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European Stock Exchanges

Date 07/07/2005


Paul Arlman, Secretary General, Federation of European Securities Exchanges
Michał Wiktorowicz, Research Department, Federation of European Securities Exchanges

Competition as a driving force of change

The trend to demutualise stock exchanges started in 1992 with the 'companisation' of the Stockholm Stock Exchange. Since then many other exchanges have demutualised, and most of the rest now have plans to do so. A key goal of demutualising a stock exchange is to enhance the exchange's ability to react to competition from other exchanges and trading systems. A wide range of merits of demutualisation for exchanges have been suggested. Most importantly, demutualisation may allow a stock exchange to be more responsive to the needs of its users and customers, and particularly investors and issuers, and to reduce the need for the exchange to satisfy the interests of the financial intermediaries who were previously its members and owners. This may facilitate an exchange granting direct access to its trading system to market participants other than financial intermediaries.

Demutualisation was pushed by the emerging idea of competition of exchanges. At present competition between exchanges seems in fact obvious and, despite its young age, deeply rooted in the nature of exchanges' business. Competition takes place on many grounds, such as the provision of immediacy, low spreads, low volatility, liquidity, efficient price discovery, transparency and low commissions and other transaction costs[2]. The more competition there is, the more likely it is that exchanges themselves will adopt rules that benefit and protect customers. Competition is not restricted to the actions of the exchange itself. A stock exchange in a wider view is a complex organisation encompassing intermediaries such as market makers, specialist firms, regulatory bodies and so on. The competitiveness of an exchange is determined by the whole group of interdependent actors.

Competition usually calls up a struggle between fragmentation and consolidation.

It is true that competition normally produces not conformity, but market fragmentation[3]. Since competition maximises consumer choice and because consumers in the market for exchange services have very different desires, markets may come to specialise, rather than to conform, as competitive pressures increase. This is however not that simple. Exchanges have several possible strategies to apply while trying to ensure their success. There is no foreseeable prospect of a single European Exchange; this is neither thinkable from the commercial nor from the policy perspective, and European legislators and regulators have no such plans. Yet, the number of fully independent full-service exchanges will probably diminish. Who will stay in the arena depends not only on the ad-hoc decisions by the exchange managements, but also on the answer to the question of which of the possible strategies gives the better chances for success. There is no clear answer to this question which depends on many different factors. Further confusion is introduced by the emergence and rapid development of trading systems[4] which compete with 'traditional' stock exchanges.

Predicting that further consolidation will occur is only slight more risky than predicting that the sun will rise tomorrow. More interesting and uncertain questions concern the likely mechanisms of consolidation and the strategies that will dominate this new competition. At least four different outcomes can be reasonably imagined, and most are in evidence in Europe already. First, exchanges could simply merge, or develop other forms of linkages and alliances that cross borders and effectively create a de facto international exchange[5]. A second alternative is that more successful market centres could simply drain liquidity from local or regional exchanges, leaving them intact but hollowed out[6]. The third scenario is that an ambitious and entrepreneurial market centre might seek to expand by founding outposts around the globe. Finally, as brokerage firms become truly international, it may prove more cost efficient for them to route domestic customer orders to distant foreign exchanges than for foreign issuers to list on domestic exchanges.

It is predicted that exchanges' principal income will have to come from the sale of their quote and trade data. Thus stock exchanges will become media companies, or in other words content providers. As such they are likely to mimic the activities of similar media companies. Most importantly, stock exchanges will seek even more assiduously than in the past to control and exploit the intellectual property in the price and quote data arising from their trading systems. However, there are more years to come of legal and regulatory battles over whether exchanges own their quote and trade data[7].

Regulation of exchanges

Legislation concerning European exchanges comes under the aegis of the Internal Market Directorate General of the European Commission and is a matter of co-decision procedure, at the initiation of the Commission, between the Council of Ministers and the European Parliament.

