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FEDERATION OF EURO-ASIAN STOCK EXCHANGES SEMI ANNUAL REPORT OCTOBER 2005 WORLD FEDERATION OF EXCHANGES Thomas Krantz Secretary General THE SIGNIFICANCE OF THE EXCHANGE INDUSTRY At the Heart of the World Economy Since the end of the 1980s, regulated securities and derivatives exchanges have come to play a major new role in international finance. That role is qualitatively different from anything seen since World War II. Quantitatively, the markets operated by exchanges have grown to a scale unimagined before, positioning them at the heart of the world economy. This remains true despite current macroeconomic difficulties covering large parts of the world. The active confrontation of buy and sell orders on a public market determines corporate asset values in a manner that is fair and visible to all. Exchanges have made this business growth possible, and the size of their industry has changed their position within the international economy. They have done this by: • aligning their corporate strategies with the business potential • adapting the rules for trading access and listing of securities • training their staff and investing in infrastructure • boosting the commerce of finance with new telecom and computer technologies • providing stimulus for trading and improved risk management through derivatives markets • supporting pension and retirement savings schemes • participating in the reorientation of finance from bank loans into securities • promoting the increase in cross-border investment and trading This expansion in the work of regulated exchanges coincided with a trend in the late 1990s leading many bourses to switch from a business structure based on broker cooperatives with member broker/bank ownership to for-profit limited companies with outside owners. For most of the Federation’s members, business objectives changed with this new governance form. The heightened commercial feel of this industry also affected those exchanges maintaining their mutual legal form, and they have proven themselves to be successful competitors. The dynamism of these businesses is one reason for the qualitative difference in the role of exchanges in this century: the markets could not have grown in scale to the extent they did, even considering the current downturn, if their operations were not of high quality, and recognized as being the most efficient venue for listing and trading of securities and standardized derivative instruments. Exchanges are visibly identified with the commercial spirit of the times. Exchanges symbolize market capitalism. The level of their activities gives an instant short-hand summary of entire nations’ socioeconomic health. It is PAGE 28 As a social responsibility, and as an essential part of further business development, exchange managers come forward as leaders in public debates on capital markets, and to correct inaccuracies in the discussions about regulated bourses. natural that these enterprises be managed as dynamic businesses in their own right, enabling them to meet the commercial demands of the markets. The Transformed Position of Exchanges In December 1990, the World Federation of Exchanges (formerly FIBV) counted 38 members. The total market capitalization of equities listed on these bourses was US$ 9,400 billion, and the value of share trading for the year hit US$ 6,211 billion. By June 2003, the Federation had grown to 56 members. Total market capitalization had risen to US$ 25,481 billion, after reaching a high point in March 2000 of US$ 36,286 billion. The value of share trading during 2002 fell back to US$ 33,453 billion, compared to the previous year’s US$ 41,225 billion, and on an annualized basis stood at US$ 30,748 billion in June 2003. While the business environment is difficult, the charts show that the long-term growth trend of increasing public reliance on capital market financing remains intact. Like the underlying growth in the economies themselves, this upward trend remains subject to fluctuation. This long-term trend translated into: • growth in equity market capitalization over the period of 171% •growth in trading volumes of 395% •acceleration in the annual turnover velocity of shares from 66% to 121%, doubling the liquidity provided on regulated exchanges. Enhanced business profitability, privatizations, IPOs, indexes and derivative products, and cross-border trading fed this transformation. The exchanges were key actors which adapted, invested, participated and enabled this to take place. The Scale of Regulated Exchanges By all measures, the health of an exchange is vital to a market economy. As a percentage of gross domestic product, the value of equity market capitalization of Federation member exchanges varied from a low of 9% to a high of 313% at the end of 2001, the last year for which the IMF’s GDP statistics have been provided. The global average market capitalization for equities on members’ exchanges was 73% of GDP in 2001. Moreover, these assets include most of the world’s most highly prized companies. At the end of 1991, 25,980 foreign and domestic companies were listed on member exchanges. Ten years later, at the end of 2002, this number had grown to 38,333. The world’s corporations favor this source of funding, and economic theory and practice confirm the efficiency of this form of capital financing. In 1999, companies and governments raised new capital on Federation member exchanges amounting to US$ 754 billion, and this increased to US$ 896 billion in 2000 under market conditions