The Game of EuroRisk: The Quest for Dominance Among Europe’s Exchanges
Last fall, the financial world was treated to a rare spectacle when a bidding war erupted for the London International Financial Futures and Options Exchange, the second largest derivatives exchange in Europe. Many observers thought the London Stock Exchange had the inside track. The two exchanges on paper looked like the perfect match, and the LSE’s top executive had spent a good part of her career in the derivatives markets. Others speculated that Germany’s fast growing Deutsche Börse would take the prize.
In the end, however, it was Euronext, the one-year-old federation of the Paris, Amsterdam and Brussels exchanges, that won the auction with a sky-high bid of 907 million euros in cash. Euronext’s offer valued LIFFE at more than twice the price of its shares before the auction began, a clear indication of its strategic value in the competition among Europe’s leading exchanges.
Shortly after Euronext sealed the LIFFE deal, arch-rival Deutsche Börse made its own move. The German exchange announced plans to take full control of Clearstream, the European settlement house and depository, by acquiring the 50 percent of Clearstream shares that it did not already own. Despite strong opposition from some shareholders, the German exchange finalized the deal in April and now stands poised to add the highly profitable settlement house to its operations.
Together, the two deals marked a significant acceleration of the consolidation of European exchanges, and an important step forward in the broader process of financial integration in the European Union. In contrast to North America, where the great game of consolidation has only just begun, Europe’s exchanges are rapidly approaching the final stages of the process, with only a few marketplaces still up for grabs. Of those, the Italian and Spanish exchanges stand out as the most attractive candidates, and the ones most likely to tip the balance in the battle to become Europe’s dominant financial marketplace.
What does this mean for the derivatives industry, and futures markets participants in particular? First, the consolidation process, and especially Deutsche Börse’s takeover of Clearstream, has intensified a long-running debate about who should control the clearing and settlement process. On one side is the “vertical” exchange model, championed by Deutsche Börse, in which an exchange owns its clearing and settlement. On the other side is the “horizontal” model, championed by the European Securities Forum, in which trading, clearing and settlement are provided by separate entities. And somewhere in between, Euronext, which sold off the interests in the settlement houses formerly associated with its member exchanges but owns a controlling 80 percent stake in its clearinghouse.
Second, the consolidation trend has produced a de facto duopoly in European futures and options, split between the Anglo-French-Dutch combination under the Euronext umbrella and the German-Swiss exchange Eurex controlled by Deutsche Börse. Many industry participants believe Euronext has the better platform in LIFFE’s CONNECT system, but it must first overcome the steep technological and operational challenges of migrating all of Euronext’s derivatives trading onto that platform. Eurex, meanwhile, has a strong base in fixed income futures and is making great strides in developing its equity derivatives products, but its parent has not yet shown the same ability as Euronext to acquire other exchanges.
Each of the two has its strengths and weaknesses; both have ambitious plans to expand their market share. The next 12 months could prove to be a decisive phase in their rivalry to become Europe’s top marketplace for futures and options.
Euronext: Pan-European Vision
For Euronext, paying such a high price for LIFFE was fully justified by the exchange’s strategic value. Not only did the deal vault Euronext into the top rank of the world’s derivatives exchanges, it also firmly planted the continental exchange’s flag in Europe’s most important financial center and addressed an important weakness in its integration program.
Simply in terms of volume, the deal filled a crucial hole in Euronext’s product range. On a combined basis, the group’s volume last year in futures and options would have totaled 615 million contracts—only nine percent short of the total volume at its rival, Eurex. And LIFFE’s strengths in short-term interest rate contracts nicely complemented Euronext’s strengths in equity derivatives.
More importantly, Euronext has put LIFFE’s management team in charge of combining the futures and options trading in Amsterdam, Brussels and Paris into a single marketplace under London’s direction. Euronext also plans to move all its derivatives contracts to the CONNECT trading platform by the end of next year, rather than building its own trading platform from scratch.
“It’s not as though Euronext takes over and completely sweeps away everything that’s made the exchange in question successful,” explains Hugh Freedberg, LIFFE’s chief executive, who now sits on the managing board of Euronext. “They seek to preserve the key attributes of the exchange they acquire.”
