The Need for Trading Venue Consolidation in Europe
In the wake of the credit crunch and the associated market contagion, it is worth casting our minds back to the market landscape immediately before sub-prime made a sudden and unwelcome entry into the English dictionary. It was a time when markets were riding high, apparently fully recovered from previous crises, and – as is so often the case at such calmer times – focus was intensifying on industry costs. Profitability is good, the reasoning went, but wouldn’t it be so much better if the true overall cost per transaction were lower?
Given the subsequent disruption in the markets, and the massive write-downs that have dwarfed the projected savings, is there still an appetite in the industry for collective action that will improve efficiency? The simple answer is, of course, that there has to be. While the market has got nowhere near to full recovery, with some firms still battling for survival, most expect that these circumstances will only be temporary, so we should be looking towards the future by building permanent reductions in the cost of doing business.
It’s worth first reflecting on where the pressure to lower transaction costs came from. Like many other ideas and initiatives, it has travelled eastward across the Atlantic. Industry initiatives from the other side of the pond first gave us eurobonds, and then somewhere to settle them – first Euroclear and then Cedel. (The latter was, of course, a European initiative, but one supported by a major American bank.)
In the eighties, as we prepared for big bang, the US houses were out buying any and every stock broker or jobber with a quaint sounding name – and paying top dollar, too. We laughed when they overpaid, and then again when some of the acquisitions turned to dust; but we stopped laughing when the American relentless determination and enthusiasm helped to build an international financial centre in London that could equal the domestic behemoths of Tokyo and New York. Those investment banks that emerged, and now dominate the markets, have even built their own miniature version of Manhattan in the backyard of the new Billingsgate Fish Market.
Unsurprisingly, during the process these American giants looked at the cost of doing business over here and were shocked at the price differential per transaction cost. Why – the argument ran – should I pay five times as much for the total cost of executing and settling a trade in Europe as I would in the US? And it’s a fair question. The costs are clearly embedded in the infrastructure and there are historical reasons for this, but not necessarily any good ones for perpetuating this disparity.
For the benefit of comparison, we should first look at how the North American market became so efficient and competitive. There was competition between execution venues, we are told. Well, in truth, not a great deal of competition. Multiple venues, yes, but the overlap in trading lines and styles was modest, and consolidation will probably make it more so. And in clearing and settlement, the DTC is a virtual monopoly, leveraging volumes and economies of scale with lots of good housekeeping to deliver utilitised, commodity pricing.
By comparison, in Europe we’ve always had at least one execution venue per country and more are emerging all the time. With each trying to protect its own market share while trying to steal a bit of somebody else’s, there is over-capacity and – from an investor’s point of view – over-complexity. And in clearing and settlement, we have an expanding choice of clearing houses and central counterparties, with still one central securities depository (CSD) per country.
Given that industry costs will be a direct function of the number people employed, the real estate occupied, the number of lines of computer code, and the number of servers employed, if trading volumes are of the same order of magnitude, then Europe will obviously be more expensive. If we wish to see a Europe that can compete on cost per transaction, then the only answers are rationalisation and consolidation.
In execution venues, few would argue that we don’t have enough – quite the reverse. We should expect two or three to emerge as dominant market players with little business overlap. Likewise, the argument to have more than two clearing houses/central counterparties is quite weak.
In settlement, we have already seen the ambitious plans of Euroclear to strip out large costs from the market. And recently, Link Up Markets, a consortium of seven CSDs, has emerged to offer similar benefits. I believe the success – or otherwise – of these two initiatives will determine the need for Target2 securities (T2S). But in this area we will have to accept the fundamental reality that if we persevere with having one CDS per country, then our infrastructure costs will always be higher than the US.