that were becoming less favorable. The figures for fresh capital raised have dropped steeply since, to US$ 342 billion in 2001 and US$ 262 billion in 2002. But these amounts remain very significant economically. Economic reliance on exchanges is one of the key changes in finance over the last decade. Public policy makers, corporations, and the saving public have come to appreciate the importance of these figures as the historical trend remains striking. Moreover, in many parts of the world, exchange index movements have come to be integrated into the rhythm of daily life, every few minutes on the radio, at regular intervals on television, and constantly on the Internet. The capital markets have given rise to considerable expansion of the specialized printed press, too. The names of broad equity market indices are commonly recognized as being of social importance. When the market moves more than a few percent up or down, it is big national news. When exchange trading is interrupted for whatever reason, that too is major news. Clearly, a different kind of financial business has emerged on the scene. No other actor has such an affect on the public mind, and that, too, is meaningful. This heightened reliance on public capital markets has been taking place in many countries around the world, involving by far the greater part of the world’s economic life. Exchanges’ centrality to social wealth creation is established. Corporate treasurers need to factor in their ability to tap this source of cash by issuing securities, just as finance ministers try to balance national budgets with their privatizations of state-owned businesses. Public awareness of the need to invest has prompted great individual interest in equities and related exchange-traded products, too. A further benefit has been the broadening of share ownership, and with it the loosening of market forces for better corporate governance practices. Exchanges Establish Fair Rules for Efficient Markets Exchanges have a distinct, market-neutral identity within the financial services sector. They are not insurance companies, investment firms, banks, or brokerages. They operate regulated securities and derivative markets. These markets establish asset values through efficient price discovery, enabling the public to know how much companies are worth according to the latest news and economic outlook. Putting together rules, know-how and technology for transparent trading of assets worth three quarters of one year of the world’s GDP is quite a responsibility; to meet that challenge is to assist in building prosperity. Regulated securities exchanges provide
FEDERATION OF EURO-ASIAN STOCK EXCHANGES SEMI ANNUAL REPORT OCTOBER 2005 solutions by creating greater efficiencies across the public capital markets value chain, and diffusing ever more complex and better quality financial information to support the work of all actors. This essay now moves on to state some of the business questions exchange operators face. A financial market is highly sensitive to its environment; operating an exchange is a proportionately complex business. Regulation helps make the markets more efficient, but much also depends on human talent and judgment, just as is the case elsewhere in the financial services industry. Governments are profoundly involved in matters of public savings, as are the corporate issuers of securities and the investors themselves; together with them, operators of exchanges must often fine tune rules to keep this business model right. Today, the scope of this business underscores the dual, simultaneous national and international challenge that the functioning of these markets represents. For fair and transparent price discovery to occur, the business of exchanges precedes the instant of trade order execution and extends well beyond. Even if by law or custom the exchanges in every country do not operate these diverse activities directly, their involvement in them is extensive. The bundle of related businesses is what builds a coherent, secure market. The entire value chain must function smoothly, including: • writing the rules for market activity • admitting intermediaries (banks or brokers) to act on the central market • assuring the ability in-house to follow intermediaries’ positions, and so establish enforcement of market rules • admitting securities to listing • assuring on-going disclosure of corporate information • setting up adequate IT and communications systems facilities • diffusing of market information to a wide public • trading • assuring prompt and final clearing and settlement of orders • providing for securities registry, transfer agent, and depositary activities In addition to equities, Federation members conduct nearly all of the world’s on-exchange trading of government and corporate bonds, derivative instruments, investment funds, exchange-traded funds (ETFs), warrants, and convertible bonds. Also in this commercial environment, exchanges are extending further into after-trading services in search of good returns in related business fields. The Business of Running Exchanges Whether a for-profit company or a cooperative, exchanges must serve their customers and earn money to ensure business growth. This means: • improving staff operations and competency • rewriting rules as know-how, technology, products and opportunities gradually modify the market and create new challenges CONTACT INFORMATION • scaling up IT and telecommunications systems • connecting markets to ever more players • enhancing surveillance and control