Since the LIFFE acquisition, Euronext chairman Jean-François Théodore, a former bureaucrat in the French finance ministry, has continued making deals. He recently finalized an agreement to incorporate Portugal’s stock and derivatives exchange into his alliance, bringing the total number of countries under the Euronext umbrella to five. He also has signed cooperation agreements with exchanges in Helsinki, Luxembourg and Warsaw.
While overall control is centralized in Paris, each exchange that has been incorporated into the group continues to have a strong say. At the board level, LIFFE is represented by Freedberg and Brian Williamson, LIFFE’s chairman. Portugal’s BVLP is represented by Ricardo Espirito Santo Salgado, the chairman of that exchange, who was appointed in April to the group’s supervisory board. And George Möller, formerly the top executive at Amsterdam’s exchange, is now the chief operating officer for the group as a whole.
The Challenge of Integration
In a sense, Euronext functions like a federation of exchanges. Some say the structure slows down decision-making and could prove to be a handicap to integration, but others say this business model puts Euronext in a better position than Deutsche Börse or the London Stock Exchange to continue snapping up smaller exchanges and building its overall liquidity.
First, however, Euronext has to combine the existing member exchanges into a single marketplace, with a harmonized rule book and standardized systems for trading, clearing and settlement.
“Euronext’s top priority is to achieve technical integration for cash and derivative products, on trading, clearing, and settlement and custody with Euroclear,” says Théodore. “Economies of scale will come mainly from the harmonization of our trading system and from the rationalization of our clearing processes.
“Our timetable is to implement the Clearing 21 system, already used in Paris and Brussels, for the Amsterdam cash market by October 2002,” Théodore adds. He also aims to link LIFFE’s CONNECT system to Clearing 21 by this fall, to switch the French, Belgian and Dutch derivatives products onto CONNECT early in 2003, and to get the Portugal cash market tied into its trading system in 2003.
In other words, Euronext should be able to offer clients the ability to trade French, Belgian and Dutch equities on one platform by the end of this year, with one central counterparty, with netting between countries, and with one clearing and settlement system, says Merrill Lynch analyst Manus Costello.
“I believe clearing is actually central to the way Euronext works,” says Costello. “It’s the glue that binds together the whole Euronext project. They have an array of disparate markets in disparate places. What they need to pull all of it together is the clearing arm.”
Integrating multiple countries, multiple products, and multiple exchange functions presents a formidable technical challenge. So far Euronext has approached this in a pragmatic fashion. Rather than transitioning an entire market in one fell swoop, it has proceeded in stages to minimize disruption. For example, in Amsterdam’s options market, probably the most difficult to integrate, Euronext is steadily moving groups of contracts from the floor to the SWITCH electronic trading system, and only after this process is complete will it tie the trading into CONNECT.
“There’s a significant risk of losing order flow during the transition from floor to screen in Amsterdam. But they’re approaching this in a pretty smart way, staggering the transition to make sure they don’t lose market share,” says one derivatives industry veteran who oversees options market-making for his firm.
Nevertheless, the transition will be disruptive, especially for the smaller market makers, he says. Independents are leaving the floor, while the remaining market makers on the floor are migrating to the contracts that are last on the list for transitioning to the screen. “It reminds me of the people who ran to the tip of the Titanic before it sank,” he says.
Eurex has listed options on several big Dutch names and stands ready to pounce if Euronext stumbles. But the German exchange has at least one crucial disadvantage. Options market makers look to the cash market to lay off their risk, and if they stay within the Euronext system, they get the benefits of having both positions at the same clearinghouse.
Euronext’s grand goal is to build liquidity. In numbers of transactions, Euronext is now Europe’s second largest stock exchange, the largest options exchange, and the second largest futures exchange, and it expects volume to grow as cross-membership in its various marketplaces leads to greater cross-border trading. Rising volume should also make its markets more attractive places for companies to list. “The real asset is liquidity,” says UBS Warburg analyst Johan Svensson. “They’re trying to create as large a liquidity pool as possible, in order to attract new liquidity.”
