Exchange Consolidation and Models of International Securities Regulation

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INTRODUCTION

In recent years, globalization and a growing demand for capital have increased competition within the capital markets for the business of issuers and investors. (1) This has led stock and derivatives exchanges to change their business models from mutual business entities, run for the benefit of their members, to demutualized corporations, run for the benefit of shareholders. (2) Consequently, as for-profit corporations, exchanges have looked to position themselves more competitively in an internationalized securities market. Part of such positioning has included increasing exchange alliances and acquisitions on a global scale. This is highlighted by the recent merger between the New York Stock Exchange (NYSE) and Euronext (the new entity to be known as NYSE-Euronext). With financial markets now spilling across national borders, demutualized exchanges see opportunities for growth and expansion by consolidating internationally.

However, these changes have put securities regulators in the position of trying to stay ahead of the curve, as exchanges--often seen as once historic landmarks of national pride--push the limits on cross-border consolidations. Traditionally, "[f]inancial exchanges come with a lot of political, cultural, and emotional baggage." (3) Yet, the current activity of exchanges is challenging traditional models of securities regulation. This note highlights the role demutualized exchanges are playing in the convergence of international securities regulation and evaluates the extent to which exchange consolidation fits within one traditional theoretical framework applied to international securities regulation. In practice, cross-border exchange consolidation is largely shaping the path regulators are taking with respect to cross-border securities regulation. However, securities regulation will always remain bound by national borders in certain important respects.

Part I of this article will provide some background to exchange demutualization and explain the driving factors behind an increased competition among capital markets. Part II will introduce the traditional theoretical models of international securities regulation. It will focus on the idea of international "convergence" of regulatory standards and set forth examples of convergence (or the lack thereof) within, and between, the United States and the European Union. Part III will analyze how exchanges have recently influenced international regulatory coordination as illustrated by the merger between NYSE and Euronext.

I. DEMUTUALIZATION AND COMPETITION FOR CAPITAL MARKETS

A. Brief History of Exchange Demutualization The first stock exchange demutualized in 1993. (4) Prior to this, exchanges were run as mutual businesses. Mutual businesses consist of private members rather than shareholders and are run by managers for the benefit of members, not for public profit/ In demutualizing, exchanges take on the form of a "public corporation--the most efficient organizational form for large enterprises." (6) In doing so, exchanges seek the benefits of responding to competition, basing decision-making on shareholder value, pursuing new business strategies, unlocking members' equity values, and facilitating business partnerships] Since 1993, over twenty-one stock exchanges have demutualized. (8) This trend is not limited to stock exchanges; derivatives exchanges have also demutualized. (9) By 2006, several major exchanges worldwide had demutualized or changed their business structure to allow for shareholders. These exchanges include, among others, Euronext (itself the result of a consolidation of five exchanges in England, Belgium, France, the Netherlands, and Portugal), (10) NYSE, Chicago Mercantile Exchange, Chicago Board of Trade, London Stock Exchange, Tokyo Stock Exchange, Deutsche Boerse, Australian Stock Exchange, and Hong Kong Stock Exchange. (11)

B. Factors Driving Exchange Demutualization and Competition

Exchange demutualization, among other things, facilitates increasing competition within the "exchange business;" in other words, the business of providing a market where issuers can raise capital and investors can buy and sell securities. In response to recent competition, alliances and consolidations have emerged as exchanges look to increase profitability. (12) Generally, the forces driving demutualization are also those driving exchange consolidation, and fall into one of two broad categories: changes in the business and financial landscape and changes in the regulatory environment. These categories are not meant to be airtight independent causes; factors in one category may correlate with factors in another as, for example, regulatory changes produce changes in the financial landscape and vice versa.

(1.) Changes in the Business Environment that Affect Exchanges. First, exchanges are reacting to the increasing technological capabilities of alternative trading systems (ATSs), also known as electronic communication networks (ECNs), which have put pressure on the traditional role of exchanges as an order-matching intermediary. ECNs can match orders transparently, efficiently, and anonymously, and offer lower transaction costs for investors. (13) ECNs have also lowered barriers of entry into the exchange business, as a physical trading floor becomes unnecessary. (14) Thus, there has been downward pressure on profit margins resulting from order-matching, and exchanges are looking to diversify into other lines of business, such as clearing and settlement. (15) Adding to this pressure has been an increase in the amount of order-flow large that brokerage houses are crossing internally (particular for institutional clients trading large blocks of shares), which obviates the need for sending orders to an exchange. (16) Moreover, these technological innovations facilitate the trading of securities regardless of where the issuer is listed. (17) "Today's technology enables market participants to tap simultaneous and multiple sources of liquidity from remote locations," so investors can obtain real-time information about securities trading on foreign exchanges, and execute orders on those markets electronically, (18)

Collapsing national and technological barriers have thus had the effect on stock exchanges that these lowered barriers would have on any other industry, increasing global competition for the listings of securities issuers and for the trading activity of investors buying and selling those securities.

