Financial Exchanges 2005 - Shadow-boxers spar for London prize

IFR Financial Exchanges 2005
16 min read

No firm offer has yet been tabled for the London Stock Exchange (LSE). That fact may be difficult to remember in a takeover situation that stretches back to just before Christmas 2004, when the Deutsche Boerse first revealed that it was in discussions with the LSE, with a view to making a cash offer.

As Christmas comes around again, the Deutsche Boerse finds itself searching for a new chief executive. Werner Seifert was axed in May 2005 following a sustained and successful anti-takeover campaign led by Christopher Hohn of the Children’s Investment Fund, a man vilified by Seifert but a highly decorated hero in the hedge fund world.

The closest that anyone has come to making a real offer was the Deutsche Boerse announcement on January 27 2005 of a “proposed pre-conditional offer” of not less than 530p a share, valuing the LSE at £1.3bn (US$2.44bn). The only condition was that the board of the LSE should recommend the offer, which it did not, CEO Clara Furse holding out for more. All the rest of the bidding has been made in terms of “possible offers”, “potential bids” and “discussions”.

The first problem faced by the UK Competition Commission, which was handed the deal by the Office of Fair Trading and which is where the fate of the deal now rests, was whether or not there actually existed a merger situation worth examining. In the end, it was decided that both the Deutsche Boerse and Euronext were in the running to acquire the LSE, although Deutsche Boerse, given its lack of CEO and its turbulent relationship with shareholders, only “just crosses the threshold”.

On August 3 2005, the Commission published its lengthy provisional findings report (120 pages long, excluding appendices), since when Australia’s Macquarie Bank has thrown its hat into the ring.

The August 15 announcement from the investment bank was shadow-boxing at its finest. “Macquarie, as is always the case, is considering a number of potential acquisition opportunities, which includes a possible formal approach being made to the London Stock Exchange PLC,” the bank said.

Macquarie’s indication that any offer would most likely be in cash and made as part of a consortium, set analysts and journalists wondering whether or not Sweden’s pan-Baltic OMX exchange might be the trade partner in any bid. However, OMX currently has a market share of only 6% of the total value of equities traded on-book in Europe, compared with Euronext’s 23%, the LSE’s 20% and the Deutsche Boerse’s 14%.

Even Europe’s Latin markets, Bolsas y Mercados Espanoles (BME) of Spain and Borsa Italiana of Italy, are bigger, with 13% and 12% shares respectively, although they are still mutually owned, while OMX is listed. Virt-x, owned by the Swiss exchange and the successor to Tradepoint, might at a stretch be one other Europe-based exchange to be considered, although its core market is trading in Swiss blue chip equities.

Merger remedies

But unless Macquarie makes a formal approach, all attention rests now on what remedies the Commission will stipulate to prevent any substantial lessening of competition (SLC) in the event of a takeover of the LSE by either Euronext or the Deutsche Boerse.

Despite pleas from the LSE to resolve matters speedily and let it get on with its business in peace, the Commission has extended its deadline for deciding on remedies by eight weeks to November 7, citing the “exceptional complexity of the inquiry”.

The nub of such complexity comes down to “fungibility”. This relates to the clearing of trades and the concept that one exchange can get just as good access as a rival exchange to common post-trade services. Full fungibility, in the case of any takeover of the LSE, entails the idea that trading costs and entry barriers associated with post-trade clearing services must remain low, so maintaining future threats from new or expanding trading platforms as a competitive constraint on the incumbent exchange.

As the Commission explains in paragraph 27 of its provisional findings summary: “The overwhelming majority of the evidence that we received, including evidence from LSE and Euronext, suggests that fully fungible access to the incumbent exchange’s post-trade services is of critical importance for successful entry or expansion at the trading level, primarily because of the infrastructure costs of connecting to multiple systems and the costs associated with clearing trades through more than one central counterparty (CCP).”

All the remedies proposed by the Commission are, short of totally prohibiting an acquisition, to do with wresting control of clearing services away from either Euronext or the Deutsche Boerse in order to remove the risk that they might “foreclose” access to other providers of trading services.

In the case of Euronext, it is proposed that it should divest itself of control of LCH.Clearnet, while the German boerse would have to sell Eurex Clearing. In both situations a remedy might also be “a set of behavioural commitments from the merged entity to ensure that LCH.Clearnet/Eurex Clearing does not act in such a way as to deny potential competitors to LSE access to clearing services or otherwise place them at a competitive disadvantage”.

