Based on technology known as electronic communications networks (ECN), these new trading platforms allow traders to bypass the big exchanges and match buy and sell orders online.

The trend has triggered a wave of consolidation among major stock exchanges around the world that is expected to gain momentum as they struggle to compete against a barrage of emboldened upstarts.

But the markets may see newcomers grab even more market share before the big boys can contain the damage.

It’s a new paradigm that has shaken the markets and toppled the established worldwide bourses from their lofty perches, changing the very nature of the securities business.

Reform Laws Create New Trading Platforms

After a deluge of complaints, federal regulators in 2007 approved new rules ordering brokers to route their trades to the cheapest exchanges, as opposed to the most convenient.  Similar regulations were enacted in Europe, as well.

Almost immediately, a number of small but sophisticated market exchanges sprang up, and the interlopers quickly began to poach business from the major players.

In the United States, the newly minted Bats Exchange, just three years old, now commands approximately 12% of all U.S. volume. In Europe, Chi-X, burst onto the scene 18 months ago, after new European regulations took effect.  Turquoise, another upstart, was launched at the start of last September.

Even Nasdaq OMX (NDAQ), which has been “floorless” – all electronic – since its inception in 1971, is busy grabbing customers from its traditonal Wall Street brethren.  Nasdaq now trades more New York Stock Exchange listed stocks daily than the Big Board itself.

And even though they are just starting to gain traction in Europe, the latest data suggests the smallfries have been taking big pieces of market share, particularly from the London Stock Exchange.

“People used to talk about each stock having a principal exchange,” Daniel Mathisson, managing director in charge of a Credit Suisse Group AG (CS) division that uses computers to direct trades to the lowest-cost exchange, told Forbes.com.  “Now the trading’s going all over the place, and there is nothing to stop that trend.”

These new competitors grab market share by harnessing the fastest computers in the business. They’re stealing large chunks of business from established exchanges by offering quicker, cheaper trades and innovative pricing.

The inability of humans to react quickly enough to compete is borne out by the fact that   computers now account for 50% of all trading volume, Forbes Magazinereports.

“The main rationale behind this has always been higher cost efficacy and reducing IT costs,” said Merck Finck analyst Konrad Becker. “Stock exchanges are more or less like IT companies and their main role is to develop IT systems that are secure, reliable and operate a huge number of deals from different regulatory platforms, which is very expensive,” he told Forbes.com.

Diving into Dark Pools

Another way the ECNs are luring traders in is with the exotic nature of the trading tools they offer. Turquoise, for instance, offers a trading platform incorporating “dark pool” trading.

By allowing traders to operate anonymously, dark pools keep other market participants in the dark about what they’re buying and selling. The new exchanges are doing about 7% of their volume in dark pools, according to Tabb Group, a Westborough, Mass. market researcher

Some ECNs also up the ante by paying traders to provide greater numbers of limit orders – buying or selling a stock at a committed price – which attracts increased numbers of  sellers.

This entices “black box” traders who use computer programs to buy and sell stocks in milliseconds – often for a tiny loss.  They turn a profit from so-called “liquidity rebates” – usually 20 cents or so on 100 shares.  These kinds of rebates are now ingrained on big U.S. exchanges.

Big Bourses Pin Hopes on Mergers

In order to compete, the big exchanges have been moving to combine operations to lower costs and grab some of the new technology:

• In March 2007, the first transatlantic stock market was created when the New York Stock Exchange won control of pan-European market operator Euronext, linking trading platforms in New York, Paris, Brussels, Amsterdam and Lisbon, as well as the Liffe financial futures market in London.

• On July 9th 2007, the Chicago Mercantile Exchange and the Chicago Board of Trade merged the two companies to form CME Group Inc. (CME), consolidating most of the futures and commodities markets into one exchange.

• Nasdaq recently paid $935 million for Instinet, one of the largest electronic exchange operators, mostly to get the Island trading engine, an especially fast and inexpensive trading technology.  Nasdaq also bought Stockholm OMX, to increase trading of securites and derivatives in northern Europe.

“The more volume they can get on one platform, the better for exchanges, so all the mergers make sense,” said Octavio Marenzi, chief executive of Celent, a consulting firm.
But recent merger talks between Deutsche Börse (PINK: DBOEY) and NYSE Euronext broke down on December 12th over regulatory and valuation concerns.

A merger between the two would have represented a serious challenge to CME Group, the leading derivatives market. The New York Stock Exchange, Euronext and Deutsche Börse combined handled 2.5 trillion trades in 2007, overtaking CME’s 2.25 trillion trades, the International Herald Tribune reported.

