Stock exchange mergers. Three-dimensional chess

Post-trade concerns could hamper a pan-European solution

THE long-running fuss over the London Stock Exchange (LSE) and its possible partners took a new turn last week. Britain's Competition Commission indicated that there would need to be “remedies” if either of two European exchange groups, Deutsche Borse or Euronext, were to buy the LSE. In each case the most likely remedy would be a clear severance of business interests between the acquirer and the clearing company associated with it - Eurex Clearing, which is wholly owned by Deutsche Borse, and LCH Clearnet, 41% of which is owned by Euronext.

If such remedies were prescribed in drastic form, they might well rule out both mergers. Neither potential buyer would easily sell its clearing company (in any case, neither may still be very interested in a merger). Deutsche Borse insists that it simply would not offer Eurex Clearing for LSE trades. Most LSE transactions are already cleared through LCH Clearnet, and Euronext reckons its hands-off policy would prevent abuse. The Competition Commission will not reach a final verdict until November. But its focus is squarely on the post-trade aspects of any merger.

Clearing and settlement are the unglamorous but essential bits of share trading. After a purchase is agreed, a clearing-house makes sure that the stock can and will be paid for by the buyer. A securities depository then moves the title of the share from the seller to the buyer. Does an exchange's control over clearing and settlement lead to monopolistic pricing?

Because economies of scale are so important, clearing and settlement have tended to be quasi-monopolies. Opening these activities to competition seems not to work very well. An example is virt-x, a small electronic exchange for European blue-chip shares which offers clearing and settlement alternatives: nearly all the liquidity has migrated to just one of them.

America's regulators decided years ago that clearing and settlement would best be handled by a single monopolistic entity, the Depository Trust & Clearing Corporation (DTCC). So there is no problem about who clears and settles in the proposed mergers between the New York Stock Exchange and Archipelago, an electronic exchange, or between Nasdaq and Instinet, another electronic exchange.

The real issue - and it is well beyond the remit of Britain's competition watchdog - is what the future stockmarket landscape of Europe should look like. The European Central Bank, which ought to see the big picture, is in favour of a clearing and settlement system, or network of systems, within the euro area, but is wary of letting a new monopoly develop.

The European Commission is also worrying at the topic. One of its departments, DG Markets, is considering drafting a directive that would aim to harmonise clearing and settlement in Europe and would perhaps insist that they be interlinked, with transparent pricing. Another, DG Competition, last week sent a questionnaire to all exchanges to learn how prices for trading, clearing and settlement are formed and possibly cross-subsidised.

Because clearing and settlement are complex activities and their interplay with trading is not well understood, there is plenty of scope for interested parties to lobby furiously with arguments as bamboozling as three-dimensional chess. Deutsche Borse is often painted as the villain for its control over clearing and settlement, the so-called “vertical silo”. In fact the Euronext structure is not that different. Only the LSE has made a virtue of not controlling post-trade activity, a strategy that is likely to cost it its independence.

Less evident in this debate are the interests of the consumer. Freer competition might benefit brokers and investment banks, which compete with exchanges and post-trade services as well as use them. But an American-style DTCC, or two that compete, could simplify the services and cut their cost to individual investors.

The architects of a truly Europe-wide capital market, with a glance at consolidation among American exchanges, may hasten to encourage a pan-European solution, rather than fretting about silos. Then Britain's Competition Commission will have a new task: deciding whether it could accept a fusion of the LSE with both Deutsche Borse and Euronext.

Post-trade concerns could hamper a pan-European solution.