"A Global View: Examining Cross-Border Exchange Mergers"

Demutualization, diversification, consolidation and globalization are key themes underpinning this transformation as exchanges follow the lead of the rest of the financial services industry.  Recently, there have been a number of announced transactions that illustrate these themes.  Some examples include the NYSE’s acquisition of Archipelago and our merger with Euronext, the Chicago Mercantile Exchange’s (CME) plans to merge with the Chicago Board of Trade (CBOT), the London Stock Exchange’s (LSE) bid to merge with Borsa Italiana, Deutsche Bourse’s bid for the International Securities Exchange (ISE), and Nasdaq’s intention to merge with OMX.  These mergers and acquisitions reflect the ongoing competition among exchanges to build scale and speed, generate increased liquidity, attract more investors, better serve issuers, and diversify risk.

I.  A case study:  NYSE Euronext

The dramatic changes to our own business model and structure illustrate how much this industry has evolved in a very short period of time.  Just 16 months ago, the NYSE was a member-owned, not-for-profit exchange focused solely on NYSE listed stocks.  Today, NYSE Euronext is a multi-product global company with a market cap of $21 billion.  Together, NYSE and Euronext represent the world’s largest cash equities market.  The aggregate market capitalization of all our listed companies totals $28.5 trillion.  One-third of the world’s cash trading takes place on our exchanges.  In addition to our businesses in the U.S. and Europe, we have a strategic alliance with the Tokyo Stock Exchange, as well as a 5% stake in the National Stock Exchange of India.

We are also a much more diversified company.  In addition to our equities business, NYSE Euronext offers futures, options, and fixed-income trading.   Today, derivatives trading comprises 22% of our revenues.

We are also the world’s leading marketplace for capital raising.  Last year, in 2006, $68 billion of IPO capital was raised on our NYSE Euronext exchanges.  For that year, capital raised on the NYSE alone was about $40 billion, and Hong Kong ($47 billion) and London ($44 billion) for the first time, each raised more in IPO proceeds than the NYSE.  Nasdaq and AIM each raised about $18 billion last year.  While these numbers show that our listings business is very competitive with other markets around the world, they also show that other markets are gaining ground quickly.  I can’t overstate how important it is for the U.S. to strive to make our markets even stronger – because our competitors are not far behind us and are quickly gaining ground.

I know that I am preaching to the choir when I say that the continued leadership by the U.S. in the global financial services marketplace is vitally important to this nation.  The business of exchanges is the business of public capital formation.  This translates into job creation and economic growth.  The New York State Comptroller’s October 2006 Report on the securities industry found that each incremental securities job leads to the creation of two additional jobs in other industries.  We are grateful to you and your colleagues on this committee for making this topic a priority.

II.  Evolution and Future of Exchanges

The changes at NYSE Euronext have reflected four themes, which can be used to characterize the developments in this industry generally.  These developing themes in the exchange space—demutualization, diversification, consolidation and globalization—are very similar to what we have already seen happen in both commercial banks and investment banks.

First, demutualization.  We have seen exchanges embrace demutualization for many of the same reasons that companies become publicly traded, namely, access to capital to fund growth and investment in new technologies, and availability of a currency to facilitate acquisitions.  Demutualization provides the member-owners with a liquid asset, and gives employees the opportunity to participate in the exchange’s success through equity ownership.

The same dynamics that propel exchanges to become for-profit, public companies, also push them to become more efficient, thus benefiting all investors and issuers as well.

The second theme is diversification.  This is particularly true for the cash markets where growth is slow when compared to the derivatives markets (both the options and futures markets), which have achieved a growth rate of 30% over the past four years and enjoyed much higher margins.  The value of derivative financial contracts in 2006 exceeded $450 trillion, of which regulated exchanges handled less than 20%, creating significant opportunity for growth.  By comparison, the value of trading in the cash equities markets was $40 trillion, while the value of trading in the fixed income markets was $65 trillion.  Derivative futures contracts trade much more actively than stocks.  In 2005, $51 trillion worth of stock was traded on Exchanges worldwide.  In the same year, the value of trading in CME’s short-term interest rate contracts alone was $413 trillion, and trading in all derivatives was several times that amount.  The economics are clear and the resulting behavior predictable.  Diversification will continue as a driver of consolidation, as exchanges seek higher margin businesses with more growth potential and reduced risk through diversified revenue streams.

 Consolidation, the third theme, is driven by the need to invest in technology to meet investor demand for greater speed and capacity in transaction execution.  Like many other financial services businesses, exchanges benefit from economies of scale.  Prior to our mergers, NYSE, Arca, and Euronext each had teams of developers working to build new trading platforms and communications networks, and we each had separate data storage facilities.  Our merger has enabled us to combine our efforts and utilize the same platforms on each exchange, reducing substantially our technology costs.  Exchanges also thrive on concentration of liquidity.  Exchange consolidation makes it easier for issuers to access deeper pools of capital around the world.

The fourth theme in the development of exchanges is globalization.  Increasingly investors seek to diversify their portfolios, tap into the growth in non-domestic markets and hedge risk.  We must offer the ability and opportunity to trade products across time zones and asset classes on a global scale.

