When activist shareholders forced Deutsche Börse to withdraw its £1.35 billion ($2.58 billion) bid for the London Stock Exchange in March, the setback appeared to dash CEO Werner Seifert’s dream of forging a dominant, pan-European exchange. Seifert’s defeat notwithstanding, however, hopes of stock exchange consolidation remain very much alive in Europe. (As Institutional Investor went to press, Seifert resigned his post.)
The German bid has forced shareholders, users and regulators to confront a number of barriers that have stymied consolidation in recent years. British authorities are conducting a competition inquiry that is expected to require that any bidder for the LSE adopt an open architecture for clearing and settlement to preserve choice for users, potentially paving the way for Paris-based Euronext to price its bid for the London exchange, which has been put on hold for the inquiry period. The European Union’s executive commission has begun consulting industry about possible reforms of clearing and settlement arrangements in an effort to slash Europe’s high posttrade costs and create a more efficient marketplace for securities trading. Exchange shareholders and users, meanwhile, appear more eager to find common ground between their conflicting demands for higher stock exchange profits on the one hand and lower dealing costs on the other.
“That bid and everything that has come in its wake is likely to accelerate the development of a low-cost pan-European market that serves everyone’s interests,” says Alan Yarrow, vice chairman of Dresdner Kleinwort Wasserstein and chairman of the London Investment Banking Association, whose members handle most of the LSE’s turnover and a good portion of other European exchanges’. “It was just the kind of cathartic event we were waiting for.”
The change can’t come a moment too soon. After years of dawdling the New York Stock Exchange and the Nasdaq Stock Market last month leveled historic takeover bids -- the NYSE for Archipelago Holdings and Nasdaq for Instinet -- that would allow the U.S. to leapfrog Europe in terms of consolidating domestic markets (see box). And at the NYSE, at least, executives have designed their deal with global aspirations that promise to heighten competition among exchanges around the world. As Big Board chief executive John Thain explained in announcing the Archipelago acquisition, “We’re really structuring ourselves to compete on a global basis.”
To be sure, both of the proposed U.S. deals face hurdles of the kind that have held back exchange consolidation in Europe. And even if the takeovers go through, they will take time to sort out. The NYSE in particular faces a big challenge in combining its traditional, floor trading system with Archipelago’s wholly electronic dealing platform.
What seems destined to emerge, however, are bigger, shareholder-owned electronic exchanges that duplicate the structure of the European market. Instead of seeking to protect the interests of their members, as mutual organizations tend to do, the U.S. exchanges will look to grow trading volumes and expand their reach. This development will hasten the prospect of head-to-head competition with European bourses and could lead to transatlantic mergers.
“The fact that these big American exchanges are coming together makes the landscape completely open,” says Jan de Roeck, who handles relations with exchanges for ABN Amro in Amsterdam. “Transatlantic consolidation now becomes a possibility. It makes sense to combine trading in one electronic platform. It takes huge costs out.”
An executive at one leading European bourse agrees that the rapid convergence of exchange structures is likely to force the pace of consolidation on both sides of the Atlantic. “It’s moving the NYSE into the orbit of European exchanges for the first time,” this executive says of the proposed Archipelago merger. The new entity will “most probably behave in a way that’s similar to the electronic, demutualized exchanges of Europe.”
Still, the first attempt to create a pan-European market, five years ago, collapsed when the London Stock Exchange’s smaller member-owners blocked a merger proposal from Frankfurt-based Deutsche Börse. The German exchange, the LSE and Paris-based Euronext subsequently initiated IPOs, believing that their transformation into shareholder-owned businesses would give management the flexibility, and the capital, to pursue mergers.
The new structures have created fresh hurdles, however. The three exchanges alienated many of their big users by pushing up trading fees in a bid to increase shareholder value, secure in the knowledge that, for all the talk of competition, liquidity tends to pool within national borders. The exchange’s new shareholders, meanwhile, have proven just as capable of thwarting deals as members were in the clubby old days of mutual ownership -- as Deutsche Börse’s Seifert discovered.
The opposition to Seifert’s LSE bid was led by two hedge funds -- London-based Children’s Investment Fund, or TCI, and New Yorkbased Atticus Capital -- that together own 13.5 percent of Deutsche Börse. The funds criticize executives of the German exchange for ignoring shareholder interests in their effort to build a pan-European trading empire. Seifert and company, the funds contend, failed to spell out how they would deliver synergies or resolve regulatory obstacles to a merger.
“Their initial attitude on the bid was that investors either had to take it or leave it,” says David Herro, a portfolio manager at Chicago-based Harris Associates. “That’s not how companies should behave in this day and age, and management is now paying the price.” Harris Associates’ Oakmark International Fund owns 10 percent of Deutsche Börse and 3.5 percent of Euronext.
Not content with blocking the takeover, TCI and Atticus are stepping up their activism: They are working to replace Seifert and Deutsche Börse chairman Rolf Breuer at the exchange’s annual meeting on May 25.
Their odds of succeeding appeared to improve late last month when Lord Levene, chairman of Lloyd’s, who was tapped by Seifert to seek a compromise with shareholders, abruptly resigned from the Deutsche Börse board. Levene cited the excessive time demands of the job, but most analysts and bankers believe his move signaled that shareholders would accept no compromise short of the top executives’ resignation.
“They want the bourses to return all excess cash to shareholders and focus on wringing efficiencies out of their local markets,” says one person close to the TCI and Atticus campaign. “They definitely do not want the exchanges to take on unknown risks through a merger.”
Deutsche Börse’s bid for the LSE is not dead and buried just yet, however. The German exchange reserves the right to launch a new offer if a third party -- namely, Euronext -- makes a bid. Euronext, which owns the London International Financial Futures Exchange as well as the exchanges in Amsterdam, Brussels, Lisbon and Paris, has proposed a merger but hasn’t indicated a price. Instead, it is waiting for Britain’s Competition Commission to complete its investigation into the consequences of a takeover of the LSE. The commission began its six-month inquiry last month.
