London should sell at the highest price

The proposed merger between the Deutsche Börse and the London Stock Exchange (LSE) is meant to reduce transaction costs and consolidate the fragmented European market for equities. This rather lopsided plan has to win the vote of all interested parties and many political obstacles stand in its way. Even if it falls through, the LSE is now in play and should make sure it sells out to the highest bidder.

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Let's be clear. The proposed merger between the Deutsche Börse and the London Stock Exchange is a good idea. There are too many exchanges in Europe and their joint operations are too costly. The traditional exchanges face competition from new trading systems with lower cost bases. Tradepoint, a London-based exchange, plans to go live trading the top European stocks in July and is negotiating with the Swiss Exchange. And Jiway, a merger between OM, the Swedish stock exchange operator, and Morgan Stanley, aims to target private-client brokers.
Exchange links, rather than mergers, have proved not to work in the past. So if the traditional stock exchanges are going to survive, consolidation and ruthless cost-cutting is the only way forward.
However, the problem with this merger is that it is just an idea. Two essential things must happen before it can be implemented. The details of how it will operate must be worked out. And it must be sold to all interested parties. The politics cannot be ignored.The plan in detail: When the merger was announced last month only a few details were revealed of how it would work. The intention is to create two new markets. The Wrst, iX, will target Europe's top companies for listing and trading, and will be 50% owned by the LSE's members and 50% by Deutsche Börse. iX will consist of all of the LSE's and Deutsche Börse's businesses, including Eurex, the futures exchange, but excluding Deutsche Börse's 50% stake in Clearstream International, its settlement arm, which Deutsche Börse will continue to hold. iX's chairman will be Don Cruickshank. The new chairman of the LSE, and its chief executive, will be Werner Seifert, the present CEO of Deutsche Börse. It will be based in and managed from London with major operations in Frankfurt, and will use a single trading platform, Deutsche Börse's Xetra, for all its cash markets.The second market the two exchanges intend to launch will be a joint venture between iX and Nasdaq to create a pan-European, high-growth market. This will replace the existing growth markets of London and Germany, techMARK and the Neuer Markt, and the vehicle that Nasdaq had indicated would be its launching pad into Europe - Nasdaq Europe. iX and Nasdaq will be equal shareholders in the joint venture, which will be incorporated in and managed from London and operated in Frankfurt.Deutsche Börse and the LSE may also support initiatives to set up a central counterparty and establish straight-through processing. In the meantime, settlement will continue to be delivered by the current providers, Clearstream International and CrestCo.Drawbacks of the planThere are many drawbacks. If the intention is to reduce costs, why replace two old exchanges with two new exchanges, one operated in London and Frankfurt (iX), and the other operated in Frankfurt (the high-tech joint venture)? To save expenses, operations should be based in a single city. Rather than being a way to cut costs, this looks like a compromise to share out the goodies.The central element of the merger is the need to achieve cross-border economies. But this presupposes that the historical basis for regulating markets - the existence of well-deWned national jurisdictions - can be adapted to a new, borderless environment. How the national and local regulatory powers are to share or even give up their powers has not been speciWed.The adoption of a single trading mechanism is essential to cut trading costs. However, the move to a single system, particularly for the London market participants that will have to change their internal systems to be able to link up with Xetra, will bring transitional costs. After some initial howls of anguish from its core domestic constituency, the LSE promised support for this burden.The distinction between the two markets will lead to conXict. To take just one example, it is not credible that Nasdaq would want to be associated with a market that had the seeds of its own destruction contained within it. It will therefore not support the possibility of companies choosing to graduate from the high-tech growth market to iX. Model for the futureEven if the merger goes through, iX will need to adopt a new business model, radically diVerent from those now followed by both Deutsche Börse and the LSE, if it is to succeed. Traditionally, exchanges have had seven main sources of income: membership subscriptions; fees for listing, trading, clearing, and settlement; and charges for the provision of company news and for their price and quote data. All but the last of these sources has disappeared or is just about to, either because of intense competition or because the relevant activity is being disaggregated from what used to be thought of as the core businesses of an exchange.Membership fees will continue to be paid only as long as exchanges have members. Demutualization will bring this to an end. Listing is subject to intense competition from other exchanges and, in the UK at least, the LSE has lost its regulatory status for listing to the Financial Services Authority. In the mid-1990s, the LSE stopped settling transactions, with the establishment of Crest, and also providing company information. In future, the clearing of equity transactions on the LSE will be undertaken by the London Clearing House.Today, transaction fees are a crucial source of revenues for both the Deutsche Börse and the LSE. This will not last either. The costs of processing an extra marginal trade to automated trading systems has now