Playing the Stock Exchange Game
The recent venture by the NYSE to merge with Euronext has raised the stock exchange stakes to another level and into true global dimensions. But why was this deal made now? Is it a defensive move by the NYSE to prevent the Deutsche Börse becoming the major player in investment, part of an even greater plan or just a opportunity purchase because the time is right to break into Europe? Is there a game being played between the exchanges? If so, what is the game – Monopoly, Beat Your Neighbours, Snap or Poker?
The NYSE and Euronext have been quick to call their deal a ‘merger of equals’ but I am from the school that says there is no such thing as mergers in business – only a take over and where Darwin’s ‘survival of the fittest’ laws often apply. However, given that business laws do not always follow nature, it’s worth asking the question, why Euronext and why now?
Europe is slowly getting to grips with the Markets in Financial Instruments Directive (MiFID) and is on its own consolidation path, set by politicians, for the single European capital market. MiFID implementation in November 2007 is likely to shake up today’s order/execution market structures, affecting the stock exchanges in particular.
With the creation of a currently unknown number of systematic internalisers (SI) and the entrenchment of multilateral trading facilities (MTF) there is a distinct possibility that the world’s largest investment banks will soon be in direct, aggressive competition with the stock exchanges. Only the largest banks with powerful balance sheets could become SIs and they must ensure a huge order flow to produce the liquidity that will be required to make it a success. Thus the orders will be moved away from the exchanges, reducing their own liquidity and attraction as an execution venue. A similar market situation happened in the UK market in the 1980s, leading to the ‘big bang’. Here a bullish market was further fuelled by the massive investment of banking funds buying market share through brokers and market makers, with spreads narrowed enormously. Fortunes were won and lost, with the investor a guaranteed winner. Could a similar scenario be looming with SIs buying order flow, with potential cost reductions by throwing in cheaper custody, clearing and settlement?
Why, in this uncertain climate, would the NYSE make their move to be a large European exchange when the Euronext business is coming under a forthcoming threat yet not quantified post-November 2007? The possibility is that the NYSE knows something the rest of us don’t and maybe there is a strategy and benefit not yet apparent.
These questions can only be answered by the NYSE, but we can speculate that they could have bought Euronext at the highest price, not perceiving the potential threat to the stock exchange business in Europe caused by the policies of Brussels and instigated by MiFID.
The deal looks more favourable from the Euronext end, with the previously uncertain future post-November 2007 now looking assured. NYSE is a very large parent and will produce an underwritten security that Euronext shareholders will receive a good return on the original investment and ensure that future problems resulting from changes in the European markets will rebound to New York ultimately. They should be very happy shareholders and unlikely to be swayed by any revised offer by the Deutsche Börse.
Euronext appears to have dodged some of MiFID’s threat and if the NYSE can produce and implement a strategy to build the world’s first and largest international market, it could emerge unscathed. However, the responsibility for whether Euronext is a success in Europe or not now lies with the NYSE and this may not be easy if the failed attempt to set up NASDAQ Europe is a guide.
It has recently been suggested that the NYSE might consider setting up a rival stock exchange to the LSE in London. Throwing down the gauntlet in this way would certainly grab a lot of attention in London and Frankfurt. However, this does have all the hallmarks of an idle threat from a jilted suitor and probably cannot be taken seriously. History tells us the relationships in the City including listed companies are not lightly disposed of. The hard-nosed US style of business by correspondence, where size matters, has never attracted the European culture of a relationship-driven market. The NYSE might gain a very bloody nose and reality check if they try pursuing this approach
The LSE is still steadfast and independent after years of repelling borders from all sides, sternly rejecting the many ‘marriage proposals’. Like a modern day Queen Elizabeth I, the LSE is not willing to trade her bed for neither love nor money to those clamouring to gain from its power.
By now the LSE must have the most expert board of any listed company anywhere when defending their business from a position that has always looked highly vulnerable to market analysts and commentators. This is especially the case when its capital size is measured and where its business strategy has always been questionable. However, there are plenty of smiling shareholders showing a very healthy return on their investment.
NASDAQ made an almost apologetic and very tentative pitch at the LSE earlier this year that came and went so fast that one had to question its commitment in concluding the deal. Not long after, NASDAQ went on a bit of buying spree of LSE shares, which stand at the time of writing at just over 25 per cent. Will they push on to the 30 per cent and make a full-blown bid?
