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11 October 2006

EU Stock Exchanges: Competition, Governance, Settlement and Derivatives.

In a new report, Graham Bishop analyses the implications of the boom in stock market trading bringing stock exchange mergers into EU jurisdiction, especially a DB/Euronext merger given their dominant position in trading derivatives”

Executive Summary and Conclusions
The debate on the future of the EU’s stock exchanges – and the associated downstream infrastructure – is moving to fever pitch as reports swirl around about possible combinations, quite apart from the formal offers. But the very strength in trading revenues from the boom has created an unintended side-effect: the revenues of Europe’s leading exchanges have risen to a point where the EU competition authorities could well have jurisdiction over several possible exchange combinations, most particularly over any Deutsche Börse/Euronext merger. What might they decide? Is competition law the best way to organise the economics of the EU’s financial system?

The “vertical silo” structure of Europe’s largest (measured by its trading revenues) stock exchange operator – Deutsche Börse (DB) - lies at the heart of this problem. The EU competition authorities have already made clear their concern about several aspects of this structure and are unlikely to pass up an opportunity to examine it in great detail and propose remedies for any competitive defects they may find. All stakeholders need to take account of this possibility in any combinations that include DB with Euronext or the London Stock Exchange (LSE). Surprisingly, links with US exchanges (Euronext/NYSE or the reported DB/CME link) may well avoid this scrutiny.

What factors might be weighed up?

  • A combination of the cash equities trading of many EU exchanges – including DB and Euronext (as proposed in the Lachmann Report from Paris) – might well be approved if the European Commission takes the same line as the UK’s Competition Commission 2005 analysis and sees the relevant market as being global. However, the European Commission might well then follow the CC and condition approval on the sale of at least part of Deutsche Börse’s interest in Eurex Clearing and Euronext’s holding in LCH.Clearnet to facilitate competition in trading.
  • Central Counterparty: Indeed, Deutsche Börse has already proposed to the European Commission the sale of its cash equities clearing business, and believes the offer should be acceptable. However, that limited offer may not be sufficient because the logic of the divestment is not carried through to include its derivatives clearing business.
  • The Central Securities Depositary function may be under threat from the ECB’s recent proposal for a possible securities settlement system based on its own TARGET money transmission system. Divestment could be a remedy but who would pay a full price for these assets ahead of such an upheaval?
  • Derivatives may be the biggest problem of all as DB and Euronext are fierce competitors. The historic example of the Bund contract moving from LIFFE to Eurex shows the power of competition – and Euronext.LIFFE has just announced a renewed challenge with a new family of products. Competition also covers French and Dutch equity options and, potentially, spans the entire range of securities. The two exchanges account for virtually 100% of bond/STIR contracts and between 76-96% in relevant equity products. The European Commission would need to weigh up carefully any improved efficiencies versus the loss of actual or potential competition, including in clearing the trades after their execution.

    Who will do the weighing?
    Internal Market Commissioner McCreevy has made it abundantly clear that he has no “Gosplan ... for the future structure of exchanges” and that it is for “the markets” to decide. How can the impersonal markets weigh up the factors as the exchange companies are small ones (despite their vast trading turnover) and key stakes have been acquired by a few hedge funds who give every sign of putting their private interests ahead of any EU public interest by pushing for quick solutions. That push could easily put the solution into the hands of the competition authorities alone, making execution risk a real issue for all stakeholders.

    Is the time ripe for decisions?
    In just 13 months the Markets in Financial Instruments Directive (MiFID) will come into force. The intention is to open up trading in securities across the EU to new competition, rather than maintaining some of the historic monopolies. Despite its poor image in the media, this measure should be expected to have a major impact. Correspondingly, the new Code on Clearing and Settlement should be functioning on the same timescale, shaking up the providers of those services. Finally, the ECB should have decided whether to proceed with its own ideas for maximising the safety of securities settlement.

    If big exchange mergers are pressed now, it could end with ownership of two-thirds of the business of Deutsche Börse and half of Euronext’s being put into question. The need for careful consideration of almost every aspect of Europe’s capital markets points to a long, thoughtful process. That should not be incurred on a timetable to suit the private interests of a couple of shareholders alone. Rather, it should be determined by the EU public interest in a well-functioning capital market.

    Full report

    © Graham Bishop

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