The new trading landscape

Maple Group, which also has acquired Alpha for $175 million and CDS for $167.5 million, is to be renamed TMX Group Ltd. once the share exchange is complete.

Slightly more than 26% of the new TMX’s shares will remain in public hands, several pension funds will have 38.2% control, four of the bank-owned investment dealers will own a collective 28.1% (RBC Capital Markets and BMO Capital Markets are not included) and the other Maple Group consortium members will hold the remaining 7.5%. The new firm will carry $1.5 billion in debt, to be financed by a lending syndicate composed of the four banks that are participants in Maple Group.

That debt is expected to weigh heavily on the new TMX’s initial valuation. Another big challenge the merged company faces include the unsettled stock market environment – in the second quarter of 2012, trading volumes were down by 25% vs a year ago, according to the latest data from the Investment Industry Regulatory Organization of Canada (IIROC). The merged entity also must deal with restrictions placed on the deal to satisfy regulators that the public interest won’t be harmed.

Maple Group has agreed to conditions designed to ensure that investment industry competition isn’t hurt, market access is preserved and innovation is not stifled. Some of the restrictions also serve more parochial interests, such as forcing the new firm to keep certain operations in particular cities – derivatives trading in Montreal, and the venture-capital business in Vancouver.

While these restrictions may be justified from the regulators’ point of view, they also naturally impede the merged company’s ability to wring all of the possible value out of the deal. The restrictions may mean that expenses can’t be cut as severely as they could, and the firm won’t be able to exploit its overwhelming market power fully.

For example, in a research report on the new TMX, GMP Securities LP analyst Stephen Boland calls the pricing restrictions imposed by regulators “exhaustive” and suggests that this entails regulatory costs that will be higher than expected when the deal was first announced.

Along with conditions to deal with governance and ownership restrictions, regulators also: have the power of approval over exchange fees and internal cost allocations; are imposing restrictions on the sort of discounts or incentives the exchange can offer, to ensure fairness; and are prohibiting order-routing incentives.

In approving the acquisition of CDS – which essentially creates a for-profit monopoly in the clearing business – the new TMX must, among other things: maintain a planned 29% fee reduction for 2012; pay rebates to its users to reflect expected cost savings, whether they are achieved or not, starting at $2.75 million in fiscal 2013 and rising to $4 million by fiscal 2016; and share any revenue increases equally with its users. The clearing division also is required to charge the same rates to all users.

All this serves to dampen some of the financial appeal of the deal, and suggests that the new TMX will be constrained strategically. “Although it is not explicitly stated in all the regulatory documents,” notes the GMP report, “we do not believe that TMX will be in a position to regain the market share lost prior to the arrival of Alpha.”

The new firm already has the dominant market share. Simply combining the market shares of TMX and Alpha, based on IIROC data for the second quarter of 2012, indicates the combined firm accounts for about 82% of equities trading by value.

So, in acquiring Alpha, Maple Group has taken out its biggest challenger in the trading business – Alpha had an 18.5% market share, according to IIROC’s stats.

Even if the larger, stronger TMX is constrained on the domestic front, it should be better armed to seek growth in other markets. That said, the integration of Alpha and CDS is expected to take some time, so some of the more strategic benefits of the transaction aren’t likely to be realized overnight.

At the same time, regulators have promised to exercise enhanced oversight of the new firm – and some of the deal’s critics have questioned whether regulators are equipped to deliver on that promise.

The Ontario Securities Commission (OSC) acknowledges this criticism in its recognition order approving the deal, and says it’s looking at its capacity to oversee the new TMX, which is likely to require additional expertise.

“We already carry out oversight of exchanges and clearing agencies in a number of areas,” notes Susan Greenglass, director of market regulation at the OSC, “including governance, conflicts of interest and ongoing operations. This oversight will evolve and change along with the market in order to ensure the appropriate regulation to protect the public interest.”

For one, the OSC is going to have a much bigger job overseeing fees charged by TMX. Historically, regulators have been reluctant to get into the business of regulating fees. Now, however, by allowing a near-monopoly, they have put themselves in a position in which they must have a role in overseeing things such as trading, listing, clearing and market data fees.

In addition to requiring TMX to seek approval to change its existing fees, the regulators also are going to be looking at the fairness of those fees.

The industry has been complaining about the ever-rising cost of market data for a couple of years now, calling on regulators to intervene. The Investment Industry Association of Canada (IIAC), which has been championing regulatory intervention to restrain data costs, had published a study in 2010 that concluded that dealers are paying excessive prices for market data. The IIAC report had proposed that prices be cut by 40%.

While the OSC has sidestepped that subject as part of its approval for the Maple Group deal – declaring that market data pricing and trading fee models raise issues beyond the question of whether to approve the transaction – the OSC is promising to study trading fee models, including the use of structures designed to appeal to high-frequency traders in particular. The OSC plans to publish a consultation paper on data pricing, likely in the autumn.

There are other challenges facing the regulators. Not only are they expanding their oversight responsibilities and taking on a much bigger role in fee regulation, they also must figure out how to co-ordinate supervision of CDS among the various members of the Canadian Securities Administrators. And there are issues raised by the transaction, such as listings conflicts, that have yet to be seriously addressed.

Having allowed the Canadian trading business to be consolidated and vertically integrated under the control of a few large financial services players, it is particularly important that the regulators now follow through on their promises of enhanced oversight.

To drive that point home, the IIAC is setting up an advisory committee to monitor the implementation of the conditions that regulators have placed on the acquisition. The IIAC indicates that its members are particularly concerned about four major areas: market data fees; fairness in trading fees, access and costs; fairness of clearing fees and access to clearing services; and, the regulatory infrastructure that is needed to provide enhanced oversight.

So, while the acquisition deal itself may finally be complete, the restructuring of the trading landscape really is just getting started. There is much for the new TMX to do to make this deal work amid the myriad restrictions it has been saddled with.

At the same time, there is even greater pressure on regulators to prove that they can safeguard the public interest in the face of this powerful new force.

If the new TMX stumbles, it’s only its shareholders that suffer. If the regulators fail, the rest of the industry, investors and the economy at large may feel it. IE

© 2012 Investment Executive. All rights reserved.