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From the moment Frankfurt-based Deutsche Börse and NYSE Euronext announced their proposed merger a year ago, their competitors began ringing the antitrust alarm. Not about stocks, mind you. Although the two companies operate six major stock exchanges across Europe and the U.S., regulatory and technological changes have made equity trading a competitive free-for-all, to the extent that the New York Stock Exchange today handles less than a quarter of the volume in NYSE-listed stocks. No, what competitors really complained about was the stranglehold that the combined company would have had on the fast-growing business of exchange-traded derivatives in Europe.

The listed derivatives market has remained extraordinarily concentrated even as it has grown dramatically over the past decade. The trading volume of European equity index futures and options reached 1.4 billion in 2010, with a notional value of $52 trillion, according to research by Hamburg-based Berenberg Bank. Both figures represented a fivefold increase from 2000. Trading in European interest rate derivatives tripled over the same period, to 1.2 billion contracts, while the notional value of those contracts was six times larger, at $730 trillion. Deutsche Börse’s Eurex subsidiary and NYSE Euronext’s London-based NYSE Liffe dominate the space, and a merger would have created a virtual monopoly. The two exchanges together control more than 95 percent of all trading in European listed interest rate futures and options, and more than 80 percent of all listed equity index futures and options, according to Richard Perrott, a London-based analyst who covers diversified financials for Berenberg.

Those numbers prompted the European Commission to block the proposed $7.4 billion deal February 1. The derivatives markets “are at the heart of the financial system, and it is crucial for the whole European economy that they remain competitive,” said Joaquín Almunia, the competition commissioner. “We tried to find a solution, but the remedies offered fell far short of resolving the concerns.”

The commission’s veto won’t be the final word on competition. A revolution is gathering force that rules out any return to the status quo. European regulators are pressing ahead with new legislation that aims to foster greater transparency and competition in both listed and over-the-counter derivatives. The moves, if adopted, threaten to shatter the lucrative duopoly enjoyed by Eurex and Liffe.

Rivals, meanwhile, are already planning their own assault on the market leaders. The London Stock Exchange Group and BATS Chi-X Europe, an electronic upstart that has shaken up European equity trading in the past five years, are pursuing a variety of strategies to grab a bigger slice of the derivatives pie, from creating their own, customized stock indexes to launching derivatives platforms to trying to acquire their own clearing services. These initiatives promise to unleash the same kind of competitive whirlwind in the derivatives markets that Europe has seen in equities.

“We’d be in a situation where derivatives trading would be much more akin to equity trading as barriers to entry broke down and margins dropped, but derivatives clearing would still remain attractive — and profitable,” says Berenberg’s Perrott. “Open interest stays open for a long time at derivatives clearinghouses, and that will still give their owners a competitive advantage.”  

The reasons for the interest in derivatives are simple and powerful. The financial crisis has dampened trading in equities and provided a spur to futures and options, which give investors a quick and low-cost way to take on or hedge exposure to asset classes ranging from stocks to bonds to commodities. Consider the experience of Deutsche Börse. The Eurex unit, which handles derivatives trading and clearing, is by far the group’s largest business, generating 45.5 percent of its overall revenue — a hefty €275.1 million ($374 million) — in the quarter ended September 30, 2011. That was more than three times the €76.6 million in revenue produced by the group’s cash equity trading and listings subsidiary, Xetra. Eurex may be a mature business, but it is still growing strongly:

Revenue was up 40 percent year-over-year in the quarter ended September 30. A similar dynamic is evident at NYSE Euronext, where exchange-traded derivatives revenue rose 20 percent in the September quarter, to $226 million, or 32.1 percent of the company’s total sales. For rival exchanges eager to diversify their revenue sources and drive growth, derivatives are an obvious target.

