Together, BATS and Direct Edge Look to Take On NYSE

Stock Exchange

U.S regulators are examining Tuesday’s computer system malfunction at Goldman Sachs (NYSE:GS) as part of an investigation into a larger issue: The number of recent high-profile trading failures that have damaged investor confidence. Sources told the Financial Times last week that Securities and Exchange Commission officials are preparing to conduct meetings regarding the latest incident, worried that market participants are racing to develop speedier computer systems at the expense of safety controls.

While the trend toward larger, speedier, and more technologically advanced trading systems has concerned the SEC, it also has prompted industrywide consolidation. Announced before the markets opened Monday, a merger agreement between the electronic exchanges BATS Global Markets and Direct Edge is only the most recent example. As a single unit, they will be the second-largest stock exchange in the United States behind NYSE Euronext’s (NYSE:NYX) New York Stock Exchange.

No financial information was released, but the deal is expected to close in the first six months of 2014, pending any regulatory approval. That the details of the merger were few is no surprise: as The New York Times reported, there was a great deal of secrecy surrounding the negotiations.

When the chief executives of the exchanges met several weeks ago in Kansas City, Missouri, code names were used to refer to the two companies — “Delta” for Direct Edge and “Blue” for “BATS.” The reason for the secrecy is clear in the merger’s goal: To displace the New York Stock Exchange and the Nasdaq OMX Group-operated (NASDAQ:NDAQ) exchange as the largest stock markets in the world.

“It pretty much guarantees you’re going to have a significant force to be reckoned with in the global exchange place for decades to come,” Direct Edge CEO William O’Brien told the Times in a phone interview. The quest to become a “significant force” has guided many deals made by exchange operators in recent years. In 2012, the IntercontinentalExchange (NYSE:ICE) agreed to buy NYSE Euronext for $8.2 billion, while the parent company of the Hong Kong Stock Exchange paid more than $2 billion to buy the 136-year-old London Metal Exchange.

As with most industries, changing technology has left an indelible mark on the way business is conducted in the stock market world. Advancements in technology have generated seismic changes in the world of stock trading. Both BATS and Direct Edge were launched to capitalize on the new, high-speed trading. Both firms have maintained profitability in that environment, and their CEOs believe that a merger can make them better able to compete against older rivals. Already, the new company will surpass the Nasdaq in size.

“Our competitors have lost the ability to be as efficient as we are,” BATS Chief Executive Officer Joe Ratterman told the Times.

In the past month, exchanges operated by NYSE Euronext hosted close to 22.5 percent of all stock trading, and the Nasdaq’s markets serviced 17.5 percent. In comparison, BATS and Direct Edge together drew in 20.5 percent of all trading, according to figures compiled by BATS, which are used throughout the industry.

Stock markets are also suffering from shrinking profits, brought on by a sharp drop in volume that was partly the result of the market exodus, which followed the 2008-2009 financial crisis. That environment also influenced the deal between Euronext and ICE. The influence of the New York Stock Exchange is diminishing: The Big Board, once the benchmark for global free markets, has seen its share of trading in stocks listed on the exchange decline to 22.5 percent from 82 percent in recent years.

The merger was designed to bring together two “customer-focused securities exchange operators” to boost innovation and better serve investors. “This agreement is an important milestone for the U.S. equities market and other markets around the globe as it will combine two organizations that have been innovative in creating a more competitive marketplace to benefit all investors,” Ratterman said in the press release announcing the merger. Ritterman will remain chief executive of the new securities exchange — BATS Global Markets — while current Direct Edge CEO O’Brien will be its president.

While both the parent companies of both the Nasdaq and the New York Stock Exchange are publicly traded, the new BATS Global Markets is expected to remain private for some time.

Both BATS and Direct Edge currently run two exchanges, and they will continue to do so after the merger, as each of the four exchanges serves a different type of client. “Together, the best of both organizations will work to further improve how the world trades, consumes market data, and accesses capital markets,” O’Brien said in the press release.

But because all all four exchanges will keep operating, Themis Trading’s Joe Saluzzi told USA Today that the merger “does nothing to reduce market fragmentation, which is the No. 1 problem with our market structure today.”

Follow Meghan on Twitter @MFoley_WSCS

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