Marcus Cake

Regional stock exchanges are deprecated. What? I have been spending a lot of time with open source software and stumbled across the term “deprecated”. The term can be applied to regional stock exchanges.

According to Wikipedia:

In computer software standards and documentation, the term deprecation is used to discourage usage of a particular software feature, usually because it has been superseded by a newer/better version. The deprecated feature still works in the current version of the software, but it may raise error messages or warnings recommending an alternative practice.

Features typically get marked as “deprecated”, rather than simply removed, in order to provide backward compatibility for software users. When other programs depend on the deprecated feature, their programmers need time to change their code to avoid the feature.

Regional stock exchanges are deprecated. They will be superseded by new structures in a global market. These new features include online industry networks, global and specialist stock exchanges and a global private equity industry that can provide capital for any size of transaction - small and large in any market. Companies will need time to change their approach and use these new features of the global equity market. Regional stock exchanges are likely to throw up a lot of deprecation errors, or public relations messages, as they struggle with emerging global exchanges and online industry networks. The pace of industry consolidation has rapidly increased in the last 18 months as the global stock exchange is created. With economies of scale, a global stock exchange may be able to provide access to the equity market for companies which previously could not get access. It is unclear whether the global exchanges currently being created will improve access to the equity market by smaller companies.

Stock exchanges

Wikipedia defines a stock exchange as:

“A stock exchange, share market or bourse is a corporation or mutual organization which provides facilities for stock brokers and traders, to trade company stocks and other securities.”

Most countries have a stock exchange. Countries without a stock exchange aspire to have one. The World Federation of Stock Exchanges has a membership of 55 exchanges from all over the world representing 97 % of world stock market capitalisation, (approximately $35,000 billion). There are a further 24 affiliates, and 32 bourses which are correspondents. Stock exchanges have cast a huge shadow over the financial markets. They were the primary means for companies to raise capital for companies. There is often only one exchange in each country. They had a monopoly on providing capital to companies. They focused on the largest companies and smaller companies struggled to find access to capital.

After one hundred years, they still do the same thing in the same way. Match buyers and sellers and distribute information through closed networks. New technology offers a new and more efficient structure for a stock exchange. Current technology could allow a single computer to execute all the stock exchange transactions in the world. The internet could mean that anyone could transact through that computer. There is a continuing economic cost of not applying the new structures that have resulted from advances in technology. The economic cost includes the lost opportunity of a large number of companies being unable to access the market for capital in regional economies.

The following quotes also highlight some previous comments on stock exchanges.

“Fewer but larger stock exchanges in Europe’s increasingly consolidated financial hubs are part of a new world envisaged in an IBM report on how the continent’s capital markets might look in 2015. Retail investors stand to gain most as value is drained away from the middlemen, according to IBM. The report, based on a survey of almost 300 exchanges, brokerages, regulators and hedge funds, suggested the world’s financial markets are about to move into a transformational phase with ‘a rate of change unseen since the 1970s’ … Another IBM consultant, Suzanne Dence, said Europe’s stock exchanges would also be forced to rapidly adapt, as well as consolidate, in the face of greater competition. “While exchanges provide a level of unique value in providing surety about the counter-party that you are dealing with, much of the rest of their service is little more than a glorified eBay.” - Middlemen will feel the squeeze in markets consolidation, predicts IBM report, 2006

“In the nineteenth century more than 200 stock exchanges opened in the USA. The invention of the telegraph permitted liquidity to flow to a few fixed places. The invention of the telegraph killed all but a handful of US stock markets. In the Capital Markets Revolution the capacity of digital technology to bring together all fixed points to another fixed (or indeed floating) point means that technology of the internet generation will decimate the world’s existing stock exchanges. Fewer than five major stock markets will remain by 2010. Perhaps two or three of these will be entirely electronic markets which have not yet been created.” Patrick Young et al, Capital Market Revolution: The future of markets in an online world, by Patrick Young and Thomas Theys, Financial Times Prentice Hall, 1999, p47.

