TEMPERS ARE STARTING to fray in Europe’s securities markets. A group of agent banks, led by BNP Paribas and Citibank, and calling itself Fair&Clear, is fighting for its life in the European clearing and settlement marketplace.
The group, which represents 80% of European securities settlement volumes, is hitting back at Euroclear, which is rapidly becoming a force in the market and claims it can reduce cross-border equity trading costs for investors from e30 to just e0.50, the same as a domestic trade.
Fair&Clear does not like what it is seeing. It proposes a set of principles for market consolidation that it says will “ensure fair competition, promote innovation and preserve choice for market participants”.
Observers are scathing. “You could also describe it as their last attempt to prevent their potential loss of market share,” says one.
Another securities services banker in London says: “There is more conflict between infrastructure providers than there ever has been and things are coming rapidly to a head.” It is between these players, more than between those old symbols of national prestige the stock exchanges, that the real action is taking place.
Suddenly the back office is hitting the front page and there is an obvious reason for this. Markets are down, revenues are down and costs are going to have to come down too if banks are to survive. One of the most pressing concerns is to bring Europe’s trading, clearing and settlement infrastructure into line. For years, fragmentation along national boundaries meant the plumbing lagged far behind the needs of the EU’s single financial market. It meant the continent’s companies faced high costs when raising capital and could not compete on a level playing field with US counterparts.
Equally, investors in Europe can only be put off by high cross-border trading costs. And with markets down and heading further south, anything to encourage them back must be a priority.
As the securities banker says: “The woeful inefficiency of most of the market players is unsustainable. As regards the markets, down is the new up and we’re going to have to get used to it and we’re going to have to do something about it.”
Money is, of course, always a strong motivating factor in getting bankers to do something. In this instance, though, many banks are suddenly showing that they are not necessarily so keen on the idea of a more streamlined Europe.
Banks have campaigned publicly for a true, single market, but they have also made money out of market inefficiencies. If these are ironed out, bang goes the revenue. And with capital market activity already desperately slack – with feeble IPO levels and next to no M&A business – all the pennies need to be closely guarded.
Despite having come some way towards integration, Europe’s main exchanges are still closely associated with the three economic leaders of Germany, France and the UK. And each of those exchanges is tied to its own favoured clearing and settlement operations. While these lines of national self-interest remain so sharply drawn, the hurdles to true European integration look surmountable only through the expenditure of substantial effort, time and money.
Playing hard to get
Set against this backdrop is the saga of the London Stock Exchange and its two possible suitors. One the one hand it could throw its lot in with Deutsche Börse, on the other it could find Euronext more attractive [see London Stock Exchange holds the key, this issue].
Deutsche Börse, led by chief executive Werner Seifert, has certainly made no attempt to hide its ardour for the London market in the past. Yet Euronext, under Jean-François Théodore, may prove to have what it takes to win over the LSE’s shareholders and its boss Clara Furse. But the LSE has so far proved a tricky catch to land, with previous attempts by Deutsche Börse, and also Swedish exchanges group OM, both ending in snubs from London.
It’s a wonder that Seifert continues to gaze longingly at London. And yet many market commentators believe such an alliance is his dream. Huw van Steenis, analyst at Morgan Stanley, says there is industrial logic for a merger based on the cost synergies that the LSE could make. However, he does not think a bid is imminent.
His counterpart at Salomon Smith Barney, Mamoun Tazi, says a merger bid from Deutsche Börse is “just a question of time”. He is expecting it in the second half of 2003.
Everyone knows that a bid by one party would immediately trigger a counter-bid from the other European player, and maybe even from a non-European bourse such as the New York Stock Exchange.
But the Europeans remain the favourites in the race, driven on, no doubt, by neighbourly rivalry. As one London banker puts it: “Frankfurt wants to be the central player.” A UK fund manager goes further. “Frankfurt has always been very jealous of London’s position and they would love to get the LSE,” he says.
However, John Romeo, director of financial services consultants Oliver Wyman, says any move to take the exchange away from London would be business suicide. “I would be surprised if anyone bought the LSE and then wanted to move it out of London,” he says. “With its proximity to the primary European decision makers at the big investment banks it just wouldn’t make sense.”
As interesting a topic for gossip as future alliances among Europe’s stock exchanges may be, it is something of a red herring. It’s not that further unification of Europe’s leading exchanges would not be highly significant. It would be. But the real story lies further down in the plumbing, with the clearing and settlement infrastructure. This is where real unification is happening, and faster than many may realize.
