Rapid Consolidation of Private Exchanges: Innovation Speeding Collaboration

The private exchange wave. It was kicked off by Goldman Sachs through its flotation of Oaktree on GSTrUE. It was then joined by a few individual firms, and finally by a consortium of Wall Street behemoths called Opus-5. And now they are joining together to support a common platform, Nasdaq’s Portal system. From today’s Wall Street Journal:

A dozen Wall Street firms have decided to drop their competing trading
systems for the unregistered securities known as 144a offerings and
cooperate on a single platform operated by Nasdaq Stock Market Inc.

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In recent months, investment banks built competing off-exchange markets
for these 144a transactions, or sales of securities from companies that
seek to raise money without the scrutiny and regulatory burdens of
going public. The sales are open only to large, qualified investors,
such as mutual funds and hedge funds. The systems ranged from Goldman Sachs Group Inc.’s GS TrUE to Opus 5, from an alliance of eight big investment banks.

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By using a single system operated by Nasdaq, investors in these
instruments will congregate at the same site, which should result in a
more-liquid market. Although making the market more transparent will
result in lower trading profits for investment banks, increased volume
is expected to offset smaller trading spreads.

This move is both highly rational and entirely expected, as a series of fragmented exchanges would be highly inefficient and bound to consolidate over time. I made this observation around six months ago as the private exchange wave was just getting started. From IA 05/19/2007:

If GSTrUE is successful, as I expect it will be, is there any doubt that Morgan
Stanley and the like are close behind? And with the great leap forward in low
latency trading technology, what is stopping a flow aggregator like Nasdaq or
any ECN from pooling the deals originated on these private exchanges and
enabling them to be traded more broadly? In fact, I am almost certain that this
is how it will play out.

By doing this with Nasdaq, the group is getting institutional credibility, the imprimatur of a public exchange and access to a larger pool of liquidity. And it plays on the growing theme of high-quality, institutional issuers avoiding the US public markets in order to raise capital without the hassle of Sarbox. Today’s WSJ article raised the shocking statistics about the extent of private issuance, the same theme I had written about in May’s post:

The 144a market is enormous — last year, the total capital raised
through such deals was greater than the amount raised on the American
Stock Exchange, the Nasdaq and the New York Stock Exchange combined,
according to Nasdaq. The unregistered 144a securities are limited to
qualified buyers because the companies don’t have to follow
Sarbanes-Oxley reporting requirements or GAAP accounting standards.

Here were my key take-aways from that post:

So, to recap, if:

• You have a massive pool of institutional liqudity in need of high-quality product; AND

• You have a sea of high-quality companies that would like
  liquidity but are put off by the regulatory demands of going public in
  the U.S.; AND

• You have innovative investment banks structuring these early
  deals between high-quality issuers and high-quality, leading-edge
  investors willing to buy a new and untested product; AND

• You have ECNs with capacity that can pool flow across these
  private exchanges and centralize trading, clearing and settlement in
  order to broadly and efficiently distribute product; THEN

• You get a withering U.S. new issues market that will slowly and inexorably die on the vine.

I think this is the way things are turning out. The only thing I find shocking is the speed with which fierce competitors have banded together to do the right thing for issuers and investors alike. Sometimes the private sector can, all on its own, get to the right answer, and fast. And this is clearly one of those times.