Feature: NYSE battle could strengthen vertical silos – or weaken them

Feature: NYSE battle could strengthen vertical silos – or weaken them

No one does hostile takeovers quite like the Americans, and Nasdaq OMX and Intercontinental Exchange look like masters of the art.

As FOW went to press, their bid offered NYSE Euronext shareholders a premium of around 15% over the offer from Deutsche Börse, after share price movements that eroded some of the hostile bidders’ advantage.

The pair have also taken the gloves off and thrown them away. The offer document touched nerves in Frankfurt when it questioned Deutsche Börse’s track record with mergers, saying that its 2007 acquisition of the International Securities Exchange had not lived up to expectations.

While many in the industry had predicted that a rival bid might emerge, the size of the offer caught many by surprise. Nasdaq and ICE are now doing the rounds of NYSE Euronext shareholders, hoping to force the board to meet them for talks.

As the Deutsche Börse bid is structured as an all-share merger, the NYSE board is not obliged to seek the highest price for the company. However, pressure from shareholders at the company’s AGM – due to take place on April 28 as FOW went to press – may force the company into talks.

Strengths of the bid

At $42.67 a share based on April 18 closing prices, the revised Nasdaq/ICE bid submitted on April 19 was then a 21%, or $2bn, premium over Deutsche Börse’s offer. The exchanges also claim they will be able to find far greater efficiencies than NYSE-Börse, originally promising an additional $300m of savings, achievable in a shorter timeframe.

Their plan is to split up NYSE Euronext, with Nasdaq taking the New York Stock Exchange, the Euronext stockmarkets of Paris, Amsterdam, Brussels and Lisbon, and the NYSE Arca and NYSE Amex options exchanges in the US.

ICE would take over Liffe’s thriving futures and options business, including NYSE Liffe US and its joint venture clearing house, New York Portfolio Clearing. This would diversify ICE’s business greatly and move its centre of gravity still further into Europe (see graphic).

A combined ICE-Liffe business would propel ICE up the derivatives league table, tripling its current volumes by adding over a billion traded contracts a year to its output.

The businesses are very complementary – Liffe would strengthen ICE’s commodities offering a little, but would add much more weight to its equity index product portfolio. The combined group would have $1.8bn of revenues, just over half of CME Group’s, and trade 1.5bn contracts a year.

US regulators might raise objections to the combination of NYSE and Nasdaq and their dominance of the US cash equities and equity options markets, in each of which the combined entity would have about a 50% share of trading.

In Europe, joining Nasdaq’s Nordic stockmarkets to those of Euronext would knock out one big equity market player and regulators might want to consider that. But as in the US, traditional exchanges now face fierce competition from start-up electronic venues such as Bats and Chi-X

However, the ICE-Liffe tie-up is unlikely to raise any competition concerns on either side of the Atlantic. NYSE Liffe US is still tiny and anyway the US futures market is highly consolidated in the hands of CME Group. In Europe, ICE-Liffe would still be smaller than Eurex by number of contracts traded.

Competition concerns

The Deutsche Börse bid also raises competition problems, arguably more serious ones – and especially in Europe, where the European Commission perhaps has a more hawkish track record on such issues than the US Department of Justice.

NYSE-Börse would own a pan-European derivatives powerhouse with over 3bn contracts traded a year – a fraction more than CME in 2010. Although its share of the European futures market, not counting Russia, would be less than CME has in the US, when you throw in options, it would have a bigger slice of the whole listed derivatives market – 91%.

It would also unite the Frankfurt stock exchange with all the Euronext markets, creating a much bigger competitor for the London Stock Exchange, Nasdaq OMX and national markets like Bolsas y Mercados Españoles and Oslo Børs.

In the US, the deal would create a concentration in equity options, where Eurex’s International Securities Exchange is the third biggest market. But even with Arca and Amex this would have a smaller market share than the Nasdaq-NYSE pairing.

To sum up, there are concerns about competition with both bids. One creates a monopoly in US securities which would also be a dominant player in options and, separately, a diverse, transatlantic derivatives business. The other would lead to a monopoly in European listed derivatives, which was also a big hitter among European stockmarkets and a diverse, transatlantic securities business.

Trading blows

Nasdaq and ICE have tried to pre-empt the concerns about competition, both by highlighting the fact that they think the other bid is more at risk, and by offering a $350m reverse termination fee, payable if the deal falls at the regulatory hurdle. This is intended to demonstrate their confidence in getting the deal past the watchdogs, and to undermine the NYSE board’s argument that “unacceptable execution risk” is a reason to reject their bid.

However, market participants say the terms of the termination fee are onerous and it is unlikely that the conditions of payment will be met.

Deutsche Börse is likely to argue that its combined derivatives behemoth would act as a counterweight to the US’s CME Group, and that any competition ruling should be made in a global rather than a European context.

The German exchange has a point: with its Globex electronic trading network reaching all over the world, CME is in many ways a global exchange now.

However, NYSE-Börse’s dominance in Europe would be such that regulators could only approve it if they really believed derivatives exchanges were a special sector where norms of competition policy did not apply.

