(Reuters) - After three years of on-again, off-again deal talks, BATS Global Markets Inc Chief Executive Joe Ratterman and Direct Edge Holdings LLC’s Bill O’Brien met in April over lunch at a restaurant in New York’s Tribeca neighborhood.
The exchange operators, both backed by big banks and originally set up to undermine the dominance of NYSE Euronext NYX.N and Nasdaq OMX Group Inc (NDAQ.O), were feeling the same headwinds as their larger rivals.
Already razor-thin, profit margins were under further pressure amid a three-yearlong decline in stock trading as economic uncertainty relegated retail investors to the sidelines and low market volatility also hit volumes.
The solution was to combine to gain scale, cut costs and use the expanded platform and data to generate new streams of revenue. On Monday, BATS and Direct Edge said they would merge.
The deal will create the second-largest U.S. stock exchange, catapulting over Nasdaq and landing right behind New York Stock Exchange parent NYSE Euronext in terms of equity trading volumes. The deal, financial terms of which were not disclosed, will bring four exchanges under the same umbrella.
“We have four books today. We have a like-minded approach to competition. We both started for some of the same kinds of reasons.” Ratterman said in an interview. “Individually, our market data may not be as deep or broad as Nasdaq or NYSE’s current offerings, but together, we would have a much broader and much deeper coverage.”
Ratterman and other sources familiar with the deal said the two exchange operators were merging, instead of one buying the other. He declined to reveal the terms of the share exchange.
Still, for now BATS seems to have the upper hand. Ratterman will become the CEO of the combined company, which will be called BATS Global Markets and be headquartered in the Kansas City area, where BATS is currently based. O’Brien will be president. The deal is expected to close in the first half of 2014, subject to regulatory approvals.
In the past, sources familiar with the situation said Direct Edge and BATS could not agree on price. A source said last year that Direct Edge was also in talks to sell itself to TMX Group Inc, the operator of the Toronto Stock Exchange, for around $500 million.
The merger comes after a series of similar consolidation attempts in the exchange sector over the past few years, many of which failed due to regulatory opposition.
Most recently, NYSE Euronext decided to sell itself to IntercontinentalExchange (ICE.N) in a deal currently valued at around $10.6 billion. That deal, which looks set to go through, will cut NYSE’s reliance on stock trading, as it would make it a bigger player in the derivatives market, where ICE competes with CME Group Inc (CME.O).
The latest round of consolidation, however, leaves Nasdaq as the odd man out. Monday’s deal comes just days after a three-hour-long blackout of the stock exchange market last week that left CEO Robert Greifeld with yet another black eye after a high-profile glitch around Facebook Inc’s (FB.O) initial public offering last year.
Although Nasdaq has diversified away from stock trading and into technology and other corporate services to the point where it gets only about a quarter of its revenues from equities trading, the deal could still create fresh headaches for Greifeld.
Ratterman said that the combined company would consider entering the listings business, allowing companies to list their shares on its exchange, and also compete with Nasdaq and NYSE on market data offerings.
NYSE, Nasdaq and Direct Edge had already been charging fees for their proprietary trading data, which provides a steadier source of income than trading fees. Traders use the data, such as bids for shares and other market information, to create market strategies.
About 15 percent of NYSE’s $2.3 billion in revenues last year came from market data. About 21 percent of Nasdaq’s $1.7 billion in revenue was derived from its data products. BATS only began charging its U.S. clients for access to its proprietary market data as of July 1.
Ratterman also said the combined platform would give traders a cheaper venue to trade. That would further eat into the profit margins for all stock exchange operators.
ICE CEO Jeff Sprecher has been critical of a practice by U.S. stock exchanges of giving large rebates on trading fees to attract order flow, calling the practice “ridiculous.” He has said he wants to end the practice at NYSE after the takeover.
Direct Edge has been one of the most successful stock exchanges in attracting retail order flow through its discounting programs. Ratterman said he has no plans to change that.
“Jeff can talk all he wants about how he thinks the equity markets ought to change, and I hope he makes some of those crazy changes he’s thinking about to NYSE, because that will accrue to our customers big time,” Ratterman said. “I think he should try it.”
The future of BATS - former called Better Alternative Trading System and known for its technology - has been in question ever since it tried to go public on its own exchange last March under the symbol “BATS” BATS.Z. A technical glitch led to the IPO being pulled. Ratterman said there were no near-term plans to try to go public again.
Earlier this month, the company’s largest U.S. exchange, BZX, had an outage that lasted nearly an hour due to an internal network problem. The same day, in an unrelated glitch, Direct Edge was also forced to briefly stop accepting orders on its EDGX exchange for a small range of stocks.
The new company will switch all four stock exchanges - BATS and Direct Edge operate two each- on to BATS’ technology platform, in a move that is also expected to save costs and reduce complexity for customers.
BATS also runs a U.S. equity options market, as well as BATS Chi-X Europe, which is the largest pan-European equities exchange by market share and value traded.
Ratterman said BATS is looking at possible expansions in Canada and Japan. Jersey City, New Jersey-based Direct Edge has already said it plans to expand into Brazil.
BATS’ investors include Citigroup Inc (C.N), Credit Suisse Group AG CSGN.VX, trading firm KCG Holdings Inc KCG.N, and private equity firms Spectrum Equity and TA Associates.
Direct Edge is owned by a consortium, with International Securities Exchange (ISE), owned by Germany-based Deutsche Boerse AG (DB1Gn.DE), holding a 31.5 percent stake, and KCG, Citadel, and Goldman Sachs Group Inc (GS.N) each holding 19.9 percent stakes. JPMorgan Chase & Co (JPM.N) also has a position.
Reporting by John McCrank; Editing by Paritosh Bansal, Gerald E. McCormick, Lisa Von Ahn and Leslie Gevirtz