The city of Hannover is one of my favorite cities in Germany. A university town with about 540 thousand inhabitants, it is known for Horses and shares a lot of history with the UK since George III, the King of Great Britain, also became King of Hannover after defeating Napoleon.

On a recent stroll I stumbled across this rather impressive stock exchange building:

Hannover Stock Exchange

As the debate over the future of the London Stock Exchange rages, what can these smaller exchanges teach us?

The research has led me to three thesis:

  1. The centralization of stock trading is driven by regulation, technology and powerful network effects with the natural outcome of one global stock exchange
  2. Smaller exchanges can survive through either specialization or by being venues for buying equities listed on the larger exchanges
  3. A local economy is actually not that dependent on having a local stock exchange and there are powerful alternatives

A short history of regional stock exchanges

The early wild west

All early stock exchanges were regional exchanges since they were literally places here local businessmen would come together to trade, invest and exchange information. The earliest stock exchanges were often in coffee houses, with the first purpose built exchange opening in Antwerp in the Netherlands in 1531. Strictly speaking, those exchanges were mostly commodities exchanges, where both local and imported commodities like grain and coffee were traded. But the exchanges also served as places where merchants could buy insurance for their ships or raise money to finance a voyage. The first generation of stock exchanges were all located in european port cities and all opened in short order: Hamburg 1558, London 1566, Rotterdam 1595, Amsterdam 1611

There was, generally, little to no regulation. The local businessmen would typically self organize into boards of trade, with the blessing of the local monarch. Those boards of trade would self police, but the government would not make laws for trading.

The industrial revolution combined with the advent of global trade created more commodities to be traded (steel, coal) in bigger volumes and in places that were not traditional trading hubs. Boston got one in 1834, Chicago in 1882, Munich in 1830, Stuttgart in 1861, Shanghai in 1866 and Bombay in 1875.

When the SEC was created in 1934, it recognized 24 regulated exchanges and 19 with a temporary exception that allowed them to keep operating temporarily even though they did not meet SEC standards.

Regulation and consolidation

Fraud was rife in early stock markets and the 1929 stock market crash was a catalyst for governments to introduce national regulation. In the US, the Securities Act of 1933 regulated for the first time at a federal level the disclosure companies had to make to investors if they wanted to be listed at a stock exchange. The creation of the SEC led to minimum operating standards for stock exchanges, which led to the closure of 10 regional exchanges.

Other companies introduced similar legislation, although often more gradually. The UK for instance already had a regulated stock exchange system and merely had to strengthen the laws governing it gradually from the 1940s to 1960s.

The shift from local to national regulation was a boon for the bigger exchanges. For the first time, stock exchanges were really one single market, and what a “stock” really was became the same across states and regions.

Stock exchanges have network effects. The presence of more investors means better price discovery. Functioning price discovery attracts more investors. The presence of many investors incentivizes more companies to list. More listed companies make the stock exchange more attractive to investors.

Regional differences in regulation were a real break onto these network effects. An investor in, e.g. Milwaukee, might not be familiar with New York laws, and would prefer to invest under a regulatory regime they already knew. Federal regulation removed that barrier.

Regional stock exchanges generally had 3 strategies:

  1. Consolidation to become a bigger exchange themselves, like the San Francisco Stock and Los Angeles merging into the Pacific Exchange
  2. Trading NYSE listed stocks, basically become a local sales outlet for these stocks and free-riding on the NYSE price discovery
  3. Innovating in a niche, like Philadelphia introducing equity options in 1975

Telecommunications making geography irrelevant

There still was one powerful break constraining the network effects of stock exchanges: Information took a long time to travel and only limited amounts of information could be sent. While the telegraph already enabled sending a message around the world in minutes, it was expensive to do and it was not possible to constantly stream, e.g. the price of every single security listed all the time.

Trading itself was still done through open outcry, meaning even after the message had been sent, a human would have to go and buy the actual stock. In 1971, the NASDAQ exchange was launched as the first fully electronic stock exchange. An investor could now enter an order anywhere on the world, and it would be electronically submitted to the exchange, where it could be transacted without any human involvement.

Such a system means geography is irrelevant. An investor living in Hannover might have their order filled faster on the electronic NASDAQ in New York than on their local exchange. The last advantage of the local exchange was gone.

In 1975, the SEC created the “National Market System”, meaning there had to be one national ticker price for stocks, no matter the exchange they traded on. This meant investors who bought the same security at the same time at different exchanges could refer to the same price. In the same year, legislation abolished fixed commissions, creating price competition between the exchanges.