One more cross-border acquisition could take Euronext over the top, but how much can it afford to pay? Securities analysts worry that Euronext paid too much for LIFFE—and may not be able to bid as aggressively as it likes on future acquisitions. With most of the cash from its IPO gone, future deals will have to be made with stock, but its stock price is likely to lag behind its peers until integration begins generating results. Says UBS Warburg’s Svensson: “It is difficult to justify the multiples Euronext paid for the Lisbon stock and derivatives exchanges. The price paid for LIFFE is easier to justify, but both acquisitions represent important management challenges.”
Deutsche Börse: Controlling the Value Chain
While Euronext has grown through a series of blockbuster cross-border mergers, Deutsche Börse has taken a different path, expanding its business by capturing leading contracts from other exchanges and developing hot new contracts on its own.
Its subsidiary Eurex, the world’s largest futures exchange, succeeded several years ago in capturing Europe’s benchmark government bond contracts from LIFFE—a rare feat in the futures world. Eurex also succeeded in developing what have become the benchmark equity index futures for Europe, and it is working hard to attract more liquidity to its options.
Last year, when stock trading activity sagged all across Europe, Eurex racked up record trading volumes and generated more than a third of Deutsche Börse’s total earnings before interest and taxes. In the first three months of 2002, volume in fixed income futures and options has been flat, but trading continued to increase in equity options and index products. The margins are higher on equity products, so this should lead to greater profitability.
On the stock side, Deutsche Börse still lags behind Euronext and the London Stock Exchange in terms of the number of transactions, but the exchange has formed alliances with the Vienna and Dublin exchanges, under which they use its Xetra trading platform, and it has found a new growth segment in exchange-traded funds.
That is not to say that Deutsche Börse has not attempted to buy other exchanges. An attempt two years ago to merge with London Stock Exchange was unsuccessful, and now there is talk of a possible combination with Italy’s Borsa Italiana, once that exchange offers its shares to the public. But when it comes to futures and options, most of the big pools of liquidity have already been captured by Euronext and Eurex.
“All the European futures and options markets have either merged or been bought with their domestic stock exchange, or been consolidated with another derivatives market,” says Euronext’s Théodore.
The more important arena of competition, however, is in the contrast between their approaches to clearing and settlement, and especially Deutsche Börse’s controversial takeover of Clearstream.
Clearing and Settlement: The Fight for Control
When Deutsche Börse announced it intended to expand its ownership of Clearstream from 50 to 100 percent, it sparked objections from a number of dealers who didn’t like the idea of one exchange consolidating trading, clearing and settlement into a single vertical network, and provoked at least one bank—J.P. Morgan—into moving its business from Clearstream to rival Euroclear.
“Our primary objection was that we do not believe in the vertical model that Deutsche Börse is pushing,” says Richard Berliand, global head of futures and options at J.P. Morgan Futures, who is also a member of the LIFFE and London Clearing House boards. “As a consequence, we voted with our feet.”
Although no other dealers have followed J.P. Morgan’s lead, many seem to share J.P. Morgan’s apprehensions. Through organizations such as the European Securities Forum, they argue that the most efficient arrangement is to unify clearing and settlement across Europe into a not-for-profit utility operated by its users, i.e. the major dealers and banks, with exchanges competing with each other but not controlling clearing and settlement. Their model is the Depository Trust Clearing Corp., and they argue that a similar structure in Europe would greatly reduce the cost of cross-border securities trading.
“We want to create a pan-European capital market with a single infrastructure, so where you trade, how you trade and what you trade ceases to be an issue,” explains Pen Kent, chairman of the European Securities Forum, which represents a consortium of bankers. “That doesn’t mean we necessarily want all the exchanges to join up, but we believe that clearing and settlement should be completely cheap and efficient and uniform throughout. The model we’re trying to create is not a lot different from the DTCC, because the U.S. has been there before, found the right solution, and it seems to work.”