At the time of the introduction of the euro in 1999, the European Commission came forward with a rather ambitious plan called the Financial Services Action Plan[8] (FSAP), which covered the entire area of the financial markets: securities, banking, pension funds, investment trusts and insurance, and called for the adoption of 42 legislative measures. It was accompanied by the so-called Lamfalussy recommendations, drafted by a group of 'Wise Men' who tried to speed up the European legislation, improve its quality and prise the process open for consultation. 'Speed up' is important because an EU law may take a very long to come into life. Quality is important as modern techniques of legislation have not yet been introduced in Brussels, cost benefit analysis is hardly known and regulatory impact statements are a phrase from academia not yet seen in practice too often. Finally, the processes in the past took place behind closed doors. This has changed, and new proposals are now often the subject of consultation with business.

Lamfalussy proposed that European legislation should consist of four levels. At level I the Council of the EU and the European Parliament adopt framework legislation. At level II the European Commission adopts technical implementing measures[9], following advice from the Committee of European Securities Regulators (CESR) and following the approval of the European Securities Committee (ESC). At level III, co-operation between national regulators regarding implementation takes place. CESR may provide non-binding guidelines and recommendations. At level IV enhanced enforcement measures require the European Commission to check Member State compliance with the legislation, and legal action against inconsistent or delayed implementation may be introduced. Experience so far is limited to the first two levels: there is still a lot of work to do.

The issues dealt with by the FSAP that are of the most relevance to financial markets are as follows:

The Markets in Financial Instruments Directive[10] (MIFID) is by far the most important for Exchanges and for investment banking. The MIFID sets the framework for financial markets, requires regulators to watch their functioning and quality very carefully, and enumerates requirements for Exchanges, intermediaries, and others active in our capital markets.

The MIFID provides for the European passport for exchanges and intermediaries. The MIFID also allows non-exchanges, for instance banks with a large number of clients, to internalise securities orders. FESE has managed to influence the MIFID process in such a way that internalisation can happen but only under a number of conditions that create or try to create a level-playing field between the exchanges and internalising banks or brokers, as well as ECNs and ATSs.

The outcome of the MIFID in real life is not easy to assess as so much has still to be done at Lamfalussy levels II and III. However, one outcome is clear to me, and that is that there will be more competition. Another result will be much more focus and attention on 'best execution' for all clients.

The Market Abuse Directive[11] (MAD) instructs all jurisdictions in the European Union to have a system under which those who try to abuse capital markets may be punished. The original idea was that only the courts and prosecutors would play a role, but fortunately the legislation that is now on the books also allows regulators under administrative law to pursue, prosecute and enforce. MAD even created openings for self-regulatory approaches that are often far more effective than official ones.

The Prospectus Directive[12] in its original set-up tried to arrange for a passport for listed companies and bond issuers. The ideal situation would be that those who issue equities or bonds should be allowed to issue them wherever they want throughout the EU, and would only need approval by a regulator once. The directive achieves this for bond issuers, but ties equity issuers, for some good and bad reasons, to their national regulator in the country of incorporation. Incidentally, this means it discriminates in favour of non-EU issuers who can choose whichever regulator they like.

Many of the directives that have been passed as a part of the FSAP call for reviews and/or for reports on implementation and effectiveness.

Implementation and enforcement of the new legal framework for Europe's financial markets are a widely agreed focus of work for the European institutions, for member states, and for the participants in the financial sector. We see an important role for the private sector in ensuring proper and equitable implementation, with the benefit of creating a truly single European Market.

For example, not all cross-border problems can be handled by existing cross-border dispute resolution services, such as FIN-NET and SOLVIT, since the former applies only to retail customers and the latter lacks the necessary independence and expertise to handle the complex issues in the financial services industry. In this context, we have proposed the establishment of a European complaints procedure to handle cross-border disputes between businesses and national regulators on issues such as passporting. Disputes could occur in the areas of securities markets, investment banking and fund management. Once the Lamfalussy process is fully applied to banking, insurance and so on, the dispute resolution service[13] should serve these areas as well. Hence it is important to establish the role well in advance of such extensions of the process. A flexible and voluntary service is indeed necessary in order to offer the anonymous, independent and expeditious procedures that the industry wishes to see available.

The Federation has carried out a study[14] in this area which is now under public discussion.

Regulatory structures

There is heated debate in Europe about current state of integration of EU financial markets[15] and the role and structures of securities regulation in particular.