At the moment, Euronext has a shareholding of 41.5% in LCH.Clearnet, the provider of both Euronext’s and the LSE’s clearing services. Although Euronext’s voting rights are capped at 24.9%, the Commission deduced that a merged Euronext-LSE entity would have the ability to influence LCH.Clearnet’s strategic decisions in its favour and, in order to protect its substantial investment in the LSE, “a strong incentive to influence adversely access to clearing services in the UK”.

Deutsche Boerse, on the other hand, while having a 50% shareholding in the Eurex joint venture with SWX, was deemed to already have control over Eurex through its majority control of the supervisory board and its 85% economic interest. Just as with Euronext, the Commission concluded that first, a Deutsche Boerse/LSE merged entity would lead to the introduction of Eurex Clearing as LSE’s provider of clearing services; and second, that the merged entity would “have the incentive and ability to foreclose entry and expansion in the UK at the trading level”.

Stickiness of liquidity

Fittingly for a merger story in which there have been no firm takeover offers, competition within the arena of exchanges comprises threats and feints. Mere threats are enough to induce trading fee reductions and improvements in service. And whatever way the European merger is resolved, the threats are growing on a global scale.

The most genuine threats to the LSE are posed by the New York Stock Exchange and Nasdaq, which are each resolving current deals – NYSE’s merger with Archipelago to become a publicly listed company with electronic trading, and Nasdaq’s acquisition of Instinet from Reuters. Both have expressed intentions to expand into Europe, helped by the fact that the heads of many trading desks in London are expatriate US citizens.

Such threats are taken seriously, even if recent attempts in Europe to compete head-on make sorry reading, and even when the prerequisite condition of fungible clearing has already existed.

Clara Furse’s Dutch homeland has been the testing ground for a rare head-to-head competitive experience. In May 2004, the LSE launched DTS to trade in the top 50 Dutch equities, in competition with Euronext Amsterdam. DTS has never sustained significant market share, but its effect was to force Euronext to reduce its fees by approximately 30%. Similarly, Deutsche Boerse launched in 2001, and relaunched in 2003, its Dutch Stars initiative, though that has only ever averaged a 1% market share.

The Dutch experience has demonstrated the problems of opening up what, in stock exchange parlance, is called a “second liquidity pool”. As Deutsche Boerse explained to the Commission with respect to the UK, it means that competitors would rather buy the LSE than set up a rival service as “the stickiness of liquidity meant that any threat of entry was not credible”.

This realisation may be why Euronext shelved Project Tiger, its ambitious plans to enter the UK market in June 2005. A real shift of liquidity – which sticks to one exchange not just because of trading fees and the costs of switching, but also because of wider “network effects” – has never been successfully achieved. Nevertheless, as one major exchange told the Commission, the threat of liquidity shifting is life threatening to an exchange. “Even a small possibility of losing liquidity creates a strong behavioural incentive on the exchange,” it said.

Big Six could rule

This precious liquidity, which can make or break exchanges, for the most part rests in only a few pairs of hands at the leading investment banks and trading firms. And traders can certainly influence events. When the LSE entered the Dutch market, it only did so at the invitation of dissatisfied traders who had given commitments to support the new offering.

The Commission takes note of how concentrated liquidity is. “Trading on the three exchanges under discussion is concentrated on a small number of large financial intermediaries that generally combine both principal (on their own behalf) and agency (on behalf of a client) trading activities,” it said.

According to data from Thomson’s AutEx BlockDATA service, trading on the London Stock Exchange in equities within the FTSE All Share index (for the year to August 23 2005) was led by Deutsche Bank, which accounted for 15.19% of all trading activity as measured by volume of trades.

There is clearly a “Big Six” of the banks responsible for trading volumes of more than 8%. They are Deutsche Bank, UBS, Lehman Brothers, Merrill Lynch, CSFB and Citigroup, which together account for fully 64% of trading volume.

Similar concentrations, and more or less the same top names, can be seen among those banks and firms trading in DAX 30 equities on the Deutsche Boerse, although Nasdaq has a more even distribution, led by UBS.

