier 317 structure created by a shift in electronic trading systems’ methods. As with globalization of any industry, continuing deregulation in the financial sector will nurture more creative products, more competition, and more consolidation until a chaotic environment stresses the current trajectory and causes a sharp reversal. In this industry, there would be no reversal of a global exchange, but the force of an international regulatory body would prevail. Fragmenta- tion of the major exchanges will result when the rise of private ex- changes draws liquidity from the major markets to the point of re- ducing performance and functionality. Other alternative collective structures could emerge from restructuring alliances in multiple sec- tors, such as technology companies. As with all systems, the trading exchanges will continue on an evolutionary path. And while in the era of globalization, they will continue to go through stages and phases of consolidation and frag- mentation, just as other industries do. However, since the stakes can be high when dealing with huge sources of capital and economic control of companies, industries, and countries, wild cards are a pos- sibility, although unlikely due to sophisticated monitoring. The ad- vantage of an interdependent exchange is that it is based on an elec- tronic platform that tracks all transactions. A wild card that would disrupt the trading revolution might be, for example, a sovereign fund with enough wealth to overpower or threaten a major economy by successfully manipulating a market, which would lead to financial wars. However, evolution of a global economy makes most countries participating in it interdependent, with a high probability that spillovers of any cataclysmic event would carry significant economic damage to the perpetrator. A more likely scenario is the rapid shift between dominant regional financial centers that would lead to a significant global im- balance of major economies and threaten a global economic col- lapse. This is in line more with the emergence stage of a self- 318 Seeing the Future Through New Eyes organizing structure. At that point, controls would be put in place to stop economic destruction and reverse course. Success of these con- trols depends on the governing bodies to implement appropriate measures and acknowledgement by the global community of the inferences. The trajectory building by the consolidation of exchanges, overall, produces benefits that far outweigh risks. Cycles and insta- bility can slow down the evolutionary process, but they will be cor- rected. 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