Merger of BATS and Direct Edge creates the second largest US equity exchange by volume.

With volumes and margins dropping in US equity trading, it comes as no surprise that we’re seeing consolidation in the equity exchange business. And as such the newly-announced merger of BATS and Direct Edge isn’t quite shocking.

What did come as a surprise to many who looked at the deal is the fact that the combined volumes of the two firms place it squarely in the #2 position behind the NYSE, with a 21% market share of US equity trading. The NYSE is at 23%, while Nasdaq sits at 18%.

While each exchange has its own unique history, essentially BATS and Direct Edge were both set up by large banks and trading companies, looking for an alternative to the NYSE and Nasdaq stranglehold on equity trading, as well as a way to control and reduce their costs of trading. Direct Edge’s shareholders remain KCG (formed from the Getco-Knight Capital merger), Goldman Sachs, Citadel, and a group of five brokers led by JPMorgan Chase. BATS shareholders include Getco, Morgan Stanley, Credit Suisse, Nomura and Citigroup.

With volumes and margins dropping, each of BATS and Direct Edge felt the need for larger scale in order to survive and compete with the ‘big boys’, of which they are now one.

We think that there are important lessons to be learned in the forex sector from what’s happening here. Namely, that at some point volumes and margins will indeed drop, and there will be more consolidation — in both the institutional Forex ECN sector, as well as among retail forex brokers. Those who position themselves better to have access to capital will be in a better position to set the terms of consolidation, and become the eventual acquirers. As such, we expect to continue to see more (attempts at) forex industry IPOs and capital raisings, such as those we’ve seen recently by Plus500, KVB Kunlun, and FXCM.

For some good background on the BATS-Direct Exchange merger click here (NYT article).

For more on the global Forex industry see the LeapRate-Dow Jones Forex Industry Report.