become essentially zero. Competition between trading systems is pushing transaction fees to this level. And even this is too good to last. The notion of payment for order-Xow already exists in the brokerage market, and it won't be long before this takes root in the exchange market. Exchanges will soon be paying to have orders executed on their trading systems.So exchanges' key source of income will have to come from the sale of their price and quote data. They will become content providers rather than distribution channels. They will also implement much broader marketing and branding strategies than now. Prime-time television advertising, now the preserve of Nasdaq, the most successful global exchange brand, will become the norm. Rather than seeing the creation and maintenance of technology solutions as a vital element of their operations, they will outsource all but the most minor IT activity.Political goalsThe proposed merger is becoming a channel for a range of disparate interests groups in the European Union to pursue their divergent goals. Many of these are against the merger, or against what they claim it represents.From an economic viewpoint, the city where both iX and the high-tech joint-venture should be located is irrelevant. The success of an exchange does not depend on where the black box and operational staV supporting the trading system are placed. The success of a Wnancial centre is also increasingly becoming divorced from the success of any exchanges located in the Wnancial centre. Remote access means that market participants will choose their locations not on the basis of where the exchanges are located, but on such criteria as the existence of a suYciently large and well-qualiWed group of professional service providers, the ease of living in the location, and the tax environment. However, the location of an exchange remains a vital political symbol for the success of a Wnancial centre. And it is here that there is a critical divergence between British and German interests. Given London's position as the pre-eminent Wnancial centre for Europe, iX should unquestionably be based in London if the intention is to develop a European Wnancial centre to combat that of the US. This assumes, however, that the Germans would be happy to give up their ambition for developing Frankfurt as a European Wnancial centre on the back of the success of the Neuer Markt - an assumption that is clearly false.The French, who are not party to the proposed merger, have a direct interest in seeing it fail, as its success would adversely aVect the potential for Euronext, the entity combining the Paris, Brussels and Amsterdam exchanges. France assumes the presidency of the European Union on July 1 for six months. This will give it the power to set the agenda for the EU over this period, and France is expert at exploiting such opportunities.A French proposal to establish a European regulator of Wnancial markets would be good politics. It would reconWrm France as having the grand vision necessary to reinvigorate a stagnating EU, with the endless decline of the euro. It would play well with domestic voters, who would see it as a bulwark against British, and implicitly American, capitalist values. A vein of anti-Americanism has been evident in discussions about the merger, with three banks directly involved in the negotiations kindly assuming the role of bogeymen - Goldman Sachs, which is advising Deutsche Börse; Merrill Lynch which is advising the London Stock Exchange; and Morgan Stanley.Such a proposal would also seem to be a natural response to the exchange mergers: if the markets are merging to form a European entity, surely there is a need for a merged European regulator in response? One merit to France of proposing the creation of a pan-European securities market regulator is that the mere announcement of the proposal, rather than its implementation, would further French political goals. It will stir up international interest and concern about the creation of iX, and inevitably slow it down. The creation of a pan-European regulator will take years to achieve. It presupposes the harmonization of national company law, the willingness to cede jurisdiction over a vital area of national interest, and many other issues. This cannot happen rapidly.LSE in playThe announcement of the proposed merger between Deutsche Börse and the LSE eVectively means that the LSE has put itself in play, in investment bankers' language. If the merger does not succeed, the future of the exchange as an independent entity must inevitably still be in question. Having put the LSE in play, its management's best strategy now is solely to seek the best return for its member/shareholders. At a time when the longest bull market appears to be coming to an end, and when the competition in the market for markets has never been greater, the brand of the LSE is a great asset. In 1986 following the Big Bang in London, many of the jobbers and brokers sold their franchises at vastly inXated prices, just when competition in that market was being opened up. Now is a similar opportunity to realize the inherent value in a venerable institution that is likely to have past its peak. Bluntly, the exchange's management should sell out at the highest price.In the iX proposal, the two exchanges have implicitly been estimated at having the same value. This valuation, however, is purely political as no other terms would have been acceptable to either the Germans or the Londoners. There would be no shortage of bidders for the LSE. Deutsche Börse would be a willing bidder. Euronext has already oVered London 50% of itself in a joint venture, and may decide that it is worth oVering an even larger amount of cash in order to scupper the launch of iX. Nasdaq would also prove a more than willing bidder. Then there are all the unexpected entrants - the software companies, data vendors, and even the large investment banks themselves.

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