To achieve this, Europe needs to decide on the most important aspects of the future regulatory structure and of the future shape of legislation. Does Europe believe that legislation of high standards will attract issuers? Perhaps it will have just the opposite effect? Does Europe need a high degree of legislative interference or not? Can high standards be achieved in practice? What is the relationship between a degree of legislative interference and certainty for market players?

The empirical evidence is still insufficient. However, one point needs to be underline: thorough cost-benefit analysis of possible future legislation should always be supported as this is probably the best means of assessing the level of impact the new legislation will bring.

From an idealistic (or as we prefer to see it 'realistic') point of view, such an analysis could give some indications as to the possible impact of new legislative acts. The financial industry should be eager to present the necessary figures. Of course, the proponents will always exaggerate the benefits and the opponents will do the opposite. While the figures themselves might not be completely accurate (and possibly could not be even with the greatest diligence), the ratio between costs and benefits will not lie far from the truth.

In relation to regulatory structures sensu stricto, the Committee of European Securities Regulators published in 2004 a report entitled 'Which supervisory tools for the EU securities markets?'[16] CESR underlines that the degree of integration of the securities markets in the EU varies significantly, both according to the sectors and categories of market players considered. EU securities regulators should therefore develop an 'adaptive' strategy to face the progressive integration of markets.

One of the preconditions for CESR members to carry out effectively their new obligations to cooperate under the FSAP is that supervisors should be given equivalent legal and functional capacity to act. The greatest priority of CESR is precisely to deepen the co-operation arrangements under the FSAP, to enhance the supervisory relationship between authorities and to improve the convergence of approaches and decisions within the network of securities regulators. However, this analysis would be incomplete if it did not flag that the need to consider supervisory tools of a transnational dimension is closer than it was when the Committee of Wise Men, chaired by Baron Lamfalussy, was set up. CESR believes that these options should be considered only if it is very clear that the present system cannot be developed to provide proper solutions to the question of supervisory convergence.

It seems appropriate to pay special attention to the further development of the supervisory and regulatory structure in Europe, especially in the light of the coming implementation of FSAP and Lamfalussy levels II, III and IV[17].

CESR without doubt touches upon important questions. We note and applaud that CESR advocates a gradual approach, as this is the only one that securities markets can benefit from. We strongly support and actively work towards regulatory supervisory structures that can play into the changes in the markets. At this stage, national regulators cannot be asked to relinquish national responsibilities and national accountability towards their governments and parliaments. At the same time, in order to be effective, such regulators and supervisors have to be flexible and place the greatest possible trust in their colleagues. The fact that several regulators are involved in the supervision of an entity providing services across European borders should not result in each of these regulators acquiring a veto right on each and every action of such entity The bond market 'scandal' is being pursued separately by at least six (!) regulators.

An interesting possibility is the designation of a lead/coordinating supervisor. The issue of a lead regulator has been put forward in the public discussion and we would most certainly support further substantive discussions on that subject. We believe that cross-border companies are burdened by a bewildering array of supervisors, each of which can claim their powers and competences with legal justification. Effectiveness and efficiency, however, may easily get lost. In the past, central banks as banking regulators and as lenders of last resort had at times cooperated very effectively while recognising national powers and competences. Any steps towards deeper cooperation should be seen constructively but approached primarily from an efficiency and effectiveness point of view.

Looking into the future

The European exchanges are at present in fierce competition, not only between each other but also with the US markets. The competitive relationship with the US has also spread into legislative areas. Until recently, the US attitude towards international standards like IAS was that a company could have any standard it liked as long as it was the American one. The US regulators were deeply convinced of the superiority of their approach which is auditor ? and lawyer ? led and contains thousands and thousands of detailed instructions. Most of the European economies approach accounting standards from the angle of principles plus application of a good portion of practical sense. The current discussion on International Accounting Standards (IAS), and the convergence between such standards and the American standards to be worked out in London by the International Accounting Standards Board, will hopefully lead to a global set that will allow companies to be as transparent as they should and will assist investors to compare companies much better and thereby improve their portfolios.