Growing competition

However, competition is growing in derivatives from lower cost, smaller exchanges. On April 12 Turquoise, the multilateral trading facility owned by the London Stock Exchange and a group of banks, did Deutsche Börse a big favour by announcing that it would begin offering FTSE 100 derivatives from June.

Competition is also expected to come from the combined Bats Chi-X Europe, which is being formed through the acquisition of Chi-X Europe by Bats Global Markets.

The group hopes to replicate its success in the cash equities market, where the two MTFs together account for around a quarter of European stock trades. In March Chi-X signed a deal to create derivative products based on regional indices with Russell Investments as part of its push into the market.

In any event, many derivatives market participants are in favour of the global trend for exchange consolidation. One professional from a leading bank, who did not want to be named due to his firm’s involvement in the deal, said: “There is a huge benefit to the market in creating a single trading and clearing entity providing a central pool of liquidity.

“There are lots of people launching derivatives trading or clearing services, but ultimately liquidity is key to success.”

War of the models

What is causing concern among market participants and regulators alike, however, is the expansion of the vertical silo model in clearing that either deal would create.

In the vertical clearing model, an exchange owns the clearing house that clears its trades. One consequence of the wrangle for control of NYSE Euronext is that this issue has come to the fore, not only in the market but also, and more worryingly for the exchanges, among regulators.

The pros and cons of the vertical silo model have been debated since the formation of Clearstream in 2000, when Deutsche Börse took over Cedel.

Critics of the model, which tend to include smaller exchanges, rival clearing houses and some market participants, argue that separately owned clearing houses – the so-called horizontal model – offer a better chance for market participants to select the most cost-effective and efficient service at every stage of trading.

The issues involved are complex. Certainly, if clearing houses are separate from exchanges, there would seem to be more chance of the clearing houses feeling competitive pressure, because an exchange could dump an unsatisfactory clearing provider and go elsewhere.

However, under current arrangements, exchanges’ users would still not have any day to day choice about where their trades were cleared.

The existence of independent clearing houses, such as LCH.Clearnet, also makes it easier for new exchanges to pop up, buying in the clearing services they need. That theoretically keeps some tension on the big exchanges.

But again, the standard service offered by third party clearing houses stops short of the pooling of risk between exchanges that occurs in the US options market, where nine exchanges use the Options Clearing Corp and the open interest is fungible.

It is this kind of model that attracts some start-up exchanges, such as ELX Futures in the US interest rate market, which has tried to lobby the Commodity Futures Trading Commission to make CME accept trades effectively transferred from ELX, enabling ELX to benefit from CME’s liquidity. So far, CME has refused.

The ultimate model, which in the exchange-traded derivatives world exists only on paper, is called interoperability, meaning that a single exchange could connect to more than one clearing house (which could also serve multiple exchanges). This opens the door to investors having a much more finely focused choice over where their trades are cleared.

An alternative view is that there is no need for this, or for competition between clearing houses. They are natural monopolies – but as such, should not be profit-making entities, operating instead as utilities for the benefit of the market. The US has gone a long way towards this model, with the OCC for the options market and the Depository Trust & Clearing Corp for equities and bonds. The OCC, for example, though owned by some of the exchanges, rebates profits to all members once it has spent what it needs to.

Paradise postponed

Today, however, the futures market is very far from such utopias. CME, Eurex, ICE and Nasdaq OMX own their own clearing houses; Liffe is in the process of building its own and abandoning LCH.Clearnet; LSE Group has thought about doing the same.

Either an ICE-Liffe deal or a NYSE-Börse one would merge two of these silos into one bigger one.

Anthony Belchambers, chief executive of the Futures and Options Association, says that, while there are “clearly potential cost savings to be made through the convergence of execution platforms and even in the integrated delivery of execution and clearing services, market competitiveness, including clearing access, must be taken into account”.

He adds: “Getting the balance right will be important as we go forward in this difficult economic climate.”

It is this balance that the competition authorities will have to seek. Already the clearing issue looks like being one of its main considerations. Last month, the EU competition commissioner Joaquín Almunia warned that “analysis of this operation will not be a simple one”.

He added that he “would not be surprised” if the competition review was extended beyond the initial month-long investigation. And he made it clear the vertical silo model was a concern for the Commission.

“From the competition point of view, I tend to prefer models that are not a vertical silo,” he told a hearing in April. “More open competition, more opportunities, this more open business model, together with interoperability from the competition point of view, is preferred.”

US regulators have so far not spoken openly on the issue. However, US Department of Justice raised concerns in 2008 about ICE’s ownership of ICE Clear and one analyst has said the NYSE deal may revive its concerns.

In a research note released last month, Brad Hintz of Sanford Bernstein said: “The most important issue facing these competing offers is the possibility that the ICE/NYSE Liffe merger will resurrect DOJ concerns with vertical integration of futures execution and clearing.

“If this issue arises, ICE will likely drop out of the bidding and the Deutsche Börse deal moves forward.”