The dealers’ ambition is to net as many transactions as possible by consolidating clearing into one or two European institutions. “The biggest fight now for most practitioners in Europe is to get risk capital allocated within their organizations,” says Roy Leighton, chairman of the advisory board at Credit Lyonnais and head of the U.K.’s Futures and Options Association. “The more you can net and use your allocation efficiently, the more business you can do.”
Leighton notes that at the LCH, his firm can net where permitted trades from LIFFE, the International Petroleum Exchange, and the London Metals Exchange, as well as OTC repo and swap transactions. He hopes the LCH will form an alliance with Clearnet, Euronext’s clearing firm, so clients of the two would be able to share a common pool of capital.
While the principal driver seems to be potential savings in risk capital, operational savings are also possible. If two counterparties are on the books of the same settlement organization, the cost can be half a euro, an amount comparable to the U.S. But settling a trade that involves two different settlement houses across borders can cost 10 or 20 times U.S. costs.
“The high level of fragmentation is the main problem in Europe, as it means users have to cross from one system to another,” says Ignace Combes, deputy CEO of Euroclear. “If Client X is with Euronext and Client Y is with the German system, that means cutting across two different systems, and the cost of settlement can be as much as 20 to 30 euros, compared to just half a euro if the transaction was done entirely on Euroclear’s books. And because clients have to interface, either directly or through agents, with so many different systems, with different standards, different ways of communicating, their back office costs are inevitably very high.”
The horizontalists also fear loss of influence in decision-making. “The primary problem is the lack of ability to influence process in the clearing arena,” says J.P. Morgan’s Berliand. “You can’t influence the credit treatment or pricing. When I talk about influence, I’m talking about governance. The clearing function is something that benefits from direct ownership by market participants.”
Other dangers are more subtle. A monopolist exchange that controls clearing can set customers’ margin levels high, perhaps use that collateral at the clearinghouse to maximize profit for the exchange, and even issue ruthless margin calls that could damage firms and exacerbate market declines. Under a DTCC-type system, dealers have control over margin levels, margin calls, and what happens to their collateral. Euroclear’s Combes believes Europe’s future clearing and settlement system must have strong user governance, “where, as in the case of the DTCC in the States, it is the users who decide on prices and how much profit is needed to reinvest in the business. The system cannot exist simply to maximize profits.”
Kent points out that the European Union has come out in favor of a single market in financial services. He hopes that European regulators will force the European exchanges to consolidate clearing and settlement in much the same way the Securities and Exchange Commission drove consolidation into the DTCC in the 1970s.
Kent also believes that additional pressure will come not from dealers, but from the investment community. “Under the euro, all the major investing institutions are going to be benchmarked in their performance against each other,” Kent says. “They are not going to be able to perform well unless they can manage their assets with complete freedom. They’re going to say: ‘Hey guys, the Euro zone is now a single domestic market, for God’s sake. Why have we got all these tin pot little national systems instead of one thing which serves this new domestic market?’”
Vertical vs. Horizontal: The Counter Arguments
Not all dealers favor the horizontalist model, however. Some, admittedly a minority, argue that exchanges should control the full transaction chain in order to deliver the efficiencies of one-stop shopping. True cost savings, they believe, can come only from straight-through-processing, which is much easier to achieve in a vertical structure. They also argue there’s nothing inherently wrong with exchange control of the clearing and settlement process, because competing for-profit organizations are likely to produce the greatest level of innovation and cost efficiency.
Verticalists also predict that the horizonalists’ expectation of savings from cross-border integration will prove negligible. Achieving real integration, they say, is much more difficult than the horizonalists claim. “The horizontal model will be difficult to execute, especially on the back-end,” predicts Deutsche Bank analyst Alexander Hendricks. Europe still speaks 15 different languages, he points out, and legislation, taxation, regulation, settlement dates, and delivery processes are still governed by separate governmental bodies.
If clearing and settlement are owned separately from trading, “you’ll always find one company blaming another when a trade doesn’t go smoothly,” adds John Mathias, a director at Merrill Lynch International. “But if you own the full value chain, it’s you who is responsible for everything happening smoothly.”