Specific reasons that stock exchanges are deprecated
The specific reasons that the vast majority of stock exchanges are deprecated are listed below:

• we know the rise of a global broadband internet that gives every point on the globe access to every other. However, penetration of broadband is approaching 90% in key countries. The capacity to distribute information is now accessible to every individual by leasing a web server for a small monthly fee.
• global online industry networks will emerge to support the global equity market. Advisers previously tied to regional exchanges will begin to work in other countries over the internet. Local advisers will list companies on the best global exchange for teh company, rather than a local listing.
• stock exchanges only assist a company with order execution and do not guarantee companies liquidity. Companies are ultimately responsible for coordinating equity research, investor introductions, media and public relations that may deliver liquidity.
• Stock exchanges have not assisted listed companies with the collaborative aspects of the equity market. They have preserved their proprietary networks and restricted the flow of information. The networks and flow of information have been restricted.
• companies list on stock exchanges for liquidity and to access capital markets. For many companies, a listing on a stock exchange does not provide this. Large companies will gravitate toward five global stock exchanges or electronic contract networks. Smaller companies are not guaranteed liquidity. The private equity industry has grown significantly and can provide capital for any size of transaction - small and large. Regional stock exchanges may lose their large companies and smaller companies are less likely to list.
• advances in technology mean that the matching of buyers and sellers can be processed by a single computer. A single global exchange would have a significant cost advantage (due to economies of scale) compared to exchange restricted to a local market.
• It is expensive to list on a stock exchange. For many companies, access to capital via a stock exchange is simply not economic. Many companies are unable to access capital and die. Small and medium enterprises are considered essential to economic development. A global stock exchange is likely to emerge with significant economies of scale. It may even be able to service companies that could not previously list.
• “search engines”, a semantic web and dedicated online networks means that any market participant can find qualified information or market participants with a desktop internet search. This is a contrast to decades of building relationships and meeting people.
• individual entrepreneurs can design an online industry network with open source software and scale it to service a global audience using Amazon EC2. There will be many entrepreneurs that develop new structures for niches within the financial markets. Many of these will encroach upon stock exchanges. These new ventures will target niches that stock exchanges have not pursued - collaborative activities and technology to deliver significant cost savings
• global capital markets are likely to emerge in the next few years. Capital markets will no longer be US centric and other financial centres are playing a greater role in global capital markets.
• stock exchanges have not innovated - they still perform the same function they performed more than a hundred years ago - match buyers and sellers, and distribute text to a regional audience. Stock exchanges have chosen to maximise revenue from regional monopolies, applied technology to reduce cost and maximise profits for shareholders. There was, however, a significant opportunity that has been missed. For some, the opportunity still remains. For the majority, the opportunity has passed.Perhaps, the need to meet quarterly performance outweighed strategic opportunities.

What would an online network for the equity market look like?
I have written many articles on online industry networks and stock exchanges. The following comment provides an insight into what it may look like.

“In the new reality a complete minnow of a stock exchange will grow to be a world player. It will be an offshore market and may be in Bermuda, Jersey or Singapore, or even a yet to be established cyberspace market with nominal geographic presence in Andorra or Monaco, or perhaps a financial center in a high tax jurisdiction, such as the Irish Republic; or perhaps a state yet to achieve independence. Remember, in the Capital Markets Revolution the status quo no longer exists.” Patrick Young et al, Capital Market Revolution, p. 53.

“The stock exchanges of the future will migrate away from the geographical bounds that the interest groups behind any potential European Stock Exchange seek to retain. Instead of a national view, a sector approach is emerging: for example, investors will not view the market in terms of, say, Germany, Sweden or the UK. Instead, their view will be in terms of pharmaceuticals, IT or forest products.” Per E. Larsson, CEO, OM Group

There will be an online industry network for the equity market which supports the global capital market and is complementary to stock exchanges. An online industry network is unlikely to be a “stock exchange”. It would leave the low margin capital intensive matching of buyers and sellers of shares for others. An online industry network is likely to focus on the collaborative activities.

Regional stock exchanges are deprecated. It may take time for this to be reflected in revenue, balance sheets and customer numbers. The few exchanges that can adapt and understand the internet may survive and thrive. The opportunity remains for some . Many stock exchanges have significant capital, quality relationships with regulators and a desire to preserve the status quo. The large exchanges are applying their vast capital to consolidate the industry. However, the future of even the largest exchanges is not assured. All stock transactions could be executed through a single computer located on the internet. This is likely to be well understood by many stock exchanges given their competitive pressure received from electronic contract networks over the last two decades. Stock exchanges could delay the emergence of online networks, but are unlikely to stop them. I shall watch the response of proprietary industries to online networks with great interest.

NOTE: The original inspiration for this article was an article by Paul Graham titled “Microsoft is dead” and, a follow-up article, “Microsoft is dead: cliff notes“. The article resonated with me. Stock exchanges and Microsoft are just being subjected to creative destruction and economic renewal.