“If you’re working on strategy for a bank, you’ll need to be aware that people have made predictions and projections of several years hence for unification of the exchanges,” says one banker in London. “It’s clear that it is all happening much faster.” The most dramatic results of unblocking the pipes linking Europe’s national markets will be the lower cost of cross-border trading, which still lags behind domestic and US trading.
“Trading costs have fallen 10% to 15% in the past year, roughly double the rate over the past five years as a result of changing trading patterns as well as fee reductions,” says Romeo. “Domestic execution in Europe is now on a par with the US but, cross-border, there is a long way to go.”
He says the biggest benefits will come through elimination of redundant infrastructure across markets, including trading systems, but more important in back office. “Some of that saving could be passed on to the end investor,” he says.
This could come soon even though there is still much to be done before Europe can hope to compete equally with the US.
Brian Todd, vice-president of network management at JPMorgan in London, says: “There are different standards in terms of laws and regulations. We need to work together to get common standards. But don’t forget we have gone a long way already. These differences have allowed Euronext, Euroclear and Deutsche Börse to create some pretty powerful propositions in their own right and for anyone to compete with them is going to be tough.”
Consolidation or cooperation?
Certainly there is a collective will to drive change – now perhaps more than ever as the bear market stretches into its fourth year. Anything that can stimulate greater market activity and lure investors back – such as cheaper dealing – will surely be welcomed. The IPO market in Europe in 2002 was very slow, though Euronext and the LSE both increased their market share of IPOs on principal exchanges in the region.
PricewaterhouseCoopers’ figures showed London down by34% from the previous year to just 91 IPOs. However, its market share of IPOs on all Europe’s main exchanges increased from 44% to 54%. Listings on Euronext were down 38%, but again its total market share went up from 17% to 19%. Germany’s market share halved to 4% as it experienced a 76% drop in the number of new listings.
Across Europe, total IPOs fell 45% to 170 last year, with the amount raised dropping 66% from e33.4 billion to e11.4 billion.
Against that backdrop, clearing and settlement players are airing their ideas for market consolidation or co-operation. In this instance, the latest buzzword is “interoperability”.
This idea is being proposed as an alternative to consolidation in the drive to integrate national systems and remove the cost of clearing and settlement as a factor in investment decision-making.
Market players have invested heavily in developing national clearing and settlement systems down the years. They may not therefore want to see these platforms replaced with a new consolidated platform that does not substantially improve domestic arrangements. One obvious solution would be for it to become a utility service, as it is in the US. Above all, what is certainly needed is free access so that central securities depositaries (CSDs) cannot exploit any unfair monopoly.
Interoperability, according to its supporters, would allow competition between CSDs. The structure would provide competitive cross-border business for European equities.
At the moment there is still some residual suspicion of Euroclear and Clearstream’s ability to handle equities because both developed in line with the Eurobond market of the 1970s.
So one solution, as suggested by Deutsche Bank, is for a central securities settlement institution (CSSI – see chart, page 49). It could be based on an existing organization, or preferably a new one, to be owned by participating CSDs. Users would get access through the CSD of their choice and would have one single point of access for domestic and European cross-border business. This is revolutionary.
The model would still allow for further consolidation and has won backing from local CSDs in Switzerland, Italy, Spain and the UK, with other countries showing some support.
As Swen Werner, author of the Deutsche Bank report putting forward the CSSI idea, says: “Europe now follows an approach different from that of the American market. Today most European markets are served by profit-oriented operators, whereas the US builds on the utility approach. Further rationalization ought to recognize this.”
Werner continues by saying that no single CSD, or collection of them, is superior to any others when it comes to cross-border transactions. “Reducing the overall number of systems in the long run would reduce the development and maintenance costs. In the short and medium term, high sunk costs for the depreciation of systems hinder a sudden switch to a single European CSD. Open access and egress will allow the exploration of market forces.”
Although there is a lot of national resistance to giving up exchanges to other countries, there is not such resistance when it comes to the ownership of CSDs. Euroclear has taken over CrestCo in London, Sicovam from France, CIK from Belgium and Necigef in the Netherlands. Dutch market players at the time said it was like giving the crown jewels away. But still it was allowed to move. Its march across Europe might prove far more significant than any strained alliances among Europe’s stock exchanges.
Now Euroclear with four CSDs, all monopolies, has a 60% market share in European equity trading and claims that it can dramatically cut the cost of cross-border equity trading for investors to the same price as a domestic trade. It has got there in full view of the market but is only now seriously putting noses out of joint. “Euroclear has been talking to people and no-one has stopped them,” as one London banker says, adding in reference to Fair&Clear’s statement. “But now things are really hotting up.”
Bad headaches
One way or another, either through consolidation or cooperation, the unified market is approaching. That sounds like good news but it’s giving a lot of banking strategists bad headaches.