This transformation of the exchange business is producing significant benefits for investors, issuers and shareholders alike. 

Investors are starting to enjoy the benefits of access to markets over multiple time zones, more efficient and cheaper access to investment vehicles through a single trading platform, and the ability to trade more diversified (and thus less risky) portfolios.  Ultimately, these factors work together to improve market quality, delivering tighter spreads, greater depth, lower volatility and producing the concomitant enhanced returns for investors.

Issuers are seeking and getting the advantages of increasingly large liquidity pools, new listing alternatives and capital raising opportunities, easier access to both domestic and international investors, and lower cost of capital – and therefore higher valuations.

Our shareholders are getting the benefit of the cost savings and synergies we deliver across the combined NYSE-Euronext businesses, and the upside that comes with participation in faster growing products like derivatives, and increased exposure to global markets.

While much has been accomplished, much remains to be done to best position U.S. markets to deliver these benefits to investors, issuers and shareholders.

The consolidation in the exchange industry is by no means at an end.  Every exchange is reexamining its business model with the goal of being well positioned to participate in the markets of the future.

Ultimately, we expect to see a relatively small number of large, multi-product, global exchange operators, of which NYSE Euronext will be one.  Transactions between the U.S. and Europe are leading the way, but eventually Asia, as an increasingly important component of the global economy, will participate.  Japan and India are important markets where NYSE Euronext has already formed formal alliances.  China is also a very important region, one where we have strong relationships and believe that over time there will be opportunities to further strengthen these relationships through strategic alliances.

III.  Key trends affecting the exchange business

We think there are three important trends that are affecting the exchange business.

The first development is the influence of technology on trading.  Market participants are demanding speed, transparency and anonymity, all at lower cost.  At the same time, the growth in algorithmic trading has substantially increased both order and transaction volume.  In response to this confluence of factors, the NYSE has increased capacity, insured reliability, and will deliver turn-around speeds under 10-milliseconds by the end of 2007.  In addition, customers here and in Europe want choice in execution models.  Our Euronext and Arca brands provide full electronic trading, and our NYSE Hybrid Market offers the benefits of electronic trading coupled with the pricing power of a floor-based auction market.

The second development is off-exchange trading, which includes internalization and trading on alternative trading systems, which are sometimes referred to as “dark pools.”  In NYSE securities, off-exchange trading increased from 13% in January 2005 to 20% of share volume in May 2007.  As participants in the markets take their order flow off-exchange, and particularly when they internalize by trading between customer orders and their own accounts, they compromise the integrity of the price discovery process by not exposing their order flow to the broader market.  This disadvantages investors who may not get the best price.

The third development is the continuing downward pressure on exchange fees, which is increasing the movement toward further consolidation.  The explanation here is that exchanges have a very high degree of operating leverage.  Once you have covered the fixed cost of an exchange, the incremental cost of a trade is quite low.  This creates continued pressure to consolidate trading volume onto a single platform and thereby drive prices down.

IV.  The Global Competition for Listings

Major exchanges in the U.S. are facing listing competition for a number of reasons, as has been widely discussed and debated in several reports on this subject, including Senator Schumer’s report with Mayor Bloomberg on Sustaining New York’s and the US’ Global Financial Services Leadership, the report by the Committee on Capital Markets: Reducing Regulation and Litigation While Enhancing Shareholder Rights Will Improve the Competitiveness of U.S. Capital Markets, and the report by the U.S. Chamber of Commerce’s Commission on the Regulation of the U.S. Capital Markets in the 21st Century.  

Attracting foreign listings is important to the continued leadership of the U.S. capital markets.  While the NYSE has long been the global leader in attracting international listings, our share of non-domestic IPO's is declining.  The NYSE and Nasdaq together listed 57% of the global IPO proceeds for companies that listed outside their home market in 1999, but that share declined to 18% in 2006.  Overall, the U.S. exchanges’ share of the global market cap of listed companies has shrunk from 46% in 1999 to 39% in 2006.  The primary reasons for this are as follows:

1.  There is a widely held view that the regulatory framework in the U.S. is burdensome and costly.   The cost of internal controls reporting under Sarbanes-Oxley (SOX) has been the subject of much criticism in recent years.  Recent SEC and PCAOB actions to modify what is required under Section 404 should prove helpful in addressing this concern.  This will only be the case, however, if the audit firms internalize the guidance that the SEC and PCAOB have issued; otherwise the regulators’ rationalization of Section 404 will be ineffectual.

2.  The cost associated with reconciliation to U.S. GAAP has been a deterrent to listing in the U.S.  We applaud the SEC for their proposed rules to eliminate the accounting reconciliation requirement by recognizing International Financial Reporting Standards (IFRS).  This is a significant step in insuring the continued competitiveness of U.S. markets.

3.  The cost of litigation in the U.S., in particular class-action lawsuits, is one of the leading deterrents to companies considering listing in our markets.  As Senator Schumer and Mayor Bloomberg observed in their report, “the legal environments in other nations, including Great Britain, far more effectively discourage frivolous litigation” and “the prevalence of meritless securities lawsuits and settlements in the U.S. has driven up the apparent and actual cost of business  -- and driven away potential investors.”  The need for litigation reform is clear and compelling.

