Exchanges or casinos?
A smart article in the Wall Street Journal ("Trading Up: Inside Exchanges' Race To Invent New Bets", 7/6/07), Aaron Lucchetti and Alistair MacDonald explain some of the motivation behind the current wave of mergers and acquisitions among financial exchanges the world over.
The big prize is not the everyday transactions, the usual buying and selling of commodities, stocks, and bonds. They key is derivates, as they explain: "futures and options contracts that let investors bet on anything from the temperature in Osaka to the next move in home prices in Denver." The market for such intangibles is booming, with hedge funds, investment group, and pension funds all eager for high returns.
Competition, especially due to globalization and electronic trades, has cut into the exchanges' profit on conventional transactions. In fact, the exchanges now make the bulk of their profits (three-quarters, according to the WSJ article) now on derivatives, a major change from six years ago. But the derivatives business is growing at a rate of at least 30% a year, and the profits are excellent as the inventors of the derivatives at the exchanges have far more control over timing and pricing. As the article puts it, "With derivatives, the first exchange to launch a popular product usually ends up virtually owning the market for it -- making the trading fees more profitable because they're protected from competition."
The effect of has been for exchanges to suddenly become product developers, much like consumer companies like Procter & Gamble, Kraft, or (more appropriately) state lottery systems. The article cites such derivatives as one based on guessing the direction of the zloty, the amount of snowfall in the Eastern US, the rate of personal bankruptcies, even the box-office take of new movies. Now speculating on futures, from soybean crop yield to pork bellies, has been around for a long time. But the new derivatives market goes far beyond these tangible assets, a way for producers and buyers of a product to spread out risk. But this reach to increasingly esoteric intangibles is something new.
In the US, all this derivatives trading was put in motion by a 2000 law that relaxed the rules on what the exchanges could legally offer. Let's face it. Stocks and especially commodities have always been a high-risk investment, requiring a gambler's nerves. But the new derivatives are looking more and more like placing money on the spin of the roulette wheel. But with one exception: the house gets its profit whether the "gamblers" break the bank or go banko. And there's always someone with more inside knowledge on Polish monetary policy or Hollywood box office projections than someone else.
Note , however, that there is some slight curb, according to the article "To pass regulatory muster in the U.S., exchange-traded derivatives aren't supposed to simply work like forms of gambling -- they must have economic meaning for at least some customers, who use them much like insurance against various business risks."
In any case, the exchanges that are the leaders in this new market are the most desirable. Part of the furious attempt to consolidate exchanges focuses on the power of the futures exchanges and their sudden prominence over straight stock exchanges.
