John Gapper on exchanges
In yesterday’s FT, John Gapper writes ‘An art lesson for stock exchanges’ (behind the paywall) comparing the fortunes of the two main art auction houses (Sotheby’s and Christie’s) with that of stock exchanges:
The things-are-different-this-time argument goes as follows. Auction houses used to depend on a small group of buyers from a few countries who collected a narrow segment of art. Now that their revenues have diversified…they are less vulnerable to a catastrophic blow from one financial event.
In a crisis, however, markets are more correlated than it seems in the good times. [...] A mishap that caused a plunge in stock markets and the collapse of several hedge funds could easily sap demand not merely from New Yorkers for modern and Impressionist art but from many buyers for all kinds of things.
That goes in spades for exchanges, which rely on rising trading volumes to maintain their high valuations. A dislocation in financial markets would cause a lot of frantic activity in the short-term, which would be good for futures and options exchanges. After that, exchanges would have to adjust to slower times than they have been enjoying in recent years.
This does not mean that exchanges are likely to go out of business. But they are subject to the same swings in fortune as auction houses. Nobody would have made money by betting against the growth of capitalism and asset trading in the past three decades but it has been a bumpy ride before and it will be so again.
I like this article, especially as it touches on a subject that regular Park Paradigm readers will recognize as a central interest for me – ie the similarities between markets and exchanges accross assets or products. However, I disagree with his final implication – ie that a significant market dislocation would negatively impact trading volumes in the medium term. Intuitively I would agree that this is probably true for the art market (or housing market) where transaction volumes have historically been positively correlated with price movements.
However for assets like stocks (or fx or commodities) which have more liquid, higher velocity trading patterns, I don’t think this correlation applies, or if it does it is very much secondary to strong secular increases in trading volume. If you look at the LSE’s own historical data, the number of bargains per day in UK equities has increased consistently every year from 37k in 1994 to 212k in 2004 – approximately a 20% CAGR, and this through a period that included massive price volatility. In the previous 20 years the CAGR was closer to 5%, so clearly there has been a fundamental change. I think this underlying driver of this change has been the rise of automated and electronic trading. I suspect that you would find a similar pattern of accelerating volume growth accross most if not all financial exchanges.
I’m not suggesting that it would be prudent or appropriate to extrapolate this 20% or greater CAGR in trading volume into perpetuity, however I think that the convential wisdom (or sceptical wisdom) underestimates the potential for this growth to continue and perhaps even accelerate over the next several years. I think the more salient risk factor one needs to consider when looking at the prospects for exchange businesses is the degree of sustainability of pricing or margins as volumes grow and the entry-barriers for competitive alternative trading venues to emerge.
(As an aside would love to see John author a blog, I think he would garner very interesting discussions around his views as they are usally topical and with an interesting perspective.)