It is not only accounting standards that create tensions, but more generally the threat of extra territoriality of US legislation. Sarbanes-Oxley, the law that made a part of American corporate governance into a federal matter, has had an important impact on European companies with a listing in the US. The approach of our regulatory friends from the other side of the Atlantic Ocean is that a company that has once listed in the US, cannot de facto leave that jurisdiction. It is however comforting that the Trans Atlantic Dialogue (TAD) has agreed to draw up agendas of urgent issues to discuss and that consultation about future legislation is certain.

There is one issue specifically for European electronic exchanges, jointly with our friends in Sydney and Toronto, that is part of the discussion across the Atlantic. It is the issue of putting foreign trading screens in front of American investors. Such access would help us to make our exchanges even more liquid and serve US clients more efficiently. This already happens in the futures markets which have successfully broached the American market under the supervision of the CFTC, but the SEC, with jurisdiction over all equity products, has not been willing to open the doors, claiming that foreign exchanges that want to do business with American investors in America should become American-, that is SEC-, regulated exchanges. This of course is impossible, if only because it would mean that exchanges would be part of two jurisdictions at the same time. After several years of rather fruitless contacts, it is high time to finally make some progress. The recent announcements by NYSE and Nasdaq relating to market restructuring, as well as the SEC decision in principle on the National Market Structure, may, one hopes, lead to a more open attitude from both American regulators and market organisers.

Final remark

Many academics, as well as professionals, agree that strong legal standards tend to attract, rather than repel[18]. Indeed, when one examines the actual migration of issuers and listings across jurisdictions, the dominant pattern has been the movement of listings to exchanges in jurisdictions that are noted for their strong protection of minority shareholders. Even in Europe, where firms today do possess a substantial degree of 'issuer choice' ? namely, the ability to choose the disclosure standards that apply to them ? few firms seem to be opting for the lower cost, less demanding options, but instead are voluntarily complying with the highest level of disclosure. By opting instead for a higher disclosure regime, the migrating firms maximise their share price and become able to raise additional equity at lower cost. This finding is, of course, consistent with a new academic literature that argues that liquid and deep securities markets can develop only in jurisdictions that protect the rights and expectations of minority shareholders. We hope that this trend will continue.

Europe should pursue this direction.

The authors of this article are writing in a personal capacity.

[1] Most of the issues described in this article are important for all types of exchange, but the authors focus on stock exchanges.

[2] Schwarz-Schilling, C, Wahrenburg, M, Regulating Competition between Stock Exchanges, 2002,

[3] See Blume, M, The Structure of the US Equity Markets, Columbia Law School, The Center for Law and Economics Studies, Working Paper, 2002.

[4] For example Instinet.

[5] See the European Exchange Landscape,

[6] It seems to be a well-established fact, although there is still no unanimity of views, that greater transparency and higher listing standards in a particular market may attract listings from issuers and trading interest from portfolio traders.

[7] Lee, R, The Future of Securities Exchanges, The Wharton School, University of Pennsylvania, 2002

[9] In accordance with Council decision 1999/468/EC ('comitology procedure').

[10] Directive 2004/39/EC of the European Parliament and of the Council of April 21, 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, OJ L 145/1, 30.04.2004,

[11] Directive 2003/6/EC of the European Parliament and of the Council of January 28, 2003 on insider dealing and market manipulation (market abuse), OJ L 96/16, 12.04.2003,

[12] Directive 2003/71/EC of the European Parliament and of the Council of November 4, 2003 on the prospectus to be published when securities are offered to the public or admitted to trading and amending Directive 2001/34/EC, OJ L 345/64, 31.12.2003,

[14] McDonald, O, Feasibility Study for a European Ombudsman, 11.06.2004,

[15] Ieke van den Burg, Draft Report on current state of integration of EU financial markets, European parliament, Committee on Economic and Monetary Affairs, 18.01.2005

[16] Committee of European Securities Regulators, Which supervisory tools for the EU securities markets?, 25.10.2004,

[17] Committee of European Securities Regulators, The role of CESR at level 3 of the Lamfalussy process (04-104b), April 2004,

The respective Federation of European Securities Exchanges comments can be found on:

[18] See Coffee, J C, Berle, A A, Competition among Securities Markets: A path to Dependent Perspective, Columbia Law School, The Center for Law and Economics Studies, Working Paper No. 12, 2002.