The verticalists also believe that risk capital may become less of an issue as Europe’s exchanges consolidate down to two or three. “If you have one, two, or three marketplaces, you are essentially getting large-scale netting within each silo,” says Mathias.
Behind this debate lies a more practical issue—buying Clearstream will make a big contribution to Deutsche Börse’s bottom line. Although the purchase price was higher than expected—30 percent over the consensus valuation, according to one Frankfurt analyst—the incorporation of Clearstream’s existing business lines will almost immediately boost the exchange’s profit.
According to a UBS Warburg estimate published in February, the full consolidation of Clearstream will add 140 million euros to the group’s operating profit this year, roughly 46 percent of the group’s total operating profit, and 261 million euros in 2003. After restructuring charges and amortization costs, the impact on net income will be negative this year, then positive in 2003 and thereafter.
Taking full control over Clearstream also may allow Deutsche Börse to slash the cost of clearing and settling trades in international stocks listed on its exchange, potentially a key strategic advantage in the battle with Euronext and the LSE.
Werner Seifert, CEO of Deutsche Börse, says the incorporation of the settlement house will allow his exchange to create the most efficient and lowest cost processing chain for securities in Europe, and accelerate the introduction of new products and services. Seifert also has been at pains to stress that Deutsche Börse will respect the "voice" of market participants as consolidation reshapes the European securities industry.
"This is not the last step in the consolidation of European securities trading, clearing and settlement," Seifert said last May, when the exchange revealed that it had reached an agreement to acquire the remaining 50 percent of Clearstream. "Deutsche Börse is eager to consider cooperations, ventures, partnerships and acquisitions all along the chain—with other exchanges, CCPs, CSDs, ICSDs and even ventures with customers.
"From its inception, Clearstream has recognized the importance of customer input and corporate governance structures that build confidence for our market participants," he added. "As consolidation accelerates through the European securities industry, Deutsche Börse will continue to respect the importance of market participants and will operate in a manner that gives them the loudest voice in determining the future direction of the market's development."
Leaning Tower of Pisa
Not everybody sees the conflict between Euroclear and Deutsche Börse in terms of horizontal or vertical models.
“Operation-wise, Deutsche Börse and Euronext are similar,” says UBS Warburg’s Svensson. “They both have a vertical structure going down from the transaction level to clearing and settlement. The only difference is that Deutsche Börse, by acquiring Clearstream, will own the entire vertical chain 100 percent, while Euronext owns 80 percent of Clearnet, its clearing agent, and four percent of Euroclear, its settlement agent. The difference is the level of openness, and Euronext is more open.”
Euronext also owns a 17 percent stake in the London Clearing House, which it inherited through its acquisition of LIFFE. As of now, LIFFE transactions continue to clear through the London Clearing House, while Clearnet handles all cash and derivatives trades, including OTC trades, for the French, Dutch, Belgian, and Portuguese markets.
“They call it horizontal, but in fact it’s a wider non-integrated vertical silo,” argues Graham Cope, director of corporate communications at Clearstream International. “When you get inside that silo, you still have different entities, different systems and completely different situations under one brand name. They’re using that one brand name as a cover to say: ‘Look, complete horizontal integration has been undertaken,’ but in reality no true integration has been completed, and no cost benefits have been transferred to the users. They talk the story, but scratch the surface and you find a lot of strategy, but not a lot of realization.”
Cope believes that Clearstream’s alignment with Deutsche Börse will allow it to bring new levels of vertical efficiency to the whole clearing and settlement process, with promises of cost reductions of 20 percent over three years in addition to the 50 million euros already delivered last year. He adds that it’s hardly surprising that J.P. Morgan moved its clearing business to Euroclear shortly after Deutsche Börse announced its intentions to acquire Clearstream. Euroclear, after all, was until recently a J.P. Morgan subsidiary, and is still making multi-million dollar payments yearly for its independence.
A joint research study published in February by McKinsey & Co. and J.P. Morgan envisions a third possibility in clearing and settlement: a “Leaning Tower of Pisa” outcome. The report predicts that vertical structures gradually will become more horizontal as regulations become more harmonized, and suggests that the effects on players and the whole industry will be less pronounced than the market anticipates.
