"Natural enemies" in uneasy exchange deals: expert

A trader looks up at the board on the floor of the New York Stock Exchange March 2, 2009.

NEW YORK/CHICAGO (Reuters) - Exchanges have been forced into uneasy partnerships with banks, their "natural enemies," as the balance of power in trading has shifted in recent years to a few operators in U.S. markets, an electronic trading veteran said on Friday.

Matthew Andresen, former president of execution services at Citadel Investment Group, said this consolidation of power has been most pronounced in the sharply competitive cash equities market, where traditional venues like the New York Stock Exchange and Nasdaq Stock Market battle fragmentation and struggle to earn thin margins.

The financial crisis, however, could shift the balance of power back away from banks if they are forced to run more over-the-counter products through clearinghouses and exchanges, he told the Reuters Global Exchanges and Trading Summit.

"In the wild of Wall Street, banks and exchanges are natural enemies," Andresen said in Chicago.

"Even if you can see them at the same watering hole now and again, there's no changing the fact that they are not on the same rung of the food chain, and whoever's higher is something that changes and flexes with the regulatory environment and so forth. But given the first chance, they will eat each other."

Andresen, 39, retired from hedge fund giant Citadel a year ago. He is the former CEO of Island ECN, an electronic stock market that, with a handful of peers more than 10 years ago, helped spark the current era of competition among exchanges.

Exchange operators NYSE Euronext (NYX.N) and Nasdaq OMX (NDAQ.O) have since fought an aggressive pricing and technology war with upstart venues, such as BATS and Direct Edge, run by banks, hedge funds, and other big trading firms.

As exchanges and alternative trading venues proliferated, their customers consolidated and gained strength.

The retail stock broker business, for instance, which used to support hundreds of firms all competing for the individual investor, has been remade, and is now dominated by a handful of firms such as TD Ameritrade Holding Corp AMTD.O, Charles Schwab Corp (SCHW.N) and Fidelity Investments.

At U.S. stock exchanges, just two firms -- Citadel and Knight Financial -- handle the majority of retail stock volume, and seven banks dominate the institutional trade.

"The exchanges have less power and the liquidity providers have more, and that's what's changed," Andresen said.

The banks and other providers of liquidity -- the availability of buy and sell orders in stocks -- have used their newfound power to retake the exchanges, fueling a trend toward so-called remutualization, in which exchanges sell profit-sharing stakes in their trading platforms.

NYSE Euronext recently agreed to sell stakes in its AMEX options market and its Liffe U.S. derivatives exchange, and Nasdaq OMX plans to do likewise in its majority-owned interest rate swap clearinghouse, IDCG.

Even futures exchange operators, which mostly control the clearing of their proprietary products, have remutualized non-core ventures. CME Group Inc (CME.O) and IntercontinentalExchange Inc (ICE.N) have each sold stakes in their new clearinghouses for credit default swaps, or CDS.

"We've exploded into this incredibly fat world where the barriers to entry, even to be an exchange now, are much, much lower and to operate one are trivial," Andresen said.

As banks jump into the exchange business, they are also trying to protect their profits from the vast and unregulated OTC world of derivatives trading, whose vulnerabilities have been singled out as a cause of the 2008-2009 financial crisis.

And the OTC world is perhaps the next industry that is ripe for explosive change, he said.

"The next thing that has to happen -- and we've seen a horrible object lesson in why it has to happen -- is to move the world of bilaterally cleared and settled over-the-counter derivatives to a centrally cleared exchange traded model."

The Reuters Global Exchanges and Trading Summit runs through April 1 in North America, Europe and Asia, with some 20 guests scheduled to speak.

(Reporting by Ann Saphir and Jonathan Spicer; Additional reporting by Doris Frankel; Editing by Richard Chang)