The merger was an attempt by Deutsche Börse to reduce its cost structure. The German exchange’s cost per trade was about 31 cents in 2007 – 35 times more than the CME and 12 times higher than the NYSE, according to a study by Celent. Thanks to the Euronext deal, NYSE saw its cost-to-income ratio drop to 49% in 2007 from 75.7% in 2006.

If Deutsche Börse acquired NYSE Euronext, the combined entity would account for 95% of all European exchange-traded derivatives, creating antitrust issues. A foreign company buying a landmark like the Big Board would almost certainly raise hackles in Washington.

But even though the talks ended with no result, it seems inevitable the two exchanges will have to make cross-border mergers to contain costs.  The new exchanges are simply taking too much market share to ignore.

“I’d definitely say the ECNs are winning, says William Lupien, who founded the Instinet trading system. “Things happen awfully fast once you reach the tipping point. We’re now at the tipping point.”

The Big Board To Watch

One place to look for a possible profit angle on the shift in trading platforms might be an old standby.  Nasdaq OMX has shown itself to be a particularly nimble participant in the new trading world.

Besides the Instinet and Stockholm acquisitions, the company recently bought the Boston and Philadelphia exchanges to increase trading of options, interest rate swaps and other derivatives. Nasdaq is trying to push more transactions onto its superfast, supercheap servers before its competitors can catch up, Forbes reported.

“As you add scale, your incremental cost goes to zero,” says Robert Greifeld, Nasdaq’s CEO since 2003.  “Our goal is to add more incremental trades at zero cost.”

The company handles about one-third of total U.S. equity trading, and takes in $800,000 in fees, on a typical two billion share day.

Thanks to its savvy dealmaking, revenue has quadrupled since 2004 to $3.3 billion, while earnings skyrocketed from $11 million to $362 million. The shares are down 50% since January 2008, trading at $26 or 13 times earnings.

Source: Upstarts Have Big Bourses Feeling the Urge to Merge

That doesn’t leave members of the central bank’s policymaking Federal Open Market Committee (FOMC) much room to maneuver. Still, the policymakers may have more ammunition in their arsenal and the statement that accompanies the rate decision at the end of the two-day session could shed some insight on the “creative” actions the Fed could consider in addition to rate cuts (For instance, the central bank could extend the new investment firm discount window, offer additional loan guarantees, or utilize any number of other tools).

And the Fed may well have to use those other tools. As Japan’s “Lost Decade” demonstrated, “zero” interest rates won’t necessarily jump-start an economy – especially when interest rates weren’t really the problem. And as several Money Morning investigative pieces have demonstrated, the low interest rates aren’t necessarily inducing banks to lend. Indeed, many banks are using the federal bailout money to finance buyout deals.

The ministers of the Organization of the Petroleum Exporting Countries (OPEC) will meet in Algeria on Wednesday and President Chakib Khelil implied that a surprisingly sizable production cut is in the cards.  While OPEC controls about 40% of the world’s oil supplies, energy analysts hold more stock in actions rather than words. Said one of those analysts: “You can announce all the cuts you want. Compliance is the key.”

Market Matters

In a major story last week, Bank of America Corp. (BAC) may be eliminating 35,000 jobs as it adds Merrill Lynch & Co. Inc. (MER) to its ever-growing list of subsidiary companies.

But in an even bigger story, Wall Street powerbroker, Bernard Madoff stole the headlines (and about $50 billion from investors in the process).  This former chairman of the Nasdaq Stock Market Inc. (NDAQ) ASDAQ was arrested for committing perhaps the largest investor fraud in history (Enron may be off the hook) as Bernard L Madoff Investment Securities LLC appears to have been “basically a giant Ponzi scheme” (his own words).  Though the client list seemed relatively small, at first, the implications will be quite widespread, as some of the largest hedge funds of funds participated in Madoff’s investments; their clients include some of the world’s (formerly) wealthiest folks.  Additionally, regulators will have quite a few questions to answer as lax oversight failed to uncover this massive fraud that may have been perpetrated for years.  Stay tuned – this one isn’t going away any time soon.

In “lighter” news, the U.S. House of Representative passed a “preliminary” auto bailout package that would provide $14 billion to the Big Three – Ford Motor Co. (F) may not need any for now – and create a new car czar to oversee an industry restructuring.  While Wall Street initially hailed the move as a positive step to a necessary overhaul, the Senate demanded greater concessions from auto unions and the bill became basically “dead on arrival.”  Since the U.S. Treasury Department appears to be growing more comfortable with the bailout concept with each passing day, Bush administration officials implied that aid via the $700 billion Troubled Assets Relief Program (TARP) would be forthcoming even without Senate approval. By the way, an oversight committee gave the financial bailout a rather poor initial report card, claiming a lack of transparency in terms of how dollars are being spent and whether recipients are complying with government intentions (no wonder the automakers want to participate as well).