New entrants will face some stiff challenges in trying to fulfill their ambitions, however. Derivatives differ from cash equities in ways that have tended to stymie competition. Shares of SAP, the German enterprise software maker that is a component of the Euro Stoxx 50 Index, are the same wherever they trade. If an upstart electronic exchange can provide a faster, cheaper way to trade the stock than Deutsche Börse, where SAP is listed, that exchange can win a significant percentage of the trading volume. (Last month, according to data from Thomson Reuters, BATS Chi-X Europe handled 34 percent of the volume in SAP, compared with 56 percent for Deutsche Börse.) Such increased competition was the whole rationale behind the European Union’s Markets in Financial Instruments Directive, the 2007 law known as MiFID. The sweeping regulatory reform abolished concentration rules, whereby many countries had required trading to go through one central exchange, and instead directed brokerages to provide best execution service to their clients. The rule fueled the rise of new players, known as multilateral trading facilities, or MTFs, the most prominent of which were Chi-X Europe; Turquoise Global Holdings, which is owned 51 percent by LSE Group and the remainder by a dozen banks; and BATS Europe. Their success prompted Lenexa, Kansas–based BATS Global Markets to acquire Chi-X in December and merge their two companies into BATS Chi-X Europe, a powerhouse that controls about a quarter of European equity trading.

By contrast, listed derivatives are proprietary products controlled zealously by individual exchanges. If an exchange can develop a hot product, as Eurex has done with its futures on the Euro Stoxx 50 and European government bonds and Liffe has done with futures on Eurodollar interest rates and the FTSE 100 stock index, it can enjoy a near-monopoly position in that product. Extended periods of open interest also work to deter derivatives traders from switching among trading venues, especially in a world where the vertical silo model — under which an exchange controls both trading and clearing — holds sway.

Deutsche Börse CEO Reto Francioni underscored those competitive advantages in a speech at the Euro Finance Week conference in Frankfurt in mid-November. “The future belongs to integrated exchanges because they offer market participants a single port of call for secure and reliable transaction processing,” he said, noting that even some competitors that criticize vertical integration are seeking to adopt the model. London Stock Exchange Group, for instance, has complained to EU authorities for years about Deutsche Börse’s integrated silo, but it currently is in talks to acquire control of its main U.K. clearing provider, LCH.Clearnet Group.

European regulators are acutely aware of the problem. The Commission, the European Union’s executive agency, blocked the Deutsche Börse–­NYSE Euronext merger precisely because it would have created a mammoth company with overwhelming dominance of the European market for trading and clearing exchange-listed derivatives — a “near-monopoly,” as Almunia put it. Such a development would run counter to the Commission’s efforts in recent years to level the playing field and promote greater competition among European exchanges.

In October the Commission released a draft proposal of a revised directive known as MiFID II that seeks to strengthen the transformative changes wrought by its predecessor and increase competition in derivatives markets. The draft calls for two significant alterations in market structure that would directly impact derivatives exchanges and their parent companies. The first change would force incumbent exchanges to license their indexes to rivals, effectively tearing down the proprietary walls in the derivatives markets. Deutsche Börse, which co-owns index provider Stoxx along with SIX Swiss Exchange, is likely to resist such a requirement fiercely; contracts based on the Euro Stoxx 50 are among the most popular and heavily traded derivatives products in Europe.

The second proposed change would introduce open access for derivatives clearing. Such a move would require the largest clearinghouses, like Eurex Clearing, to clear trades conducted on other exchanges and allow customers to net the margins they post on competing but similar derivatives contracts. That could provide a big boost to the ambitions of rival marketplaces. Currently, any exchange looking to compete with Eurex or Liffe has to organize its own clearing arrangements for clients. Those arrangements require clients to post additional margin and prevent them from being able to offset trading positions, or open interest, they hold with other venues. The higher costs effectively deter broker-dealers and other market participants from shifting their trading volume away from the incumbents. Not surprisingly, smashing open the vertical silo model has become one of the top priorities for challengers like LSE, which launched its own competing derivatives platform, Turquoise Derivatives, in May 2011.

The EU is also working to finalize a piece of legislation — the European Market Infrastructure Regulation, known as EMIR — that aims to have a similar impact on over-the-counter derivatives. The law will require OTC derivative trades to be channeled through a clearinghouse and will mandate that firms report data about their trades to a central trade data repository. Analysts believe the regulation, which is expected to be approved by the European Council and the European Parliament later this year and come into force in 2013, will foster more transparency in OTC transactions — and greater competition among central counterparty clearinghouses.

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