After Veto, Europe’s Exchanges Gird for Derivatives Battle

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.

The road from draft proposals to final legislation is a lengthy one, and exchanges will be lobbying aggressively in coming months to shape the final rules. Deutsche Börse and NYSE Euronext can be counted on to put up particularly stiff opposition, judging by their unwillingness to offer much in the way of remedies in their failed attempt to win approval for their merger. The two companies had argued that the proposed deal should be viewed in a global context and pointed out that Chicago-based CME Group was allowed to acquire the Chicago Board of Trade for $11.2 billion in 2007, creating the world’s largest derivatives exchange.

The German and U.S. exchange operators had suggested three potential concessions. The first was to offer to divest NYSE Liffe’s single-stock futures and options, which would have had almost no impact on the combined group’s market share and profits. The second was to offer to relax the criteria whereby competitors could clear their own equity index and interest rate products at Eurex Clearing, a proposal that stopped well short of the full access that competitors had sought. Third, the parties said they would allow competitors interested in launching rival interest rate derivatives to license Eurex’s trading technology. Those half measures played a big role in the Commission’s decision to block the deal, analysts say.

“Competition authorities didn’t like the idea of combining Eurex and Liffe full stop and were pushing for divestment — or, at the very least, a stronger potential remedy,” says Berenberg’s Perrott.

Will Rhode, a London-based senior analyst with TABB Group, a New York–based financial market research firm, predicts an intensive period of infighting to define the final MiFID II rules. “There is a lobbying window open right now in Europe that may last from six to nine months, during which time all market participants are going to have to consider which hills they’re prepared to die on, which hills they’re willing to give away,” he says.

The troubles of Deutsche Börse and NYSE Euronext offer the latest evidence that the exchange industry is like few others. Technological developments and increases in cross-border capital flows are acting as powerful drivers for consolidation, but the forces of regulation and nationalism are pushing just as hard in the opposite direction.

Singapore Exchange set off a flurry of merger activity in October 2010 when it announced an agreed-upon A$8.4 billion ($8.86 billion) offer for ASX, operator of the Australian Securities Exchange. SGX CEO Magnus Böcker said the deal would allow the combined company to play a leading role in shifting the world’s capital markets toward the fast-growing Asia-Pacific region. Three months later LSE made its own international move by reaching an agreement to acquire Toronto-based exchange operator TMX Group for C$3.6 billion ($3.56 billion). And just six days after the LSE-Toronto deal, Deutsche Börse and NYSE Euronext unveiled their blockbuster deal.

Rarely have so many been so frustrated. In April 2011, Australian Treasurer Wayne Swan blocked the takeover of the Sydney-based exchange, bowing to domestic protest over the Singapore government’s role in the deal. (A vehicle of its sovereign wealth fund, Temasek Holdings, owns 23.5 percent of SGX.) “It’s not the right deal for Australia if we want to ensure the strength and stability of our financial system,” Swan said. Canada’s response was more subtle but equally effective: In June a group of 13 Canadian banks and pension funds calling themselves Maple Group countered with a higher bid for the Toronto exchange and sent LSE chief executive Xavier Rolet away empty-handed. The EU rebuff to Deutsche Börse and NYSE Euronext provided the most dramatic setback yet to the would-be consolidators and will almost certainly prompt a major rethinking of strategy by key players.

“Isn’t it time to step back and ask what it is we are trying to achieve?” says Georges Ugeux, chairman and CEO of New York–based investment banking consulting firm Galileo Global Advisors, and a former NYSE executive. “Because the basic question that the exchanges must answer is, what is the added value that globalization can create in the securities markets? Once they answer that question, then perhaps they can look for solutions that create value — and not just for more mergers and acquisitions.”

The growth-by-takeover model may prove a hard habit to break. Developing a new business from scratch is a much riskier prospect than buying one outright. Yet a few entrepreneurial efforts do exist. At the same time that LSE was pursuing Toronto, its Turquoise subsidiary was launching its own pan-European futures and options platform, Turquoise Derivatives.