These issues are well documented and frequently discussed.  They are also not new.  What has changed is the viability of the alternatives available to non-U.S. companies in the form of more liquid and well-governed home markets as well as an increasingly vibrant private placement (Rule 144A) market in the U.S. as the proliferation of hedge funds has helped increase the number of qualified institutional buyers (QIBs).

Growth of Viable Alternatives for Raising Capital

Local markets outside the U.S. have improved as a result of stronger corporate governance and regulatory standards as well as investments in technology.  Increasingly, many companies are choosing to raise capital while only listing on their home country exchange.  It used to be that if a company wanted to raise $1 billion, it only had little choice but to access the U.S. markets.  Now there are many markets that can facilitate such an offering.  In 2006, three of the top 20 global IPOs from India and China listed solely on their domestic market while raising over $1 billion each.  This would not have been possible five years ago.

Also, registration in the U.S. is increasingly unnecessary for a company raising significant capital from U.S. institutions.  Private placements through Rule 144A have become an increasingly popular way for companies to access U.S. capital without having to comply with the regulatory burdens of registration.  The number of Rule 144A private placements grew from 130 in 2004 to 204 in 2006.  Even more telling, the amount of capital raised by foreign issuers with a 144A component grew from $57 billion in 2004 to over $137 billion in 2006.  (Please see attachment.)  By comparison, NYSE Euronext (NYSE and Arca markets only) and Nasdaq raised $58 billion last year.  This phenomenon, and the growth of internalization and dark pools, raise cause for concern, as they undermine the transparency that is the hallmark of our markets, and limit access by public investors to these investment opportunities.

Regulatory Developments

On the regulatory front, we are optimistic about recent developments.  Under Chairman Cox’s leadership, the SEC has taken a forward-looking and global view of capital markets.  As a result, we have seen the beginnings of a dialogue between the U.S. regulators and the European regulators that has already gone much further than some people would have thought.

The SEC has made a bold move in promoting the concept of mutual recognition, whereby the SEC would recognize a non-U.S. regulator as comparable to the U.S. regulatory scheme, and thereby allow U.S. investors to trade the securities listed on foreign exchanges without requiring those securities or exchanges to be registered with the SEC; investors from recognized countries would also be offered reciprocal access to securities listed on U.S. exchanges.  This would permit more efficient trading among markets by substantially easing the complexity of cross-border trading, resulting in expanded availability of capital and increased opportunities for market participants on a global scale.

In developing a mutual recognition scheme, there are some fundamental elements that should be incorporated.  First, any mutual recognition initiative should include the College of Regulators at the outset.  The College of Regulators comprises regulatory authorities from a number of countries, including the United Kingdom’s Financial Services Authority, as well as the financial regulators of France, Belgium, the Netherlands, and Portugal.  The U.S. SEC has already laid the groundwork for recognition of these regulatory regimes through the MOU they collectively signed in January of this year.  There would be significant competitive consequences to a decision by the SEC to move forward on a mutual recognition program on a country-by-country basis.

We also believe it is important to insure that mutual recognition is accomplished in a way that permits U.S. public investors to access the global markets.  Appreciating that some limits have to be imposed, we recommend limiting the nature of the securities that can be traded by U.S. public investors, such as to well-known seasoned issuers, and diversified funds such as ETFs.  Allowing well-known, seasoned issuers to be traded on public exchanges in the U.S., based on their registration in a mutually recognized foreign jurisdiction, will best insure the continued vitality of the public markets in the U.S., and also insure U.S. public investors continued access to the deep and liquid markets they rely on.

Another aspect of regulation that is significant to exchanges' ability to evolve and compete is the regulatory process that has been historically imposed on SROs.  While this process made sense in previous decades, in today's rapidly evolving global marketplace, our ability to evolve our business model and innovate, and our ability to compete against other foreign and U.S. exchanges is hindered by the lengthy review process that all SRO rules must go through.  Foreign competitors, as well as U.S. futures exchanges, and other markets that compete with our stock exchanges, are not subject to such procedural hurdles.  We are working to modernize the specialists' role, to provide new market data products to internet providers and others, to facilitate the listing and trading of new ETFs and exchange traded investment products, along with many other initiatives to make our market stronger, more liquid, and more competitive.  Whether we succeed is largely dependent on the efficiency of a regulatory review process over which we have little control.  We are encouraged that under Chairman Cox's leadership, the Commission and staff recognize the importance of the U.S. markets' competitive position in the world and have made that a priority.

V. Conclusion

The speed of transformation of exchanges globally is remarkable.  But we are really just catching up to where many other parts of the financial services industry find themselves – including the investment banking industry.  As we, and our colleagues in this business – here at this table – seek to diversify, globalize, and modernize, the beneficiaries will continue to be the investors, entrepreneurs, and workers at the companies whose growth is driven by the engine that is our capital markets.

Again, I thank you, Mr. Chairman, Ranking Member Allard, and all the members of the Subcommittee for giving me the opportunity to speak today and I look forward to answering your questions.

 Growing 144A Deal Flow (pdf)