Elsewhere, Merrill’s John A. Thain reversed an earlier position by “choosing” to forgo his 2008 bonus and Morgan Stanley’s (MS) John J. Mack quickly followed suit.  The Dow Chemical Co. (DOW), Sony Corp. (ADR: SNE), and 3M Corp. (MMM) joined BofA and others in announcing sizable job cuts.  FedEx Corp. (FDX) and The Procter & Gamble Co. (PG) reduced prior outlooks and sales projections.

Oil prices fluctuated greatly as traders weighed contrasting supply/demand reports:

• The Energy Information Administration expects weak demand to result in declining consumption through 2009 even as significant production cuts could be announced at the upcoming OPEC meeting.
• With oil trading below $47 a barrel, Goldman Sachs Group Inc. (GS) (of “we’re going to $200/barrel fame”) contradicted past forecasts by claiming prices could fall to $30 (and lost some credibility in the process).

Stocks reacted favorably to rumors of President-elect Barack Obama’s $500+ billion stimulus package (see below) and the apparent progress with automaker negotiations.  As the week moved on, reports of new job losses and more financial woes halted the brief optimism and the Senate’s inability to pass an auto bill brought more excessive volatility.  A “flight-to-quality” sentiment contributed to yields on 3-month T-bills dipping to 0.0% (that’s ZERO percent … talk about risk averse).

Economically Speaking

“I am absolutely confident that if we take the right steps over the coming months, that not only can we get the economy back on track, but we can emerge leaner, meaner and ultimately more competitive and more prosperous.”

Somehow an economic stimulus plan which directs $500+ billion into new FDR-like public works programs to increase employment does not necessarily imply “leaner and meaner.”  Still, many analysts believe the Obama plan (still in its infancy) may be just the tonic needed to jumpstart the economy.

Meanwhile, the European Union announced its own $200 billion package as the 27 member countries struggle with global recession.  Not to be outdone, Japan revealed some sizable stimulus measures of its own late in the week.  With the recession already pushing a year in duration, Duke University released results of its Global Business Outlook Survey which showed that 60% of domestic CFOs believe the downturn will last until the 4th quarter of next year – and perhaps longer. Similarly, a
Wall Street Journal forecasting survey predicted four straight quarters of negative growth as measured by gross domestic product, or GDP, the longest period of economic contraction since the Great Depression.

A light week on the economic calendar ended with a couple of major reports that gave the Fed a bit more anecdotal material to (over-)analyze prior to the FOMC meeting today and tomorrow. With claims for unemployment benefits soaring to their highest level since November 1982, Federal Reserve Chairman Ben S. Bernanke and friends must make job creation among their top priorities.  November retail sales fell by 1.8% as automakers reported their worst level of monthly activity in 26 years.

Still, the decline was less than Wall Street expected, leading Morgan Stanley’s analysts to speculate about future downward revisions.  Wholesale inflation (as measured by the producer price index, or PPI) declined by 2.2% as gasoline prices plummeted by 25% in November.  Normally, consumers would welcome such news and gladly spend those savings from the pumps at the malls during the holidays.  Instead economists continue to spread more “gloom and doom” by suggesting consumers may hoard their savings and resist spending amid these uncertain times.

Weekly Economic Calendar

Source: Fed May Cut Rates Again as Policymakers Meet

But emerging market IPOs have flourished, accounting for 70% of the total value of public offerings worldwide since April 1.

Globally, the number of IPOs during the second quarter fell by 56% to 205, while the amount of money raised through IPOs fell 64% to $31.5 billion, according to data from Dealogic.

However, that steep decline was largely the result of a collapse in more advanced, Western economies.

The number of deals in Europe, 66, was down 57% from the same period in 2007. The number of IPOs in North Asia, excluding Japan, toppled 37%, from 59 to 37. And the United States suffered the most, with U.S.-listed IPOs dropping 80%, from 56 offerings last year, to just 11.

For the first time since 1978 there were no IPOs for companies with venture capital financing, the National Venture Capital Association reported (NVCA). If the second half of 2008 matches the first half, there will only be 10 venture-backed IPOs this year, less than half the 2002 total.

About 81% of 660 financiers surveyed by NVCA said they do not see the IPO window opening until next year.