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“Big banks and custodians make money out of inefficiencies,” says Oliver Wyman’s Romeo, who adds that some realism and reading between the lines is necessary. “There is interest across the board in making markets more efficient, but from a sell-side perspective there is a limit to how quickly this can happen – the big houses have invested a significant amount of capital to build a European network and do not want to see that fall to zero immediately.” The new market will be built on what it is hoped will be a higher volume of lower fees shared among fewer players. It will be harder for outsiders or internal upstarts to get in.
Although Euroclear may be palatable to the EU because it is owned by participants, it’s not so palatable to other market players. Witness the reaction of BNP Paribas, which made its own statement before the Fair&Clear reaction, decrying the conflict of interest it sees in Euroclear, which holds CSD monopolies while also being involved in commercial banking.
BNP Paribas is desperate to defend its 90% market share in France of agency banking (which includes such services as portfolio valuations and net asset valuations for pension funds). Along with Citibank, BNP is strongly committed to agency banking. Both banking groups feel Euroclear is gaining an advantage from its position and are arguing for its commercial banking activities to be split from its CSD monopolies to preclude any possible cross-susbsidies.
Charles Cock, BNP’s head of clearing and custody, says Euroclear has blurred “the lines between being part of the essential market infrastructure and being an agent bank”.
“We are entering a period of poor returns but people have to react to that,” says one of BNP’s custody competitors. “The reason we are seeing BNP being so public and aggressive and petulant about what Euroclear has done is because its back is against the wall. Meanwhile, the European Commission hopes the industry will work it all out for itself.”
Following BNP’s salvo came Fair&Clear’s response. The group says CSD, international central securities depositary (ICSD), and agent bank operations should be separated to ensure proper governance and a level playing field for all market players.
It also wants competition rules to be enforced by isolating essential infrastructure work from commercial banking.
Brokers to suffer too
It is not just custody players that are scratching their heads over developments. Brokers are also likely to see revenues hit. “All the brokers are making an awful lot of money from those market inefficiencies, says one market watcher. “As soon as things go electronic then their fees fall.”
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Brokers will have to face up to a revenue squeeze. “Brokers will have a much slimmed-down role but will still be there because they will know where the liquidity is,” says Mark Austin, JPMorgan’s head of strategy for investors services. “They don’t want normal market size deals. Brokers are expensive. Every time a broker picks up the phone to trade under $100,000 there is no money in it for them.” He is quick to point out that brokers are not about to be written out of the picture. “But they won’t be disintermediated. The only real threat they face is from an Eliot Spitzer, or any other crusader.”
Certainly the brokers are keen to describe a role for themselves. Onu Odim, co-head of Merrill Lynch’s global cash equity business, says the buy side will still need the services of big brokers. “Fund managers still want full service support, in terms of research, execution and all the other services, as long as it’s value added – although they are studying how they pay for it,” he says. “We feel we have a competitive advantage because we have a very compelling offering.”
However, he concedes that there will be fallout in the industry. “We expect more consolidation, with the top three to five brokers gaining market share alongside a few niche players,” he says.
Odim says he does not feel that threatened by the rise of alternative trading. He says there is not much evidence of firms like his losing business. “I don’t think that is the case,” he says. “Investors look at their relationships with us and, like us, they really view it as a partnership.”
In fact, they don’t. Richard Semark is global head of trading at Axa Investment Managers. He runs a team of eight traders handling equities and derivatives for fund managers in Paris, Frankfurt and London. He is also chairman of the institutional investor group at the LSE. “Our focus is purely on achieving best execution,” he says. “Where is the liquidity and can you access it? If a lot of the liquidity is on exchange order books then you need to have access to that.
“Five years ago it was with the brokers, now we have a range of options. There is the likes of Tradebook, there are the Morgan Stanleys or Goldman Sachses pipelines, using their exchange membership. There are other new pools of liquidity such as Liquidnet and virt-x.”
Single-pool model
Liquidnet, launched in the US, is another alternative, aiming to provide a single pool of liquidity across equity markets in the US, and Europe. Cross-border exchanges already exist.
Peer-to-peer trading can be compared with the Napster music website, which was widely denounced by bands and record companies alike and accused of piracy but also proved wildly popular among users.
By trading directly buy-side firms eliminate information leakage that happens when the fund manager asks his broker to execute a big order. They are being pushed to do this as much as possible in the future.
So the industry in Europe, whether paying lip service to the idea of a true pan-European market or not, realizes the need to show that it is doing something. Cross-border trading costs need to come down in line with US and domestic European levels.
“The industry as a whole is facing a massive challenge of sustained lower investment returns,” says JPMorgan’s Todd. “Cash is the new benchmark. If your returns are only a few percent you are not going to pay away half of that into management charges.
