Stock exchanges -- Strategic issues in mergers/alliances

There are a number of key issues affecting our industry generally and the implications for exchange rationalisation. But first, let us discuss the immediate future of the London Stock Exchange (LSE).

First, the future is not as a subsidiary of Om or, as far as I can judge, as the subsidiary of any other organisation. As I have said, the London Stock Exchange is not up for sale. Second, whatever the longer-term strategy, there are a lot of things we can do better. There are strengths the London Stock Exchange can develop.

We owe it to our customers and shareholders to become more commercial -- remember we were an industry service-providing mutual until March this year. The better the financial performance, the better will be our position in negotiating our role in European rationalisation and globalisation -- something most of our customers want.

So, as set out in our most recent defence document, and already under way, we are building on our existing strong business in several ways:

*By developing a pan-European market by admitting the leading European equities to trade on our existing systems.

*By repositioning techmark and aim as international markets.

ABy enhancing our strong competitive position through further investment in our trading systems, including the introduction of a central counterparty service in February 2001.

*By developing new initiatives specifically to support private client brokers.

*And developing a range of competitively-priced information products to meet the needs of our customers.

Also a management structure focused on our three main revenue- and profit-generating activities: Broker services, issuer services and information services, supported by two core business areas of market supervision and systems plus the usual central services.

Absence of single market: First, is the absence of a single market -- in the trading of financial products within the EU. The single market is absent in other segments of the European financial services market too -- my recent review of banking services for retail and business customers demonstrated that. The segment I have called `trading of financial products' is not out of step, and some of the issues are common to the whole financial services market.

I am struck by the irony of all of this: That exchanges which are at the heart of the market economy, the very place where capital and ideas come together, representing the most visible representation of the healthy disciplines of the market, are themselves sheltered from these disciplines. I think we all have to think long and hard about how the London Stock Exchange copes with this irony and whether outside intervention is required to break up these cosy arrangements.

Mergers not enough: The second strategic issue is that mergers of exchanges alone are not enough to deliver the lower costs and better service that customers want. Trading customers of exchanges across Europe actually see the product as the execution and completion of the transaction, that is secure possession of the security and certainty of payment.

This is not going to be a plea for vertical integration in common ownership. Far from it. In an Internet, electronically-networked world this is not necessary, as long as the network interfaces are not too complex -- which they are not -- nor multiply too much -- which they need not.

No, clearing and settlement can be owned and managed independently of exchanges. Indeed many market participants talk of them as `utilities'. But they do so rather innocently, as the basis for justifying no vertical integration and mutual ownership. Yes, again no exposure to market disciplines!

However, they are instinctively right in the use of the word utility. Clearing and settlement activity does tend to natural monopoly with significant economies of scale. And this would conventionally raise public interest questions of price regulation and terms of access. I will pass over whether mutual ownership is a valid form of price regulation. It may be. But it is unlikely.

Access: I want to focus on access. The major European clearing and settlement organisations exhibit the economic features of utilities, each is dominant in their own national market. The required public policy intervention is fair, reasonable and non-discriminatory access. `OK', they will all say, `Anyone who wants to be a member can be. The terms are fair'. Maybe they are, although I doubt whether new entrants always think that. However, I am talking about wholesale access, that is, the obligation to provide services to competitors -- in this case, exchanges and other clearing and settlement organisations from other member states. In practical terms, in order to serve customers from across Europe, the London Stock Exchange should directly, or through its agents -- London Clearing House and Crest -- have the right on fair terms to access, say, Clearstream or Euroclear.

Valuation problems: This analysis reinforces the problem of valuations. Lack of competition, fuzzy governance and direct government intervention serve to enable organisations engaged in the trading of financial products to operate without economies of scale, yet report healthy profits. They say they are `worth a billion this, or two billion that'. May I make two observations. First, they are not `worth' anything in particular if there is no market in them. Second, many people estimate that as much as 2 billion euro can to be stripped out of the cost base of the market in trading financial products across Europe. This represents a substantial amount of value. Somewhere revenues and margins have to drop. Where is this surplus value? It is difficult to judge. The development of a central counterparty is a very valuable asset -- so not much there then. So it is in settlement organisations where revenues, margins and value are most overstated and unsustainable.

Let me be blunt. This would clearly pose a dilemma for any organisation entering into merger negotiations if it had to throw its open market value into the pot with the inflated values of organisations that are not subject to competition and market regulation.

The third strategic issue, is that if we did again attempt some form of European merger, then the regulation of listing and admission to trading, standards of transparency in trade reporting and publication, and governance would loom as major hurdles as they did, through no one's fault, in the proposed merger with DBAG. Our customers in the UK, this time including companies and investing institutions, not just intermediaries, want to see systematic the implementation of directives into law, harmonisation of the interpretation of the law in public policy regulation, a common rule book being applied to trading, and common standards of trade reporting and publication.

Extraterritoriality: I also predict that a US tie-up or merger would raise another difficult issue, extraterritoriality -- a horrible word meaning the demand by the US authorities, the SEC and Government combined that their writ should run over all the markets run by the new entity, especially if US citizens were to have direct access to a market in a member state of the EU.

These are not bogey-men, fictions of my imagination. They are, from my media and telecom experience, the inevitable response from the US to any opening up of trade in services, in this case trading of financial products. And those of us, including Nasdaq, who want to see further globalisation of capital markets will need to work together to face these issues before the detailed proposals of any deal could be considered.

And even if the two issues of access and extraterritoriality can be solved or ignored, then both the obvious US candidates for a merger or deal have fuzzy governance, pose valuation problems and bring different market structures.

(Edited extracts from www.londonstockexchange.com)