functions. Actors, instruments, and types of securities are growing in complexity, and trading in them interacts more intensely, often across borders. • improving the information disclosed on companies and market data • leading improvements in how corporations are governed • addressing strong national and cross-border competition • investing reserves strategically • assuring a good return on capital • organizing programs for educating users of the exchange business A growing number of exchanges have introduced the shares of their companies on the markets they operate, emphasizing at the same time the for-profit and public nature of this industry. With this mix of questions in mind, it is notable that technologies and efficiencies at exchanges have enabled them to lower unit costs throughout the 1990s and afterwards. Up until the end of 2002, total revenue growth was strong over this period at 300%, and notably lower than the 395% increase in annual trading volumes. The benefits of scale and technology were passed on to customers in lower charges to clients. Challenges for Exchange Managers There is a public good in operating an exchange, and managers certainly recognize the importance of this. Bourses are not the only segment of financial services to have this distinction. However huge the markets relative to the economy, in the end, exchanges are about running regulated businesses. On balance, one cannot have regulation without a prosperous business environment, and one cannot have a prosperous exchange without clear rules and respect for them. Intangibles matter to exchanges: their marketneutral position, and the value of their reputation for fairness and transparency in the conduct of trading. Managers do their utmost to enhance the quality of these assets, for they are commercial elements central in running the business. The question is sometimes implied that the quality aspects of the business, the assurance of regulatory services, is not entirely compatible with a for-profit environment. Yet all businesses must assume costs of quality for goods and services, whatever the industry. In many jurisdictions exchanges are subject to particular questioning on this point, while the economic scale of this industry, and the market statistics, demonstrate that market mechanisms are functioning properly. Volume growth and reduced bid-ask spreads underscore the operating efficiency of exchanges. Contact Name Mr. Thomas Krantz E-mail secretariat@world-exchanges.org Website www.world-exchanges.org The size of the exchange industry is small compared to the economic function of the markets. Including consolidated companies, Federation members at the end of 2002 employed 22 062 people, and operated off a total capital base of US$ 13.4 billion. The corporate size of exchanges is also small compared to banks, insurance companies, institutional brokerages and other investment firms. Each has key financial functions to fulfill, including in the capital markets. But given the complex work of exchanges and their centrality to economic life, their relative size often means that these managers are not sufficiently heard in public financial policy debates. The public agenda may be too keyed to issues of banking and insurance; but for successful macroeconomic management, the figures in this paper demonstrate the need for greater focus on regulated exchanges. Their success cannot be taken for granted, and the experience of bourse managers must be drawn upon and used as a key tool in devising public policies. Exchanges need independence and freedom to operate within the rules of the regulatory environment. There can be unintended consequences of too much regulation that will impede the market function. The goal to pursue, the hard balance to find, will involve unleashing the full benefit of an exchange within the set rules of the local jurisdiction, remembering that there will never be a situation of zero risk for investors or issuers, and that governments should not be aiming for that objective. That simply is not what financial markets are about, and even to imply that would give a poor sense of this business. In trying to take business off the bourse, many other financial actors criticize the central role exchanges fulfill. Some commentators underplay the competitive pressures Federation members feel as enterprises. In acting in this way, they harm to price discovery on central markets, undermining a mechanism that clearly provides a social good. Also, in some jurisdictions experimentation with market structure has led to sharp falls in trading, notable widening in bid-ask spreads, or higher costs to final clients – all of these being sure signs that the market has become less efficient. Exchange managers must be involved in regulatory planning, so that adaptation to changing commercial conditions in finance is taken into account. The investing public and listed enterprises must not be disadvantaged. As a social responsibility, and as an essential part of further business development, exchange managers come forward as leaders in public debates on capital markets, and to correct inaccuracies in the discussions about regulated bourses. Most recently, they have been strengthening rules and helping to have legislation enacted that will hold corporate leaders to higher standards. Exchange enforcement of market rules has been reinforced, too. Together these measures will renew and enhance the confidence needed between public listed enterprises and investors. PAGE 29
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