Stock and derivatives exchanges: The wedding’s off

Deutsche Borse's bid for the London Stock Exchange is over. Consolidation in their industry is not

WERNER SEIFERT likes to dream of the day that Deutsche Borse, the financial-exchange company of which he is chief executive, becomes truly pan-European, complete with a non-German name. That day looks further off than ever. On March 5th Mr Seifert was forced by a shareholder rebellion to withdraw the informal £1.35 billion ($2.6 billion) offer he made in December for the London Stock Exchange (LSE). The revolt was led by hedge funds that wanted Deutsche Borse to use its stockpile of cash to pay dividends instead.

This is a big blow for Mr Seifert. He has been plotting a takeover of the LSE for several years: a previous attempt, in 2000, foundered on opposition, much of it nationalistic, from the LSE's shareholders. The failure of his second bid is not his only recent slip. Talks last summer with SWX Group, operator of the Swiss stock exchange, yielded no merger. And the venture into America a year ago by Eurex, the derivatives exchange that Deutsche Borse owns with the Swiss, has not wrested much business from the incumbent Chicago Board of Trade (CBOT). Mr Seifert is not easily put off: he has already hinted at another go at the LSE, although it would probably have to be financed by debt. But his future at Deutsche Borse seems in question, as does that of Rolf Breuer, the chairman of its supervisory board.

The LSE's other declared suitor now takes centre stage. Euronext, which operates stock exchanges in Amsterdam, Brussels, Paris and Lisbon, made a rival offer for the LSE last month, but did not name a price. Under Dutch law, its shareholders would have to approve any bid. The LSE says it is “willing to continue discussions”.

Left at the altar?

However, its share price has now given up much of the gain made when Mr Seifert made his offer. Euronext may be able to get a cheaper deal than looked likely when Deutsche Borse was bidding. Or it could walk away: several of the Deutsche Borse rebels are its shareholders too. The LSE would then have to carry on alone, assuming no other bidder appears. It is conceivable that it might. The LSE keeps breaking trading volume records. It lies in Europe's largest financial centre and in its healthiest big economy. The market for new share issues is heating up, as is demand for the pricing data that the LSE sells.

Still, the LSE's shareholders have a problem. The exchange is almost entirely a cash market. It has a tiny, token derivatives business. And derivatives, not equities, look poised to deliver better volume growth, and hence higher revenues for exchanges, over the long term. More over-the-counter derivatives business appears to be moving to the exchanges, attracted by their falling trading costs and safe systems of counterparty clearing.

A link-up with another European exchange would enable the LSE to diversify into derivatives. Either Deutsche Borse, through its part-ownership of Eurex, or Euronext, which owns Liffe, a London derivatives exchange, would fit the bill. The LSE must rue losing the fight over Liffe with Euronext several years ago.

The LSE is not alone in hankering after derivatives. While the dance plays out in Europe, the New York Stock Exchange (NYSE) finds itself in much the same fix. The NYSE sold its options business to the Chicago Board Options Exchange eight years ago. Now John Thain, the Big Board's chief executive, would like to claw his way into higher-growth areas such as derivatives or fixed income. Since no other exchange is falling over itself to buy the NYSE and its lumbering trading systems, Mr Thain might consider a purchase himself.

Much speculation surrounds the plans of the Chicago Mercantile Exchange, which is understood to have had talks with the International Securities Exchange (ISE), a venturesome, young, electronic options market that went public this week, though no link-up resulted. Also in America, Archipelago, owner of an electronic stockmarket, recently bought the Pacific Exchange, an options exchange, partly to get a piece of that fast-growing business.

Consolidation is thus in the air. One reason is that in recent years many exchanges, including the LSE, Deutsche Borse, Euronext and the Chicago Mercantile Exchange (CME), have become publicly held companies: they have money to spend on acquisitions, or can use shares to buy rivals. The markets seem keen on quoted exchanges: the price of shares in the CME has quintupled since flotation. The envious CBOT will vote this spring on going public. Shares in the ISE rose by 69% on their first day of trading, March 9th.

Mergers bring a host of regulatory issues. As in any market with only a few players, competition authorities must see that customers get their share of any efficiency gains. In cross-border mergers, the question arises of which regulator should supervise the combined exchange. This has been an issue in the battle for the LSE, because Britain's Financial Services Authority is rightly loth to give up oversight.

Still, exchange users should cheer consolidation to a degree. They will have access to more products. Trading costs should fall as more products are crowded on to the same platform. Banks' in-house technology costs may fall too, as they need to connect to only one exchange rather than several.

There is also the creation of new ways to trade. In America, the options business is abuzz with talk of “side-by-side” trading, in which options are bought and sold at the same time as the underlying shares; throw in futures and you get “side-by-side-by-side”. This is not yet possible on either side of the Atlantic. Thus although the Deutsche Borse's Frankfurt stock exchange and the Eurex derivatives trading system are linked by ownership, their trading systems operate separately. Anyone wanting to buy shares in BMW and hedge against a fall in price at the same time must trade the stock in Frankfurt and send an option order separately to Eurex. There is a risk that one of the orders will not be filled instantly or at the desired price. “It's a game of millimetres and milliseconds,” says Mike Cormack, president of Archipelago, which is trying to create side-by-side capability.

Some scepticism is in order: bankers say they can already do all this for their institutional clients, and the main markets are already so liquid that the risks are slight. But some investors may be keen. “Hedge funds and private equity may take up these instruments more quickly,” says Avinash Persaud, investment director at GAM, a fund of hedge funds. Some speculate that retail investors too could end up warming to the idea.

Ironically, it is the LSE - which currently lacks a serious derivatives business - that has taken the lead in Europe in pursuing this sort of capability. By early 2007 it should have a platform ready to trade derivatives as well as cash and other products. That is one reason why it is ripe for a link-up with a derivatives exchange. Euronext, in its bid last month, enumerated some of the gains from new products, such as the packaging of LSE-traded equities with index derivatives traded on Liffe, or linking up cash bonds traded on the LSE with Euronext's gilts futures market. Such convergence of products could come swiftly in Europe if the LSE ties the knot with another exchange.

In America, the idea of “side-by-side-by-side” trading may cause some regulatory confusion. Whereas equity and options trading comes under the aegis of the Securities and Exchange Commission, futures trading is overseen by the Commodity Futures Trading Commission, which quaintly reports to Congress's agriculture committees. Perhaps regulators, like exchanges, should consider merging.

• Primary Source