Electronic trading systems mean there are high fixed costs to operating an exchange but near zero marginal costs to executing a given trade. Next to network effects, the large exchanges gained the benefit of economies of scale. They could amortize the cost of the electronic systems over a much larger number of trades, which enabled them to offer lower costs to investors. An investor now had the choice to either buy a stock at their local exchange or at the New York stock exchange for the same price and executed at the same speed, but the New York exchange could offer lower trading costs.

Computers spelled the end of the regional exchange. A new wave of consolidation kicked off and by 2019 all US exchanges had consolidated into just 3 companies: NYSE, NASDAQ and CBOE.

The Hannover Stock exchange is part of BÖAG Börsen AG today, a group operating 5 regional stock exchanges. It has found niches in trading fund secondaries and enabling european investors to buy US stocks through electronic exchanges. As far as I could see, it is not a venue for a primary listing of any company.

Can you live without a local stock exchange? The story of San Francisco

In some ways, the history of the San Francisco Stock and Bond Exchange is similar to that of many other regional exchanges. Founded in 1882, it merged with the Los Angeles Oil Exchange in 1956 to create the Pacific Coast Stock Exchange. Struggling to compete, it was eventually absorbed into the NYSE and ceased operating as an independent venue in 2006. Today, its building on Pine Street hosts an Equinox Gym.

SF Stock Exchange

The unusual thing is of course that San Francisco is home to a tech industry that has born the largest listed companies ever. NVIDIA alone is worth more than the entire German Public Stock Market. New York, where all these companies are listed, has not created a single company with over $1 trillion dollars in market cap.

Despite not having a Stock Exchange, San Francisco is the center of a thriving investment industry centered around venture capital. New York has zero of the ten largest VC firms by total capital raised.

Clearly, technology investors want to invest and be in San Francisco and then list their companies in New York. If they want to buy shares in technology companies it does not matter to them that their order has to traverse a continent to be executed because it is all happening inside a computer anyhow.

The only time SFs financial elite tried to create their own stock exchange is the Long Term Stock Exchange, LTSE. With great support from top tier VC firms, LTSE was approved by the SEC in 2019. It requires its listed companies to follow a set of “long term principles” and is lobbying to abolish quarterly reporting requirements. It primarily acts as a secondary listing place and so far does not seem to have made a dent into New York’s dominance. No company seems to use it as their primary listing.

The other way SF has fought back against New York listing dominance is by just not listing. Venture capital has created deep and liquid pools for secondary sales, in which employees and early investors can sell their shares to other investors at specific times. A recent example is OpenAI selling $6.6 billion in stock to secondary investors. By defining specific times at which shares can be traded, companies can create enough liquidity for price discovery. At the same time, they keep control over who can buy or sell the shares by determining who is allowed to participate.

What can London learn from all this?

Network Effects and Economies of scale very naturally drive towards a monopoly or small oligopoly. Even a market which produces the biggest companies in the world is not immune against the immense pull of the bigger market.

The reality already today is that as an investor, it is more convenient to buy stocks on the NASDAQ than any European stock exchange. This trend only accelerates as low cost brokerages like Robinhood or e-Toro only offer US stocks on their platform because it is easier to trade there.

It seems there are only 2 options for London financial markets. European consolidation or specialization.

Option 1: Consolidation

If network effects and economies of scale are important, it makes sense to consolidate. In 2007, the London Stock Exchange Acquired Borsa Italiana and in 2019 Refinitiv, the data provider. However, it failed 3 times to merge with Deutsche Börse which would have created a true European stock exchange. Combined with more standardized European regulation for capital markets this could create a market deep enough to compete with the US.

However, the odds are stacked against this approach: First, the UK would need to align with EU financial regulation. Then, EU governments would need to agree to having all their exchanges taken over by the UK, and finally the European Comission would need to allow the creation of an oligopoly in stock exchanges like it exists in the US. Since the European Comission already blocked the 2017 LSEG and Deutsche Bank merger, that seems unlikely.

Option 2: Specialization

Chicago did not try to compete with New York in equities, but focused fully on derivatives. The Chicago Mercantile Exchange operates the largest derivatives marketplace in the world, where derivatives on commodities, currencies, stocks, crypto and pretty much anything else were traded. Chicago already had had a strong commodities market due to its geographic location. In the 1970s, when other exchanges struggled due to computerization, Chicago introduced currency futures. The timing was fortuitous, since the Bretton Woods system of fixed exchange rates collapsed around the same time. From then on, Chicago introduced futures on treasury bills, eurodollars and stock indexes in quick succession. By heavily investing into technology to make futures trading work and acquiring smaller competitors, Chicago created the network effect and economies of scale around its market.

London already has specialized markets like the London Metal Exchange, or Lloyds Insurance Market and is also the european center for currency trading. If it wants to win as a financial center, it might have to abandon equities to the US and win in other markets. The Chicago Mercantile Exchange is, after all, listed on the NASDAQ.