“We wanted to get ahead of the curve and bring competition to exchange-traded derivatives,” says Turquoise Global Holdings CEO Adrian Farnham. “We decided to demonstrate that it is possible, so we put ourselves in a position where as market structures evolve we will be able to offer customers a choice of trading venue.”

Turquoise Derivatives represents the first effort by a European MTF (admittedly, one backed by the full weight of LSE) to loosen the competitive stranglehold that Eurex and Liffe hold over exchange-traded derivatives, but it wasn’t built from scratch. Turquoise developed it on the back of EDX London, a derivatives venture LSE launched in 2003 that operated only in the niche markets of Norwegian single-stock futures and options and Russian depositary receipts.

The new exchange was an innovator in another respect: Turquoise Derivatives adopted a so-called maker-taker pricing system, a model pioneered by alternative equity-trading venues in the U.S. and Europe that uses rebates to build traffic. The company offers rebate fees — currently 5 pence (7.8 cents) per contract — to customers that “make” liquidity by supplying bid-offer quotes on the trading book, and it charges a “take” fee of 20 pence a contract to clients that remove liquidity by hitting those bids and offers. Although it remains to be seen whether that equity pricing model will work effectively in the exchange-traded derivatives market, some industry participants are impressed with Turquoise’s sheer moxie in launching the platform.

“Turquoise did well to take first-mover advantage and get into listed derivatives,” says Daryl McDonald, who is responsible for global equity execution strategy at investment bank Jefferies International in London. “Since the LSE already had EDX in place, Turquoise was able to leverage off that existing platform to build capacity quickly and diversify its product offerings.”

Capacity alone does not create trading flows, however; brand-name products do. From the outset Turquoise tested its rivals’ willingness to tolerate competition by asking for permission to access their intellectual property, first approaching Eurex for a license to list products based on its Euro Stoxx 50 Index. The German company summarily denied the request. Thanks to its relationship with LSE, which co-owns FTSE Group, Turquoise was able to obtain a license to list futures and options based on the FTSE 100 stock index, the leading U.K. blue-chip index. Turquoise Derivatives started trading FTSE 100 index futures in June, but results so far have been modest, to say the least. Through December only 4,308 contracts, with a notional value of £233.4 million ($363.9 million), changed hands. FTSE 100 index options, which began trading in September, have seen more action, with volume reaching 15,518 contracts by year-end, representing a notional value of £804.3 million.

Growing that volume won’t be easy. Both Turquoise Derivatives and Liffe offer futures and options on the FTSE 100 index and use London-based LCH.Clearnet for central counterparty services, but under current arrangements customers cannot offset the margins they hold on trading positions at Turquoise against those held on positions of similar contracts at Liffe. For a newcomer trying to win market share from Liffe, that’s a big hurdle for Turquoise to overcome.

“This is where the farcical nature of the current market structure becomes obvious, and it’s easy to understand why it needs to change,” says TABB Group’s Rhode. “Customers are frustrated.”

Regulatory change may eventually transform clearing — and do much to support greater competition among trading venues — but that hasn’t stopped LSE from looking to create its own version of a vertical silo. In September 2011 the company announced it was in exclusive talks with LCH.Clearnet to acquire a 51 percent stake. The agreement marked something of a coup for CEO Rolet, who had turned to the clearer on the rebound from his failed bid for TMX. LSE’s offer valued LCH.Clearnet — which is owned 83 percent by market participants, 9 percent by NYSE Euronext and 8 percent by the London Metal Exchange — at approximately €1 billion ($1.35 billion). It beat a rival bid from London-based financial information services firm Markit Group. The two sides had not completed the deal as of late last month.

Securing the clearinghouse would give Rolet and his team an enhanced ability to oversee the entire ecosystem of equity and derivatives trading, clearing, counterparty services and custody. It could also give LSE the chance to capitalize on future market opportunities like the introduction of EMIR, which will push some OTC derivatives into more-formalized clearing arrangements by 2013. LCH.Clearnet already has the capacity and expertise to handle a broad range of products, from cash equities to complex OTC swaps and derivatives, and its regional importance as a central counterparty clearinghouse, or CCP, is likely to grow.

