Kicking off a global trend

The December merger between two of Europe’s largest derivatives exchanges looks likely to set in motion a wave of consolidation among bourses, clearing and settlement houses and derivative exchanges themselves.

It may not yet amount to a European financial ‘Big Bang’, but the takeover of London’s resurgent derivatives exchange by a rival European group towards the end of 2001, may well have lit the fuse. The takeover, which became unconditional on December 27, not only has serious consequences for Europe’s clearing houses, but is likely to alter the balance in the jockeying for supremacy among the major stock exchanges. Some optimists even believe it could pave the way for derivatives exchange consolidation on a global scale.

The controversial £555 million acquisition of the London International Financial Futures and Options Exchange (Liffe), by Euronext, the European bourse created by the merger of the Dutch, Belgian and French cash equity and derivatives exchanges, in September 2000, is being greeted with enthusiasm by regular Liffe users. The takeover may have been opposed by some in the UK financial establishment – who would have preferred to see the success of the London Stock Exchange’s bid for Liffe – but the emergence of a European duopoly for exchange traded derivatives delivers the best possible outcome, say users. If Liffe had been captured by Eurex, the German-Swiss derivatives exchange that also made a takeover bid, it would have combined Europe’s two largest electronic exchanges and created an excessively powerful institution.

This would have been bad news, according to Richard Berliand, global head of futures and options at JP Morgan Chase in London, because it would have created a monopoly in many derivatives products.

However, the duopolists each have areas of strength. Euronext/Liffe is the leader in single stock options (single stock futures have also been launched by both Euronext and Liffe in the past 15 months), as well as short-term interest rates derivatives. Eurex is ahead in stock index futures and longer-term interest rate contracts.

“This is an arrangement that suits users down to the ground,” says Berliand. “It creates enough competition to ensure than everyone is innovating, and that there is not excessive price exploitation. It consolidates our costs to two major exchanges, while enabling the exchanges to be profitable, and invest to innovate,” he adds.

The surprise is that the consolidation of Europe’s financial sector is being led by the more esoteric institutions. Merger pressures had seemed greater among high-profile stock exchanges, where Western Europe alone contains some 15 national bourses, 10 electronic trading platforms and 27 clearing and settlement houses. “The consolidation of European exchanges [that everybody wants] has taken place in the derivatives industry. It has happened. We have two markets in derivatives here now – way ahead of the consolidation of the stock exchanges,” says Brian Williamson, chairman of Liffe.

While the major firms had been looking for mergers among the stock exchanges, the Euronext/Liffe deal “has given them what they sought to achieve – consolidation of trading platforms and a catalyst for radical change in clearing and settlement,” he says. With this deal, “we [in the derivatives industry] have delivered these things to their doorstep. Gift-wrapped, with a bow.”

Under the terms of the takeover, London becomes the hub for Euronext’s derivatives business, which will be run by the existing Liffe management, together with some Euronext managers. In addition, all the derivatives business will be undertaken using the highly-regarded Liffe Connect, the trading platform technology that was rapidly developed in response to the rapid ascendancy of Eurex in 1997–98.

Liffe Connect helped put the London exchange on the road to recovery. This technology, which enabled Liffe to successfully convert from the open-outcry trading system to an electronic system, has since been distributed to some 500 locations in all the key time zones.

Yet, as important as the takeover of Liffe is for the European derivatives industry, the ramifications certainly go much wider. For starters, the clearing houses now find themselves uncomfortably in the spotlight. Liffe transactions are cleared by the London Clearing House (LCH), which is an independent non-profit organisation owned 75% by member banks and 25% by the exchanges it performs clearing services for. In contrast, central counterparty services for the three other Euronext partners are provided by Clearnet, which Euronext owns.

Ownership of the clearing organisation by the exchange is common in continental Europe, but users claim that clearing costs are higher there than in the US, where the clearing houses are predominantly user-owned. “It is not enough to bring the two derivatives operations together. The clearing houses have to be consolidated as well. It is a nonsense to have so many clearing systems. That is why clearing and settlement is so expensive in Europe,” says Peter Lewis, global head of programme trading at Société Générale in London. The goal should be to create a single clearing system that is owned by both the banks and the exchanges, he says. Whether LCH and Clearnet can co-operate more closely or even merge; or whether one of them will emerge as the sole central counterparty (CCP) for Euronext/Liffe is still an open question. But the market participants want a solution, and the clearing houses are under heavy pressure to come up with one. Any move they make could trigger a wider consolidation.

For now, Euronext/Liffe traders will be allowed to choose which clearing house they wish to use, according to Williamson. However, others closely involved, insist that traders will have to use whichever CCP is currently clearing a particular contract.

Some market participants also believe that Euronext’s takeover of Liffe is only part of a much more ambitious, longer term strategy. “The acquisition of Liffe is another step in [Euronext’s] ambition to become the pan-European stock exchange of choice,” says Lewis.

Eventually, there will be two or three pan-European exchanges. Among those exchanges jockeying for position, the Deutsche Bourse (which owns 80% of Eurex) and the London Stock Exchange (LSE) are both major players, but the LSE is starting to fall behind, he says. The LSE had bid for Liffe and lost. Now, many in the market-place say the bourse lacks a clear strategy, although exchange executives publicly say this is nonsense.

If Euronext wants to be a pan-European stock exchange of choice, it will at some point have to start trading UK equities. “But how do you take on the LSE and attract liquidity from it? Obviously, the aim behind the acquisition of Liffe is to create a powerhouse on the derivatives side. Then, it is only a matter of time before it starts listing UK equities, as well,” suggests Lewis.For some derivatives market participants, the potential for consolidation is not limited to Europe.