“We are looking at a world where realistically it is very difficult to make the argument of active investment stand up. So the industry has to move to lower trading costs so that it is as attractive as cash.”
But while Europe is moving, some industry experts believe it will still drag its heels.
“You have got the background where there are not any physical or regulatory pressures to move towards lower cost trading,” says Richard Kilsby of securities market consultancy, Efficient Frontiers. Kilsby is a former executive at the LSE and was also CEO of Tradepoint and vice-chairman of Virt-x. He doubts efforts like the Myners report in the UK, which led the campaign to lower trading costs, are having much impact. “[Investors] are still at the identification stage,” he says. “At the moment there is no physical rule if you are moving towards it. You have got an extra inertia built into the system.”
Kilsby is equally scathing about the proposals of the Group of Thirty consultative group to push global integration. The G30, including central bankers and the private sector has made 20 recommendations about automation and integration. “It is pretty naïve,” he says. “Its suggestions require participants to put forward a lot of money for technology but they have frozen IT budgets, there is no money left over and there is still an awful lot to be done back down through the plumbing.”
His criticism levelled at G30, as with other high-level industry think-tanks, is that they are too far from the coalface to see what is really happening, or really required. “It is always at too high a level. At 50,000 feet up it will make sense to them but you have to get much lower down where you can see all the peaks and troughs that have to be negotiated.”
Above all, he says there needs to be more impetus added to move things faster. “There is nobody up in arms at the moment, saying things are dreadful and we really have got to change them.”
As with many other areas of financial markets and services, the US leads the way in clearing and settlement in equities, while Europe tries to catch up.
Europe with its many different countries, regulators, systems, cultures, languages and historical antipathies has many in-built problems to be overcome.
First Europe, then the US
But Kilsby, and others, feel a collective will can bring about the new infrastructure, and within the next few years. That can then lead to closer ties with the US.
Certainly fund managers such as Semark at Axa want to see it happen. “The US has a much lower cost base and Europe has the problems of more currencies and so on but it is coming and we should see the benefits,” he says.
The unification of Europe, while inevitably causing casualties, will encourage closer ties with the US, whose exchanges and trading systems have repeatedly tried to set up in Europe. “Nasdaq has kept trying to do something outside the US and hasn’t got anywhere,” says Kilsby. “There are other examples.”
Benn Steill, senior fellow in international economics at the Council of Foreign Relations in New York, says integration of the US and European securities markets would have a profound effect. “My research … into the economic impact of trading automation suggests strongly that true integration of the US and EU securities markets would cut trading costs by about 60% and lower the cost of equity capital by about 9% on both sides of the Atlantic,” he wrote recently. That’s a significant saving as companies struggle to maintain a margin between the cost of capital on one hand and returns on investment on the other.
Steill continues: “Yet such integration can only proceed rapidly if exchanges on each side are permitted to operate on a transatlantic basis. The European Commission has already pledged support for the idea of a transatlantic mutual recognition agreement on exchange access.”
He adds: “It is time for the new US Treasury team, in the interests of US investors and US companies, to override both SEC inertia and protectionist pressures from the NYSE, and conclude a deal.”
There is widespread agreement that something needs to be done in Europe. Once that is done, the next step of linking with the US can happen. However, while self-interest remains among so many players there is still a little way to go. Euroclear, for example, sets 2005 as the date for getting cross-border trading costs down to domestic levels.
With equity markets depressed against the backdrop of a possible war in Iraq, and with forecasters predicting that the bear market will run for some time yet, the industry needs to get cracking.
Maybe the catalyst for dramatic change will be the long-expected deal between either Deutsche Börse or Euronext and the London Stock Exchange (see above). But there has been talk about this for years, it still has not happened and some still doubt that it ever will.
What is sure is that banks and bankers are wrestling with the problem and not everyone is relishing the struggle.
In the past, securities infrastructure was not a big topic of discussion because market inefficiency drove revenues and profit margins. But now the depressed economic situation is putting further pressure on banks to rationalize costs.
When it comes down to brass tacks, exchanges still want to be the centre of attention and their clients, the investors, want to trade as cheaply possible. The brokers, meanwhile, want to live in the middle and be connected to as many exchanges as possible.
However, things cannot continue in their current state much longer. JPMorgan’s Todd concludes that banks and brokers must not just get their own houses in order but show the wider markets that they will benefit too.”Whether the savings will get fully back to the end investor is an interesting point,” he says. “But they should do because there is no point in doing this to the benefit of the middleman.”
For there to be a real impact across European markets, the benefits will have to pass further along than that.
