The battle for Britain

Buttonwood

Mar 1st 2005
From The Economist Global Agenda

The scrap over the London Stock Exchange is more than good spectator sport

AN ICONIC British institution is on the block. As the fans howl their protest, foreign moneymen press round, chequebooks at the ready. The End of an Era, the headlines proclaim, and How it will all go Wrong.

Is it the 200-year-old London Stock Exchange (LSE), besieged by German and French bidders, that is at issue? No, actually: it is Manchester United, Britain’s biggest football club, besieged by Malcolm Glazer, an American fish-oil and property tycoon. The two bids have more in common than one might think. In both, an entity that many Brits—though probably different ones—feel is the jewel in the national crown risks capture by a foreigner who thinks he can make more money out of it. Not so much the end of an era, perhaps, as more of the same.

Given that consolidation is the name of the game these days in financial markets, why should we care if or how one particular stock exchange buys another? For two reasons. The first is that the rules for Europe’s integrating financial markets are still very much in the making, and how this deal plays out will be important in shaping them. The second is that the almost equally venerable New York Stock Exchange may now be heading down the path of for-profit incorporation and facing similar decisions. Britain does sometimes get the jump on America in financial matters—in privatising pension saving, for example—and its experience is worth learning from.

The game so far: Deutsche Börse, the German exchange group which is also part-owner of Eurex, a big derivatives exchange, bid about £1.35 billion ($2.6 billion) for the LSE in December. London turned it down, but kept talking. The bid prompted Euronext, which owns a clutch of European stock and derivatives exchanges (including London’s Liffe), to express its own interest.

So far, so predictable. The three exchanges have been chasing each other up and down the field for at least five years. Ever since the growth of off-exchange electronic trading threatened to take most of the business from traditional stockmarkets, and the launch of the euro suggested there was serious cash to be made in offering big investors cheap and easy cross-border trading, European exchanges have been off and running. They have shed their mutual status and gone public, launched their own electronic trading platforms, done deals with clearing and settlement providers, and merged like mad.

Deutsche Börse and Euronext now dominate securities and derivatives trading in continental Europe. The LSE, which booted the ball wide fairly consistently where both technology and alliances were concerned, now finds itself in the goal rather than shooting at it. But it is still Europe’s biggest, most liquid and most international market for equities. Neither Deutsche Börse nor Euronext can afford to let the other get it.

In recent weeks, both bidders have been explaining the details of their offers (though Euronext has yet to come up with any price). More important, however, is the precise “market model” that each exchange represents. London has touted the virtues of “horizontal integration”, in which exchanges come together to offer customers the benefits of economies of scale, but trades are mostly cleared and settled elsewhere. That is supposed to discourage conflicts of interest, but may encourage higher costs. Deutsche Börse embodies “vertical integration”, with a silo of services that permits it to act as both exchange and clearer and settler of trades. Reinforced by order flow from London, the German group could afford to cut its prices well below anything other clearers and settlers can match—and then be in a position to hike them. Euronext, which owns a clearing house but also uses unrelated depositories for settlement, is somewhere in between and hence more acceptable than the Börse to many Londoners.

Two things matter most in designing a successful stock exchange: technology to make it efficient, and governance and regulation to keep it trustworthy. Buttonwood is no techie, but it is argued that Deutsche Börse’s systems are better than Euronext’s and more compatible with the LSE’s own systems. So on technological grounds, the German bid looks better.

Which is a shame, because on regulation and governance the Germans are deep in their own territory. Britain has a robust code of corporate governance; Germany has recently adopted a weaker, voluntary code of best practice. Both Deutsche Börse and Euronext have said that they will respect the dictates of the Financial Services Authority, Britain’s super-regulator. But neither wants to move its headquarters to Britain—and in an increasingly electronic business, the centre of gravity could migrate almost unperceived.

The governance issue has been brought into vivid relief by the huge wrangle between Deutsche Börse and its own shareholders. A group representing about a third of its shares opposes the bid, at least at the announced price. The Börse has refused to schedule a vote on the bid and is not obliged to by German law. And it refused to take questions over the telephone during a conference call on its (good) 2004 results. This muzzling provokes screams of outrage.

Ironically, the loudest of these champions of free speech are hedge funds, which are probably more interested in making a quick euro than in reforming German corporate governance. The dissidents now threaten to oust Deutsche Börse’s bosses at the annual general meeting on May 25th.

With this tussle going on, the urge to merge is unlikely to triumph soon. Neither British nor German competition authorities has yet pronounced on the bid and the former, at least, has expressed some concerns. For Brussels, too, the matter is important. In September, a group of clearing and settlement experts are set to report to the European Commission on the regulatory implications of different market arrangements; whether they will reflect or influence the LSE’s eventual attachment is unclear.

Whichever bidder ends up with the LSE—if either does—it could be that this is only half-time. In five or ten years, Deutsche Börse, Euronext and the LSE might well all be linked in the pan-European exchange that was London’s dream five years ago, when it first planned to ally itself with its German counterpart. They could even be part of a bigger alliance—at a stretch including the New York Stock Exchange, which last month appointed a ten-man commission to study the possibility of transforming itself into a regular corporation. Meanwhile, none of the European stock exchanges has reason to regret the bid: as the chart shows, the shares of all three have risen nicely.

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