Second, the boom in financial innovation and derivatives trading has caused exchanges to look for ways to enter these markets. (19) Able to offer investors access to a wide array of financial products, (20) exchanges can differentiate themselves in a competitive environment. NYSE-Euronext, for example, expects derivatives to be the biggest source of new revenue for the combined entity. (21) Euronext traded forty percent of Europe's $16 trillion in outstanding (notional) derivatives contracts, (22) and represents a significant addition to the NYSE's traditional strength in providing a liquid market for stocks.

Third, in recent years the U.S. financial markets have not experienced the same increased growth in market value as certain foreign markets. (23) In conjunction with a declining dollar over the last few years, this relatively slower growth than other international markets has prompted U.S. exchanges to expand into better-performing and increasingly active international markets, either by forming alliances or through mergers.(24)

(2.) Changes in the Regulatory Environment. Recent regulatory changes have also increased competition among stock and derivatives exchanges. Two important regulations passed by the Securities and Exchange Commission (SEC) that are widely seen as enabling stronger competition are the Regulation of Exchanges and Alternative Trading Systems (Regulation ATS), (25) and the recently amended, controversial Regulation National Market System (Regulation NMS). (26) Regulation ATS was adopted in 1998 in response to the growing number of ECNs, which were not "exchanges" in the traditional sense but were systems that "otherwise perform[ed] with respect to securities the functions commonly performed by a stock exchange." (27) The purpose of Regulation ATS was "to more effectively integrate the growing number of alternative trading systems into the national market system, accommodate the registration of proprietary alternative trading systems as exchanges, and provide an opportunity for registered exchanges to better compete with alternative trading systems." (28) Regulation ATS lowered entry barriers by allowing ECNs to compete directly with registered exchanges for the matching of orders. (29)

Regulation NMS was adopted in 1975, in order to connect the various stock markets so that orders could be routed on a national scale. (30) One express purpose of Regulation NMS is to allow for exchange competition. Regulation NMS, recently amended in 2005, is "premised on promoting fair competition among individual markets, while at the same time ensuring all of these markets are linked together." It sets forth the objective of promoting "vigorous competition" among both individual markets and individual orders?' Together these regulations provide strong incentives for exchanges to reorganize as corporations, in order to partner or consolidate with emerging, demutualized competitors.

The changing regulatory regime in Europe has also fostered competition and consolidation among exchanges in attempting to create an integrated pan-European capital market. The European Commission has explicitly stated that "any remaining capital market fragmentation should be eliminated, thereby reducing the cost of capital raised on E.U. markets." (32) The Markets in Financial Instruments Directive (MiFID), (33) seen as trying to stimulate competition, (34) rests on the notion that "market participants and investors [are] able to compare the prices that trading venues ... are required to publish. To this end, it is recommended that Member States remove any obstacles which may prevent the consolidation at a European level of the relevant information and its publication." (35) With these obstacles removed, several E.U. exchanges, such as Euronext, have consolidated, creating a liquid, efficient, interconnected financial infrastructure that has attracted issuers and investors, and challenged the traditional dominance of the U.S. capital markets. More closely interlinked European financial markets have provided a viable alternative for international issuers as a source of capital.

Moreover, the recent gap between standards in the United States and European regulatory environments, combined with the cross-border, mobile nature of capital, have had a secondary (and perhaps unintentional) effect of intensifying the consolidation trend among exchanges. The passage of the Sarbanes-Oxley Act (SOX) in 2002, (36) in response to a wave of corporate accounting scandals, enhanced accounting and disclosure requirements of publicly traded companies. Several commentators have suggested that the burdens of SOX compliance may have caused a decline of foreign issuers choosing to raise capital in the United States. (37) For example, a report commissioned by New York City Mayor Michael Bloomberg and Senator Charles Schumer notes that E.U. capital market revenues are growing by twenty percent per year, compared with seven percent in the …