The difference between now and then is that in 2007, investment bankers could take a company that just turned profitable public. But in a bear market, investors are more skeptical, and private companies that don’t want to see stock valuations plummet as soon as they’re listed are far more timid.

Through June, 333 companies went public globally, down from 702 last year, according to Bloomberg data. The $73.2 billion those IPOs generated was a 41% decline from 2007. At least 166 companies withdrew or postponed their initial public offerings in the that time, more than double the amount in the first half of 2007. And roughly a third of those were U.S. companies.

But it’s been a different story in emerging markets where IPOs are taking in the lion’s share of the cash floating around the world’s equity markets.

Emerging Market IPOs Pick Up the Slack

Emerging markets have accounted for 70% of the value of global initial public offerings since April 1, compared with 45% over the same period last year, the Financial Times reported.

The number of emerging market IPOs dropped by 45% in the second quarter, but that compares favorably with a 65% drop in IPO issuance in the developed world.

“IPOs will continue for companies in growth sectors and markets,” Michael Lavell, co-head of capital markets at Citigroup Inc. (C) told the FT. “In many emerging markets, the economies are still expanding rapidly, as are the earnings for the companies based there. This is why the majority of IPOs this year are coming from the emerging markets.”

OGX Petroleo e Gas Participacoes SA, a Brazilian oil and gas company, was the biggest emerging market offering this year, raising $4.1 billion in its June debut. India’s Reliance Power Ltd. and China Railway Construction (PINK: CWYCF) also weathered difficult market conditions to wage successful IPOs, raising $2.6 billion and $2.4 billion respectively.

The Middle East, flush with petrodollars and a robust 8% gross domestic product (GDP) growth rate also added fuel to a fledging IPO market and looks poised to continue.

“There were 52 IPOs during 2007 and in the first half of 2008 there have been 26,” Azhar Zafar, head of mergers and acquisitions at Ernst & Young Middle East, told Gulf News. “The total capital raised in the first half of 2008 amounted to $8.69 billion compared to $4.83 billion from 33 IPOs during the same period last year,” Zafar said.

Indeed, there has been an undeniable upsurge in emerging market IPOs, but what is most amazing is that Asia, and China in particular, has been largely absent from the picture.

That’s because the credit crunch and turbulent markets in the developed world has had a negative impact on Asia, which, unlike Latin America and the Middle East, has been unable to rely on the strength of commodities for growth.

“Asian IPOs have almost reached a standstill,” Leslie Phang, the Singapore-based head of investments at private client unit of Schroders PLC, told Reuters. “Issuers are unwilling to launch at lowered valuations and investors are more focused on reducing their equity positions.”

Of course, that may be about to change.

A Possible China Turnaround

The problem is not a shortage of Chinese companies looking to go public. The problem is that the companies that do are concerned their stock won’t be fairly priced by an apprehensive market.

“The big issue is whether they will attract proceeds at the pricing levels they are looking for and it’s a bit of a disconnect right now between what people think they can get in terms of pricing and what investors are willing to pay for these companies,” Eric Landheer, head of Asia Pacific for Nasdaq OMX Group Inc. (NDAQ), told Reuters.

“We could see a flurry of [Chinese listings] in the fourth quarter should market conditions improve,” Landheer said.

Market turmoil has forced about 35 companies in the Asia Pacific region, Japan excluded, to withdraw plans to raise approximately $20 billion in offerings this year, according to Thomson Reuters data.

If market conditions improve, we could see a rush of Chinese IPOs coming off the sidelines to take advantage of a more bullish market.

“If we had just a little more stability, I think we’d be seeing more IPOs from China. But they are being challenged by some of the same issues as domestic companies. They’re afraid to go out in an environment where pricing fluctuates significantly from week to week,” says Scott Gehsmann, a global capital-markets partner at PriceWaterhouseCoopers.

Last year, a record 31 Chinese companies raised $6.8 billion through U.S. listings, but yesterday (Wednesday), China Distance Education Holdings Ltd. (ADR: DL) and China Mass Media International Advertising Corp. (ADR: CMM) became the first Chinese companies to list on a U.S. exchange since ATA Inc. (ADR: ATAI) was debuted in January.

If China Distance and China Mass Media succeed, they could instill some confidence in other wary companies, as well as restore some much needed investor confidence. Unfortunately, it will take time to gauge their success. ATA dropped 8% during its first day of trading but has since recovered and is up more than 50% from its initial price of $9.50.

Source: IPOs Dry Up in Developed World but Emerging Markets Show Promise