One of the main focuses of the inquiry will be clearing and settlement arrangements. Europe still retains a host of mainly national clearing and settlement systems, which keeps trading costs high and limits competition among exchanges. Regulators and industry executives have debated various solutions in recent years, from creating a single pan-European utility modeled along the lines of the U.S.'s Depository Trust & Clearing Corp. to harmonizing rules and standards to foster competition and technological links among Europe’s clearing and settlement organizations.
The aborted bid for the LSE appears to be turning that debate into action. Werner Frey, the Zurich-based CEO of the European Securities Forum, which represents 22 of the world’s biggest banks and lobbies for the elimination of barriers in clearance and settlement, predicts that the Competition Commission will make open clearing and settlement arrangements an essential precondition of any bid for the LSE.
“It will set conditions that will ensure users have choice when it comes to where and how they clear and settle,” Frey asserts. “Given the importance of London as a financial center, I have no doubt that the findings of the U.K. Competition Commission will influence the view in the rest of Europe when it comes to reforming the market.”
Frey serves on the EU’s Clearing and Settlement Advisory and Monitoring Expert Group, which was set up last July to advise the EU’s executive commission on how to make clearing and settlement more efficient and less costly. The EU’s internal market commissioner, Charlie McCreevy, is expected to draft proposals next year, and most industry observers think he will seek to lay down broad principles for harmonizing clearance and settlement rules to enhance competition -- and choice.
“We’ve got to have a real guarantee of free choice and a level playing field when it comes to access and charges in clearing and settlement, to make sure that not only traditional exchange platforms but also crossing networks and other alternative trading systems can compete effectively,” says Niki Beattie, the executive in charge of market structure issues at Merrill Lynch International in London. “To ensure effective competition between trading platforms, which are much easier to switch among than clearing and settlement organizations, the front end of the process cannot be in the same ownership structure as the posttrade part.”
A regulatory decision to separate clearing and settlement from trading platforms would be a big setback to Deutsche Börse -- and a boon for Euronext. The German exchange operates a vertically integrated model, with all transactions on its Xetra equities platform and Eurex futures and derivatives market cleared through its wholly owned subsidiary, Clearstream. The LSE’s chief executive, Clara Furse, has often cited that vertical structure as a major barrier to any merger with Deutsche Börse.
By contrast, Euronext reduced its stake in its clearing arm, Clearnet, to a minority to facilitate Clearnet’s merger with the London Clearing House 18 months ago. The combined LCH.Clearnet handles clearing and settlement for both the LSE and Liffe. Euronext chairman and CEO Jean-François Théodore has indicated a willingness to reduce or sell his company’s stake in LCH.Clearnet as well as a smaller stake in Brussels-based Euroclear, if necessary, to facilitate an exchange merger.
The potential for LSE and Liffe users to lower their trading costs by netting their cash and derivatives transactions through LCH.Clearnet to lower trading costs is Théodore’s trump card in his attempt to acquire the LSE. Euronext contends that a Euronext-LSE merger could deliver twice as much in annual savings for users as Deutsche Börse’s projected E100 million ($128.6 million).
Those expected cost savings have generated plenty of support for the Euronext bid. “The fact that there are more potential synergies between the LSE and Euronext and more potential choices for users in terms of where they might want to clear or settle means that at the moment this would basically be a more popular deal than one with Deutsche Börse,” says LIBA’s Yarrow.
Even more important, some of the shareholders who torpedoed the German bid see attractions in a Euronext-LSE deal. Harris Associates’ Herro believes that there is “a better fit between the LSE and Euronext.” Although he isn’t committing himself until he sees whether, and at what price, Euronext launches an offer, Herro maintains that “the potential economies of scale mean that consolidation between Europe’s exchanges is highly desirable.”
Other regulatory moves promise to intensify competition among European exchanges. Under a new disclosure code adopted by the U.K.'s Investment Management Association, British pension fund managers will be required to demonstrate that they are seeking the best execution for trades, beginning in the first quarter of 2006. The rule is expected to lead to greater use of crossing networks and nonexchange trading facilities. That in turn should pressure exchanges to improve efficiency and pricing.
In 2007 the EU’s Markets in Financial Instruments Directive is due to take effect. The law will eliminate exchange rules that prevent brokerage firms from crossing trades in-house. It should spur the use of technology that automatically routes orders to the exchange or trading network that offers the best prices.
All of these regulatory changes should encourage competition among exchanges and guarantee user choice in trading platforms and clearance and settlement arrangements. The result will be greater trading volume and lower costs, industry executives contend.
“Deutsche Börse’s bid for the LSE has really focused people’s minds on questions of competition,” says the European Securities Forum’s Frey. “Hopefully, that should accelerate the standardization, harmonization and integration of clearing and settlement in Europe and consolidation among exchanges.”
That would be music to the ears of Eric Woehrling, who runs E200 million in European midcap stocks at Edinburgh-based Martin Currie Investment Management. Woehrling bought 4 percent of Deutsche Börse at its February 2001 IPO and sold it in November 2003 for a 50 percent return. In addition to profit-taking, Woehrling says he sold the stake because he feared “unchecked and highly expensive empire-building” by the German company.
Now Woehrling says he is reassured both by the shareholder revolt at Deutsche Börse and by the efforts of industry and regulators to reduce costs and promote competition.
“We are entering a new age where there will be a very lucrative equilibrium struck between profit-driven exchange shareholders and efficiency- and cost-driven users,” he says.
If that actually happens, Woehrling will have plenty of company in rejoicing.
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