Vision 2015, the ambitious agenda to unite the economies of ASEAN,¹ could create enormous wealth for enterprises, investors, and, ultimately, the people of Southeast Asia. But the obstacles are considerable, not least for the region’s financial exchanges.

Against all odds and predictions, leading players in Europe and the United States have created an elite class of rapidly growing global exchanges forged through cross-border mergers, acquisitions, and alliances. For the first time, mergers of exchanges across national boundaries are becoming a reality, leading to ever-greater economies of scale. In contrast, the independent exchanges of Southeast Asia, with their lower liquidity and subscale trading and clearing facilities, face a serious risk of being left behind.

Adding to the pressure, a number of alternative trading venues, such as Project Turquoise (in Europe) and the Boston Equities Exchange (in the United States) have recently been formed by brokers attempting to “remutualize” trading and thereby compel existing exchanges to hold down their pricing and improve market access. New regulations in Europe and the United States are helping these alternative platforms compete, so incumbent exchanges will have to respond by adapting.

In the short term, thanks to favorable domestic regulations and the natural pooling effect of domestic liquidity, the immediate threat to Southeast Asia’s exchanges is limited. However, the longer-term threat is very real, and once clear warning signs appear—for example, when liquidity starts to decline—it may be too late. Several smaller exchanges in Europe, Latin America, and the United States have declined or failed as a result of their complacency. Action is needed now to ensure that the exchanges of Southeast Asia remain relevant during the next decade.

The heart of the problem is the lack of depth and global scale in Southeast Asia’s capital markets. While Malaysia and Singapore have relatively deep ones, the domestic capitalization of their counterparts in Indonesia, the Philippines, and Thailand is substantially below GDP. In many developed economies it is typically 1.5 times GDP or more.

Low turnover, or the rate at which shares are traded, compounds the problem. In every regional market except Thailand, an average share is traded less than once every two years, placing Southeast Asia’s exchanges far behind those in developed markets and most of those in Northern Asia.

As a result, in 2005 the overall cost of trading was 50 percent higher in Southeast Asia than in Northern Asia and 250 percent higher than in developed Western markets. The all-important cost of liquidity, or the price impact of making a trade, was 50 percent higher than in Northern Asia and 200 percent higher than in the West. Therefore, raising equity was 2 to 4 percent more expensive (as measured by the equity risk premium) for Southeast Asian issuers than for their counterparts in more mature markets.

If Southeast Asia’s exchanges continue to pursue a fully independent future, most of them risk falling further behind or, at best, being “cherry-picked” in acquisitions by their global competitors. Regional integration, by contrast, would change this picture fundamentally. Last year the five main ASEAN exchanges, if combined, would have ranked as the 15th-largest exchange in the world and the third largest in Asia, after Tokyo and Hong Kong.

Full-scale integration is unlikely today. Meaningful collaboration has proved difficult in the past because of the many stakeholders, conflicting national agendas, and a daunting number of regulatory obstacles—from capital account controls to different trading rules and membership requirements. Moreover, there have been many unsuccessful attempts in other parts of the world to integrate exchanges the soft way, through loose alliances and dual listings, or the hard way, through mergers.

Many of these failed attempts, based on the flawed premise that liquidity pools can somehow be merged, didn’t focus on the true benefits of integration and tried to tackle too many difficult issues head on. Soft integration approaches, such as trading links and cross-listings, have struggled to generate the hoped-for volumes. More difficult strategies promoting integration through cross-border mergers have typically run into resistance from politicians and other stakeholders.

However, more recent efforts to consolidate exchanges around the world show that strategic collaboration focusing on actual areas of synergies, such as operations and technology, rather than on outright mergers can clear the way for integration. This approach, which is easier to execute than a full merger, also captures many of the desired benefits. Euronext (now NYSE Euronext) and OMX’s Nordic Exchange have both captured the benefits of consolidation without eliminating the separate identities of their constituent exchanges. Many other options exist.

In Southeast Asia the exchanges have few strategic options on their own. Significant long-term policy support will be required from governments, securities commissions, and central banks, both domestically and regionally. Changing policies and regulation can take decades, but policy makers can take immediate, concrete, and practical steps that will strengthen local markets while paving the way for consolidation. These steps should be implemented at three separate levels and, at least partly, in parallel.

The first level—and the top priority in most markets—should be pursuing further reform to bring local capital markets up to international standards, with an eye to future integration. These reforms focus first on “blocking and tackling,” including modernizing the trading infrastructure or improving the capacity and capabilities of the regulators and then on reducing or eliminating capital controls.

Next, countries should harmonize regulations across jurisdictions to promote informal market linkages, thus ensuring a consistent approach to regulating exchanges and other capital markets in each country. Over time, this harmonization process will also have considerable benefits for individual country reforms and help maintain the impetus to continue with local reforms—in Europe the process of sustained harmonization helped guide and accelerate the ongoing reforms in domestic markets. Even after almost 50 years of integration in Europe, this process is not complete there. The first milestone in Southeast Asia could be mutual recognition, so that national regulators would understand and feel comfortable with one another’s regulatory frameworks.

Selectively consolidating the exchanges and their after-trade services would be the third level, if it seems attractive and feasible. Models for collaboration based on shared standards and joint operations to share costs provide the best hope for success; grand strategic schemes will probably fail.

The first step toward such a model can be very simple. Exchanges could continue to run their own operations independently and retain their ownership or governance structures but agree on common trading rules, hours, and pricing, thus immediately reducing the complexity of trading across markets. More advanced models involving joint ownership and management teams should be considered eventually and would enable exchanges to cut their overall operating costs and share new investments in technology. One immediate priority, though, would be to develop a unified IT and operating platform, perhaps through a jointly owned subsidiary.

Ultimately, such an exchange might attract more cross-border capital, which would in turn deepen these markets and draw in additional domestic capital. Finally, it would serve as a more credible source of capital for regional champions, preventing these companies from drifting to offshore markets.

ASEAN policy makers have a historic opportunity to support the 2015 vision of Southeast Asian market integration by forging closer ties among the region’s exchanges. The relevance or even survival of several of them could be at stake.