The clearing issue is greater in the instance of the Deutsche Börse bid, which would likely result in all trades on Eurex and Liffe being cleared through Eurex Clearing.

Mark Spanbroek, former head of business development at Getco Europe, the US electronic trading firm, believes the real issue for regulators is not the merger of the exchanges but the opening up of clearing houses.

“The Deutsche Börse deal is the best for Europe but regulators must ensure that there is open access to clearing houses,” he says. “They should not be concerning themselves with the exchange mergers, but with mandating on open access to clearing. The real battle is in the clearing houses.”

There is a precedent here. In 2005, when Deutsche Börse and Euronext were competing for control of the London Stock Exchange, a report by the UK Competition Commission raised concerns over the vertical silo model.

Indeed, in the case of Deutsche Börse, it suggested a divestment of Eurex Clearing, a requirement that Eurex Clearing not be used as the provider of clearing services to LSE, or a “set of behavioural commitments” to prevent it from denying access to competitors.

Ruben Lee, chief executive of Oxford Finance Group and author of Running the World’s Markets: The Governance of Financial Infrastructure, says: “Vertical integration is portrayed as a big regulatory issue in the cash markets, but it is just as important in the futures space.

“It is really difficult for a futures exchange to develop products that compete with existing products traded on other exchanges if those new products can’t also be cleared through the same clearing house which clears the existing products.”

A puzzle for regulators

Merely understanding how institutional and structural change might work in this market is hard enough – designing and implementing reforms is a minefield.

Despite the Code of Conduct for Clearing and Settlement, signed in 2006, interoperability remains underdeveloped. One of the first problems legislators would have to grapple with is whether two firms trading with each other would have to choose the same clearing house, or could each choose a different one.

In the latter case, the two clearing houses would have to have a connection between them. This is something many observers are worried about. The point of clearing houses is to be safe repositories for risk – that security could be compromised if there was more interlinking with other clearing houses using different risk management arrangements.

Spanbroek believes regulators should mandate interoperability in order to open up the exchanges to other clearing houses. However, this is not an easy task for regulators – they already have their work cut out finding a path to clearing for OTC trades.

And in fact even that priority creates problems with the vertical silo model. Obliging firms to use central counterparty clearing for certain classes of OTC derivatives is only likely to work in practice if the exchanges’ clearing houses accept trades conducted elsewhere. That is not interoperability, but it does open the way for OTC trading platforms that connect to multiple clearing houses.

As Lee points out, this is tricky territory for regulators. “If the regulator says that a CCP has to clear certain products its raises all kinds of issues,” he says. “Some products are not suitable for clearing as they do not have the right economic characteristics, such as appropriate levels of liquidity, volatility or standardisation. If a regulator mandates a clearing house to clear something that is not suitable to be cleared, there is a danger that in the event of a default, the CCP will seek public support.

“If a regulator takes the decision to force trades in particular contracts to be cleared through a clearing house, in the end the regulator, or the government to which it is responsible, will be accountable if problems arise from such forced clearing.”

More bids?

Tangled as the NYSE-Börse-Nasdaq-ICE situation already is, it could get more complicated. Nasdaq and ICE believe their bid is gaining currency among shareholders – but other bidders could still enter the ring. CME is the sleeping giant so far, and speculation is rife as to whether it will make a play for NYSE Euronext.

Lee says: “We have not yet had a bid from CME, but in my view it has to bid for Liffe – where else is its growth going to come from? It is not credible for the CME to expect significant continued growth domestically, nor can it expect to be able to grow organically abroad. Liffe is the only big futures market for sale where foreign ownership could be acceptable.

“CME might change its attitude to operating cash markets, but if it does not, it would look to divest the NYSE. This may mean that Nasdaq could get the cash side, whoever wins, depending of course on its contract with ICE.”

CME Group said it did not comment on speculation.

Steve Robinson, a partner at advisory firm PMHK Partners, says there might also be a bid from Asia. “It’s a bit early for Shanghai, and Tokyo is preoccupied with domestic issues, but could Hong Kong throw its hat in the ring? The Nasdaq bid is a hard one for to top but a JV with an Asian provider makes sense.”

For the time being, however, NYSE Euronext faces just one barbarian at the gate and it is sharpening its weapons to fight off the hostile bid from Nasdaq and ICE.

The exchange’s rationale that the group is stronger kept in one piece is attractive, but the financial premium on the break-up bid must also be appealing to shareholders.

They are likely, too, to think about the lengthy approval process that might attend the Deutsche Börse deal. NYSE Euronext has indicated it could take up to a year before approval is granted. Nasdaq and ICE’s reverse termination fee shows how bullish they are on winning clearance.

And if the EU authorities were to follow their UK peer’s 2005 suggestion to divest Eurex Clearing in its analysis of Deutsche Börse’s bid for LSE, would its board still pursue the deal?

Whatever the outcome, this merger contest is shaping up to be a long and fascinating process, in which not only will the fate of several exchanges be decided for several years to come, but the market is being forced to think afresh about what structures would really serve it best.

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