“I would like to see a continuous process of consolidation globally. And I think it will happen within the coming year,” says the head of futures trading at one European bank.

This would probably involve each of the two European derivatives exchanges linking up with one or other of the two Chicago futures exchanges – the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBOT) – and, possibly, an Asian futures exchange. This could conceivably create a global duopoly. It is an appealing idea to many futures exchange users, further reducing costs and simplifying trading.

But the political and cultural difficulties involved make such alliances very unlikely, says one senior market participant. There is a deep resistance to change at the Chicago exchanges, particularly on the CBOT, “whose fortunes seem to sink ever lower,” he says. This year, for the first time, it has ceded its position as the biggest US futures exchange to the CME. It was overtaken by Eurex as the world’s largest exchange (by contract volume) in 1999. Some elements in the CBOT have opposed even modest change, and new top management has had to be installed.

How they compare: Top five derivatives exchanges
Exchange	2001 volume	2000 volume	% change
1) Eurex	674.0 m	454.2 m	48.4
2) CME	411.7 m	231.1 m	78.2
3) Euronext	398.7 m	326.7 m	22.1
4) CBOT	306.6 m	326.3 m	6.0
5) Liffe	216.0 m	131.1 m	64.8

The lack of attractiveness of the US exchanges as merger candidates means that the derivatives market focus is likely to remain on European developments, where the sands are still shifting despite the emergence of a duopoly. There are still several smaller national derivatives exchanges that may eventually coalesce around one of the two main axes, notes Berliand. (Finland already has an arrangement with Eurex and Portugal’s Oporto exchange is set to join Euronext.)

The main exchanges still sitting outside are Sweden, Italy and Spain, while other minor exchanges that are not yet linked to an axis include Norway, Greece, Austria and Denmark. Although none of these look likely to seek alliances within the next 12 months, they are facing pressures, says Berliand.

Most of them are now entirely dependent on equity products – single stock contracts and national stock index contracts. But national stock index products are now in decline as the Dow Jones Eurostoxx indexes, traded on Eurex, become increasingly predominant. “The franchises of the smaller derivatives exchanges will, therefore, be largely based upon single stock options. I believe that, over time, these exchanges will have to come into some form of alliance with one of the big two, even if it is not full-blown consolidation,” Berliand says.

Of the three main traditional types of financial, exchange-traded derivatives – fixed income contracts, stock index futures and options, and single stock options – all of the fixed income contracts have died on the smaller exchanges, with the exception of Sweden.

The Bund is now almost universally used to hedge European Union government bonds. Meanwhile, the rate of growth in the national index futures and options is substantially lower than the growth of derivatives on pan-European indices, chiefly Stoxx and Eurostoxx, explains Berliand. (The FTSE and Swedish OM indexes are, perhaps, the exception to this trend).

“This leaves you with one last asset class, which is the single stock options. It is why everyone is trying to list everybody else’s single stock options,” he says. It is likely to be the key battleground for some time to come. Williamson’s view of Liffe
Users of derivatives exchanges now have “two different, competitive models to choose from in Europe. The market will determine which of them it prefers”, says Brian Williamson, chairman of the London International Financial Futures Exchange (Liffe) in an interview with Risk. On the one hand, the Frankfurt-based derivatives exchange Eurex is an essentially German-owned, vertically-integrated platform, with its own internal clearing system. In contrast, Liffe is an internationally-owned vehicle, with – probably – a separate, external clearing arrangement. The precise, post-merger system has yet to be agreed.

The exchange that will do best is the one that adapts to what the users want, says Williamson. “If we have got it wrong we will have to adapt very quickly, because the return on capital required under the internal budgets is quite high,” he says. He refuses to give precise hurdle numbers publicly.

Measured by contract trading volume, Liffe was only number five among the world’s derivatives exchanges before the takeover (see table), although it did achieve a 65% increase in volume business last year. However, because its contract sizes are much bigger than those of most other exchanges, it claimed to be the second largest derivatives exchange in the world after the Chicago Mercantile Exchange (CME) – in value terms – even before it was acquired, with a notional value turnover in 2001 of €154 trillion (nearly three times that of Eurex). After the takeover, the London exchange emerged as the world’s second largest trader of derivatives contracts by volume, after Eurex.

The merger has other implications for the combined exchange. It brings together very different market segments in the equity options arena, where the London exchange has only modest success, unlike the European derivatives markets. Moreover, the Euronext/Liffe single stock option markets are still heavily concentrated on their local, domestic equities, with only limited interest shown for pan-European business, observers say.

“Our options on single stocks have really taken off since we got them on to the [Connect electronic system],” answers Williamson. Single stock option contracts rose some 96% in 2001. Such contracts are among the most difficult derivatives to put on an electronic system because they are immensely complicated.

The success of this electronic platform makes it possible to integrate the stock options businesses of Liffe and Euronext. “It means that the London exchange’s options activity is not confined to UK stocks and the [French, Dutch and Belgian] business is not confined to their domestic stocks. Put that altogether and… bang ...you have a serious part of the options-on-stock exchange business. And, you have achieved a pan-European operation much faster than the underlying markets,” he says. All this leaves aside the “huge” benefits of being able to net “your Continental equity positions against your fixed interest, highly liquid euro positions,” Williamson adds. One obstacle to this in the past has been in clearing the transactions. The London Clearing House (LCH) – the independent company through which Liffe transactions are cleared – has had no protocols with a European clearing house because the latter tend to be owned by exchanges. “[With this Euronext deal] we have opened up a bridge for people to come into London. It will also make it possible for traffic to go in the opposite direction… although, how that is now done is up to the LCH and the markets,” Williamson says.