Euronext seems to be moving in that direction. In contrast to Deutsche Börse, it doesn’t intend to strengthen its grip on Clearnet by acquiring the remaining 20 percent of its stock; quite the opposite. Says Théodore: “We spun off [part of] Clearnet, which was previously an in-house department, to open its use and eventually share ownership with other customers and interested parties.”
As for settlement, Euronext sends its settlement business to Euroclear, which, despite its name, performs no clearing functions whatsoever. Euronext does not want to own much of the settlement business. When it acquired the Paris, Amsterdam, and Brussels exchanges, it sold each of their settlement businesses to Euroclear. “We don’t believe settlement and depository are the core business of the exchange,” says Théodore.
Consolidation: What’s the Next Move?
At the moment, there’s intense speculation about which group will acquire the Italian and Spanish exchanges. Euronext has told analysts it will not make a costly acquisition anytime in the near future, but Svensson at UBS Warburg notes that it would make sense to add Madrid to the Euronext empire. But he cautions that it would be a complicated merger.
WestLB Panmure analyst Johannes Thormann believes that Deutsche Börse could have an inside track on the Milan exchange because it already has a small stake in Italy’s leading clearing organization. Patrick Young, author of a recent study on exchange consolidation, is betting on a German/Italian alliance because Deutsche Börse’s Seifert and Borsa Italiana’s managing director, Massimo Capuano, both came out of McKinsey. He points out that the Spanish exchange, on the other hand, has traditionally had good relationships with exchanges that are now part of Euronext.
OM, the Swedish exchange group, is also potentially in play. The group has reorganized its business structure to separate its securities and derivatives trading from the rest of the group, a step widely seen as preparation for a sale. However, it is not clear if the exchange is big enough and strong enough to warrant an acquisition.
These markets may prove to be the final pieces in the European exchange puzzle. For better or for worse, the Euroclear and Deutsche Börse models are likely to dominate the foreseeable future. “European exchange consolidation is now very advanced,” says James Davison, president of Cargill Investor Services. “It’s at the mature stage.” Predicts Merrill’s Mathias: “There’ll be a little bit more consolidation, and then it will all grind to a halt. There are too many political and national differences. Even in the States there are issues like that. Why, for instance, haven’t the two Chicago exchanges merged?”
Another common view is that the two aggressive empire builders, Euronext and Deutsche Börse, will carve out separate domains. “There won’t be a single European exchange, not for the foreseeable future,” says Young, “because competition in Europe will see to it that there’s at least a duopoly.” Says J.P. Morgan’s Berliand: “There comes a point when the efficiencies being achieved by consolidation are less important than the risk of marketplace domination by one particular participant. We see consolidation down to perhaps two exchanges in the same arena as being healthy. But one exchange is generally unhealthy.”
Merrill’s Costello argues that the competition between Euronext and Deutsche Börse is not a zero sum game and will actually prove beneficial for both sides. “It’s very much going to be fruitful competition for customers, because we’ll see an increasing range of products and increasing innovation technologically,” Costello says. “I think both of them could do very well out of it.”
Investors have other ways to throw their weight around. Deutsche Börse, Euronext and the London Stock Exchange all went public last year, and will now be forced to make their operations and revenues much more transparent. The market will show little tolerance for irrational purchases and will want to make sure any new deals flow through to the bottom line. From that perspective, Deutsche Börse’s purchase of Clearstream makes a great deal of sense.
Credit Lyonnais’ Leighton is looking even farther ahead to a time when the rapidly declining cost of electronic trading systems will allow dealers to create their own trading, clearing and settlement structures. He even envisions the return of mutual exchanges, with a twist: what he calls “cheap electronic platforms operating for pennies.”
The European exchange landscape may or may not look significantly different by the end of the decade. But one thing is certain: Nationalism is not the driving force it once was. “In the industry, there are always some who talk about preserving England, but most senior managers are bemused by this,” says Mathias. “Senior management wants to do what’s right, and that means a more regional response.” |