It has to be very unlikely that NASDAQ has the financial muscle to complete a bid based on their investment to date and the funds required to take out the LSE. The deal will need to be highly geared and dependent upon success in the market and future investment in the staff. Does NASDAQ have the financial clout to do this deal plus manage the consequences of the purchase?
However vulnerable the LSE has appeared in the past, it does have some very significant defenders in its corner with the might and power of its extremely loyal investors and a long client list of happy users. This has proved a strong and almost impenetrable barrier to a growing band of hostile predators in the last five years. None have come remotely close to agreeing a deal with the LSE and, like moping suitors, they slope off to find another partner. It is clear that the LSE deal is the one most would like to have, but equally, the hardest to conclude.
The LSE can also demonstrate that under intense pressure it is still able to grow a very successful business and continue to develop new technology that always appears to achieve its business objectives. All this, while keeping costs under close control enabling profit margins to continue to grow, is an extremely strong business performance that is the envy of many and underpins the ability of the people at the LSE to maintain its independence. With such a strong management team that have been honed ‘in battle’ and with this track record it will be a very difficult nut to crack and should not be under estimated.
The questions for the LSE are the same as for Euronext and the other exchanges when MiFID is introduced. Will the LSE be able to continue its successful business growth if the landscape for orders and execution are diverted to large investment banks? Can the LSE remain pivotal in the pre- and post-trade data distribution, when the data market is becoming open and fragmented and available to all via websites and new standards? These are important questions that cannot be answered until the markets bed down well after November 2007. The dramatic changes to market structures in Europe and the merger or acquisition of some of these exchanges will accelerate the maelstrom further.
If the LSE has a new fight looming post-MiFID then the Deutsche Börse will have difficulties. With a domestic market structure alien to MiFID objectives and users not willing to change to move towards a merger, it appears to be the weakest of the major European stock exchanges. Its attempts to derail the NYSE/Euronext merger will fail unless it commits to wholesale changes of its domestic market, including clearing and settlement. As unpalatable as this sounds to the German market it may be the best possible outcome, as it will need to make wholesale changes to comply with MiFID and other directives anyway.
A very workable scenario might be the merger with the LSE in the equity/fixed income markets. This is where the German market takes on the LSE trading technology platform including SETS and CREST/Euroclear with listed companies moving to the London exchange. The derivatives market remains in Germany and this is where the LSE can develop a business for the German market. Then the best of both worlds might co-exist. The LSE will gain a foothold in derivatives and the Deutsche Börse will be in a tight corner and part of the competition against the NYSE/Euronext.
A merger between the LSE and the Deutsche Börse still has an up and coming battle with the investment banks, but at least it will have a very good offering to those banks to deter them entering in competition for order flow. Can reasonable people be found on the two exchange boards to find such a business compromise or will the defensive battle lines remain in place? Only time will tell.
One of the biggest issues around the creation of a single large global stock exchange is clearing and settlement. For example, how will NYSE and Euronext offer their users clearing and settlement without the co-operation of Euroclear and the Depository Trust and Clearing Corporation (DTCC)? Has the DTCC and Euroclear already been privy to an offer by the NYSE and Euronext? Will NYSE allow Euronext to manage, clear and settle through Euroclear as they do today, with a similar agreement with the DTCC? How will costs be better for global investors if the expense of clearing and settlement remains outside the scope of any merger?
If the merged NYSE/Euronext exchange becomes the biggest international global stock market there appears to be an issue concerning horizontal and vertical lines of trading clearing and settlement. Any NYSE/Euronext pitch to create a huge vertical business will be in direct contradiction to the EU view of horizontal market structures to provide the best competition and the likely reduction of overall costs of trading, including clearing and settlement. A greater choice of trading venues, with more options where to clear and settle, underpin the new EU market being created by Brussels. Any monopoly of a forced vertical market will not only be against the principles being set and that run through MiFID but also a number of other political directives yet to hit the market.
It is clear that the NYSE has to take into account the post-deal costs of the merger and these will be considerable. Taken in relation to the unknown threat that MiFID and, in particular, the SIs bring make the merger price look very expensive, unattractive and possibly mad.