Rolet might be in a greater hurry now that the Deutsche Börse–NYSE Euronext merger has fallen apart. That megamerger would have given Liffe direct access to Eurex Clearing, with all of the attendant cost efficiencies and cross-margining possibilities of a consolidated business. In the wake of the EU veto, NYSE Euronext might seek to create a vertical silo of its own, perhaps by making a rival bid for LCH.Clearnet. “It is possible that NYSE could go after LCH and try to outbid the LSE — or break into that transaction,” says a former Liffe executive who has been avidly following events from the sidelines and spoke on condition of anonymity.

LSE may need to get the LCH.Clearnet deal done to protect its own autonomy. In the four years since his arrival as CEO, Rolet has integrated Borsa Italiana, which LSE acquired in 2007, and struck a joint venture arrangement with Tokyo Stock Exchange Group, but he has not been able to pull off an acquisition to extend the group’s geographic reach or diversify its revenue sources. Without the TMX deal, LSE could find itself becoming a takeover target once again. Deutsche Börse, which made two failed bids for its London rival in the 2000s, might take another shot at London now that it is without a partner. Nasdaq OMX Group, another failed suitor, which last bid in 2006, also might be interested in making a fresh attempt to create a transatlantic marketplace, analysts say. The exchange has struggled to chart a clear direction since it failed to pry NYSE Euronext away from the Germans with a counteroffer last year. Nasdaq’s hefty debt burden could limit CEO Robert Grei­feld’s ambitions, though.

“The LCH.Clearnet deal is obviously going to be good for the London Stock Exchange Group, especially since coming regulation will require standardized OTC contracts to be centrally cleared, but the company still needs a new strategic exchange partner,” says one investment banker, who requested not to be named. “Otherwise the executive team will have to keep looking over their shoulders, and Nasdaq will be right there.”

The other new entrant on the European derivatives scene is BATS Chi-X Europe. Chi-X took advantage of MiFID to win a big chunk of European equity trading. It boasted a market share of 20.7 percent in December, compared with 5.4 percent for LSE’s Turquoise and 4.6 percent for BATS Europe. With the financial and technological backing of BATS and the clout of a combined market share of more than 25 percent, BATS Chi-X Europe aims to make similar inroads in the futures and options markets.

Former Chi-X Europe CEO Alasdair Haynes had tried to get Chi-X Europe’s prices included in the calculations of the major indexes, like the FTSE 100, as a precursor to launching market data services and creating index-based derivative products. But FTSE Group rebuffed him.

Not to be denied, Chi-X teamed up with Russell Investments to create a new set of benchmarks, the Chi-X Europe Russell Index series, or Cheri indexes. Launched in October 2011, the series aims to fill a gap between existing blue-chip and diversified indexes. The flagship Cheri PanEurope Index, for example, was engineered to split the difference between the Stoxx Europe 600, a broad index that contains many less-liquid securities, and the FTSE 100, which contains the largest companies traded on the London Stock Exchange. The Cheri Pan­Europe Index encompasses a broader range of 216 large-cap stocks from 14 European countries and five currencies, all drawn from the Russell 1000 Index universe of large-cap stocks.

Mark Hemsley, the former CEO of BATS Europe who has taken over from Haynes as CEO of BATS Chi-X Europe, has not yet disclosed his plans for the Cheri indexes — BATS executives are in a quiet period in preparation for the company’s initial public offering early this year — but he has long shared a common approach with Chi-X Europe’s executives of targeting data services and derivatives as growth areas.

Whether or not EU regulators require incumbents to license their indexes, BATS Chi-X Europe can control its own destiny by maintaining the relationship with Russell and rolling out its own derivatives products.

Self-determination will be a valuable commodity in the months ahead. And newcomers can count on having regulatory momentum on their side. The incumbents are powerful players, though, and they will work hard to defend their valuable franchises. The fight for Europe’s derivatives markets has only just begun.  •  •