Even if the LSE does merge – with Euronext, the Deutsche Boerse, Macquarie or AN Other – there remains the possibility that the big traders may, if ever unhappy, incite some kind of change. Witness the deal this August at America’s oldest stock exchange, Philadelphia (PHLX), which is now primarily an options exchange. A group of six strategic investors – Morgan Stanley, Citigroup, CSFB, UBS, Merrill Lynch and Citidal – has bought equity stakes that, together with warrants exercisable in June 2006, will give them an 89.4% holding.

Meyer “Sandy” Frucher, chairman and CEO of PHLX, said that the exchange’s business models in equities and futures trading would be energised by the entry of the strategic partners. “These alliances will help us become a strong new competitive force in the rapidly consolidating securities exchange marketplace,” he said.

Could the future of stock markets lie with the traders that use them?

London Stock Exchange traders: Top investment banks and firms in the FTSE All Share Index. Ranked by advertised trade volume, 1 Jan 2005–23 Aug 2005
% of
1Deutsche Bank Securities73,792,83915.19
3Lehman Brothers53,462,53811.01
4Merrill Lynch41,735,8788.59
5Credit Suisse First Boston41,571,2528.56
8Goldman Sachs25,876,7905.33
9Morgan Stanley21,015,2344.33
10ABN AMRO20,266,2604.17
11JP Morgan20,148,2044.15
12Winterflood Securities11,561,8862.38
13Cazenove Securities9,390,9271.93
14HSBC Securities9,246,8031.90
16Investec Securities3,091,0800.64
17Commerz Bank2,919,6650.60
18Bear Stearns2,378,3130.49
19Numis Securities1,844,9450.38
20Sanford C Bernstein1,477,5460.30
21Evolution Beeson Gregory1,332,6630.27
22Teather & Greenwood1,231,3230.25
23Peel, Hunt & Co1,117,4670.23
24Cantor, Fitzgerald & CO843,4080.17
25ING Financial Markets756,1880.16
All other brokers = 375,215,2391.07
Source: AutEx/BlockDATA
Deutsche Boerse traders: Top investment banks and firms in DAX 30 ranked by advertised tradevolume, 1 Jan 2005–23 Aug 2005
% of
1Deutsche Bank Securities7,439,30223.67
3Credit Suisse First Boston2,923,1319.30
4JP Morgan2,881,6839.17
5Lehman Brothers2,817,8428.97
8Morgan Stanley1,596,6085.08
9Merrill Lynch1,411,5434.49
10Goldman Sachs1,346,9884.29
11ABN AMRO852,9682.71
12HSBC Securities815,5922.60
13Commerz Bank784,3702.50
14ING Financial Markets301,0130.96
15Bear Stearns257,0770.82
16WestLB Equities103,9100.33
17Sanford C Bernstein45,5130.14
18Cazenove Securities32,1710.10
19Redburn Partners17,7190.06
21Cantor, Fitzgerald16,6320.05
22E-Trade Capital Markets15,7200.05
23Jeffries & Co3,3970.01
24Banc of America Securities1,4250.00
25Winterflood Securities1490.00
All other brokers = 1930.00
Source: AutEx/BlockDATA
NASDAQ traders: Top investment banks and firms in NASDAQ. Ranked by advertising trade volume, 1 Jan 2005–23 Aug 2005
% of
2Merrill Lynch10,040,8147.51
4Credit Suisse First Boston8,203,7176.13
5Goldman Sachs7,993,7975.98
6Morgan Stanley7,846,5855.87
7Bear Stearns6,966,2875.21
8Lehman Brothers5,654,3704.23
9Knight Equity Markets5,304,3053.97
10Prudential Securities4,882,1103.65
11JP Morgan4,312,8233.22
12SG Cowen Securities3,741,2662.80
13Deutsche Bank Securities3,434,6682.57
14E-Trade Capital Markets3,206,5002.40
15RBC Capital Markets3,191,8632.39
16Fidelity Capital Markets2,951,0272.21
17First Albany2,649,6641.98
18CIBC World Markets2,361,3141.77
19Banc of America Securities2,262,8981.69
20Thomas Weisel Partners1,943,9721.45
21Wachovia Securities1,883,5411.41
22Jeffries & Co1,869,1811.40
23Piper Jaffray1,867,4551.40
24Pacific Crest Securities1,762,4801.32
25TD Waterhouse Capital Markets1,703,4751.27
All other brokers = 14417,049,05412.75
Source: AutEx/BlockDATA