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Dee-Fense! Why the London and Toronto Stock Exchanges Are Merging

Three interrelated factors are driving the London Stock Exchange's billion purchase of the Toronto stock market: technology, consolidation and Asia.

Traditional exchanges such as the LSE and the Toronto bourse have for years been losing market share to new rivals, a trend greatly accelerated by the financial crisis. The rise of high-frequency trading platforms, also known as multilateral trading facilities, have proved a particular threat in siphoning away trading volume from the older exchanges. Explains The Business Insider:

HFT platforms have raised questions about the viability of big traditional exchanges in recent years because they have eaten away at their core profitability....

This exorbitant decline in market share of traditional stock exchanges hits profits and plays havoc with their cost bases and efficiency.

As a result, the 313-year-old London market's share of equity trading in the U.K. has plummeted from more than 96 percent only three years ago to roughly 55 percent today. The Toronto stock exchange has suffered a similar plunge in Canada, falling from 95 percent of the market in 2008 to 64 percent as of last year.
TMX Group, the company that owns the exchange, also has the perpetual problem of operating in the shadow of the big New York markets. That makes it hard to grow without attracting more foreign company listings and trading. It also makes the Toronto market vulnerable to being acquired by the New York Stock Exchange or even the tech-heavy Nasdaq, both of which are also struggling to expand.

The same pressures have spurred a number of exchange mergers in recent years, along with deals by traditional players to acquire alternative trading facilities. Bigger transactions in recent years include the NYSE's $10.2 billion acquisition of Dutch exchange Euronext; Nasdaq's $4 billion purchase of Nordic market operator OMX in 2008; and Chicago-based CME Group's $7.5 billion deal that year for New York's NYMEX. More recently, Russia's two largest exchanges have explored a merger in a tie-up that could eventually include Germany's Deutsche Boerse.

Beast from the East
Along with the emergence of new places to trade, the financial crisis dealt a heavy blow to U.S. and European exchanges -- and was a boon for Asia-Pacific markets. Although stock markets in Hong Kong, Tokyo and elsewhere in Asia were dented by the turmoil, they rebounded much faster than their Western peers, as investors plowed money into emerging markets. As a result, securities trading volume in Asia eclipsed levels in Europe in 2009 (click on chart below to expand).

It remains to be seen how the growth of high-frequency trading in Asia will affect key exchanges in the region. It's also premature to say that London and New York are set to lose their historical dominance as trading centers. But for now the reality for Western exchanges is clear: The center of gravity is shifting eastward. Securities trading growth in Asia-Pacific is expected to surpass growth in Europe and the U.S. for at least the next several years, according to the TowerGroup, a consulting firm:

The securities industry in the Asia-Pacific region is poised for rapid growth in the next five years. Driving the rise in securities trading are regulatory changes enabling more competition among execution venues, growing interest in Asia among Western exchanges and alternative execution venues, and institutions looking to expand operations in rapidly growing markets like India and China.
Other recent industry acquisitions underscore the point. While the LSE's deal for TMX Group values the Toronto exchange at $3.2 billion, the Singapore Exchange last fall paid far more in offering $8.4 billion for Australia's ASX.

Regulatory roadblock?
With growth stalling, market share falling and foreign competition surging, players like the London and Toronto markets have little choice but to join forces -- if Canadian regulatory authorities allow it. The Toronto exchange lists major Canadian mining companies, and concerns have previously surfaced about the country losing control of its main producers of natural resources. The merged exchange group would be the market leader in this sector, as well as a strong player in energy stocks.

U.K. mining giant BHP found that out the hard way last year when Canadian antitrust enforcers effectively blocked the company from buying a Saskatchewan-based rival, Potash, in what would've been a blockbuster deal. Another potential roadblock for the LSE is a rule in Ontario and Quebec that limits foreign ownership of the TSX Group by a single investor to 10 percent. Regulators will have to suspend that restriction for the deal to proceed.

In short, there's no guarantee this merger gets done.

Thumbnail from Flickr user Smabs Sputzer; image from Wikimedia Commons CC 3.0; chart courtesy of Hong Kong Exchanges and Clearing