Brian Gaynor: NZX challenges Australian Goliath

Mark Weldon's move to establish an electronics communications network (ECN) in Australia is an astute and logical development for the NZX.

It demonstrates that at least one company is not raising the white flag to its Australian competitors and a number of substantial international organisations are prepared to back a New Zealand company with an attractive transtasman proposition.

This is classic David versus Goliath as the NZX is tiny both in terms of its own value and the total value of companies listed. The Australian Stock Exchange (ASX), with a market value of US$4.23 billion, is more than 45 times the size of the NZX, which has a market value of just US$90 million. At July 31, the total value of all domestic companies on the NZX was only US$35.3 billion against US$912.5 billion for the ASX.

The ASX is big and aggressive and won't concede market share to the NZX consortium without a struggle.

The NZX will establish an ECN in Australia in partnership with Citigroup, CommSec, Goldman Sachs JBWere, Macquarie Bank and Merrill Lynch. The NZX will have a 50 per cent shareholding and the rest 10 per cent each.

NZX could not have signed up better partners. Citigroup, Goldman Sachs JBWere, Macquarie Bank and Merrill Lynch are significant international financial services organisations and CommSec, a major retail-oriented investment provider, is owned by the Commonwealth Bank of Australia.

The NZX ECN is stronger than the typical David because of its consortium partners.

The proposed ECN is a new reporting system that will allow brokers to report trades outside the ASX platform. At present all trades in ASX listed shares are reported through the exchange's electronic system. The ASX charges a fee for this.

The ASX's position is protected by Market Rule 16.12, which states a trading participant must report to ASX in a trading platform the following:

(a) All sales of cash market products effected by the trading participant.

(b) All crossings and special crossings in cash market products (crossings are when a broker acts as agent for both sides of a transaction. If a broker has a buy order and an equivalent sell order, it can cross the order. This mainly occurs for large orders).

In essence, this rule has been interpreted to mean the ASX has a monopoly over the reporting of trades in Australia. The NZX and its partners believe that the rule is contestable because of the recent merger between the ASX and SFE Corporation, the Sydney Futures Exchange.

A number of Australian analysts suggest the ECN could be little more than a negotiating strategy for the 10 per cent shareholders because of the recent hike in ASX fees. These partners may be trying to scare the ASX, and if it reduces its fees they may abandon the NZX proposal.

Informed sources reject this. They believe that the NZX proposal is a serious attempt to develop a new share reporting and trading platform in Australia and the five 10 per cent shareholders are fully committed.

In essence, the ECN will be a Trade Me for Australian brokers. It will allow them to report and trade shares at a lower cost and outside the normal stock exchange trading hours.

Initially, brokers may wish only to report crossings through the ECN, but the long-term objective must be to capture a share of the ASX's regular online trading.

The consortium is in a strong position to obtain a reasonable share of Australian crossings because the five broker shareholders are estimated to have 50 per cent of this market in Australia.

The consortium should be able to attack the ASX's regular online trading market if its crossings operation is successful.

ECNs have been established in the US for a number of years with Archipelago and Instinet two of the more successful.

The Archipelago ECN was launched in January 1997 and two of its earlier partners were Goldman Sachs and Merrill Lynch, both involved with the NZX ECN. Archipelago acquired the Pacific Stock Exchange in 2000 and this year merged with the New York Stock Exchange to form NYSE Group. Archipelago shareholders received 30 per cent of the NYSE Group, which now has a sharemarket valuation of US$9.6 billion.

Instinet was founded in 1969 and became a wholly owned subsidiary of Reuters in 1987. It was listed in 2001 and merged with Nasdaq last year with Instinet shareholders receiving US$1.9 billion. At the time of the merger, the ECN was thought to have 25 per cent of Nasdaq turnover.

Although a number of North American ECNs have succeeded, the NZX consortium will have an uphill battle in Australia for a number of reasons:

* The ASX could use its political and regulatory influence to protect its position under Rule 16.12.

* The ACCC, ASIC or the Treasury may veto the proposal.

* The ASX could aggressively lower its crossings fees.

* Earlier attempts to compete against the ASX, particularly the Newcastle Stock Exchange, have not succeeded.

* ECNs have been more successful when they have been set up in opposition to floor trading facilities, whereas the ASX has a sophisticated electronic platform.

* The NZX's technology may be inferior to the ASX's.

* Other brokers, who represent 50 per cent of the market, may not support the NZX consortium.

* A number of ECN projects in Europe have been relatively unsuccessful.

Although there are a number of barriers to the NZX ECN, there is a strong possibility it will succeed, mainly because of the consortium partners. Investors appear to agree with this assessment as NZX shares rose after the announcement and ASX's share price declined.

But the ASX will not fall over. It may attack the NZX with an ECN in New Zealand, make a takeover offer for NZX or try to buy the new ECN. It will be difficult to acquire the NZX because any party wanting to go beyond 10 per cent needs Government, shareholder and board approval.

A successful ECN could also cannibalise the NZX's domestic trading, particularly in Telecom, if brokers use a lower-cost ECN in Australia for New Zealand share transactions.

The NZX is forced to look for opportunities outside its traditional areas of operation because of the small size of the domestic sharemarket.

Singapore, Ireland and New Zealand have similar populations, yet the total value of companies listed on the Singapore Stock Exchange is US$298.9 billion, the Irish Stock Exchange US$125.7 billion and the NZX only US$35.3 billion.

In terms of share trading the NZX is also relatively small, with total turnover of US$20.9 billion in 2005 compared with US$67.4 billion in Dublin and US$116.5 billion in Singapore.

The ASX's turnover was an impressive US$672.4 billion last year.

The 15 listed stock exchange companies, which are strongly earnings driven, have different objectives from broker-owned exchanges.

Mark Weldon and the NZX are constrained by the small size of the domestic sharemarket and are forced to look for alternative activities to generate earnings growth.

The Australian ECN is a positive step in this direction.

* Disclosure of interest: Brian Gaynor is an investment strategist and analyst at Milford Asset Management.