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Stock exchanges in Europe - where to next?

Date 18/06/2001

Where are the stock exchanges of Europe headed in the coming years? Are there too many? Have we got the markets and supporting structures that we need for buying and selling equities in the next period? Who will "win" in Europe?

To address these questions one needs to be reminded of what exchanges actually do; what changes they are facing; and what the alternatives to "traditional" exchanges are, at least in theory.

Historical perspective

Once upon a time there were many exchanges, not just in each country; there was more than one exchange in each town. In the first sixty years of the twentieth century Britain had various regional exchanges, which were then consolidated into one organisation. In the century before that cities like Leeds boasted more than one. The trade of exchange was originally wholly dependant on personal communication, face-to-face, and it took a very long time for this to alter, primarily through the development of the telephone. Historically, therefore, markets were, by definition, central- physical- markets.

What's changed now?

The use of technology has, by leaps and bounds, altered the way in which markets trade - as it has changed every other industry. Instant access to macro- and micro- information, coupled with the automated execution of trades by computer, has improved the efficiency of financial markets and increased the ease with which they can be accessed, not only by wholesale firms but by individual investors as well. Cheaper technology has also brought in new competitors that, in many markets, are looking to take the cream and leave traditional exchanges with all the other responsibilities that the latter normally fulfil. Such innovation has already begun to make significant inroads into fixed income markets where, admittedly, there is far greater homogeneity of products. These new competitors have therefore raised the spectre that the older exchanges might not be able to survive against the parvenus.

So, why do traditional exchanges continue to exist?

There are two principal reasons why traditional exchanges continue to exist. The first is that some national governments see the continued existence of a domestic exchange, domestically owned, as fundamental to that country's welfare and/or prestige - rather like having a national airline; some governments do but not necessarily all. In any event can a government, which is committed to the principles of the free market, effectively stop trading in the shares of companies based in that country moving elsewhere? It is unlikely; indeed, such migration is already happening to a significant degree in some countries.

What is the second reason for the continued existence of established central markets -central in the sense of attracting all participants in respect of the majority of their business, rather than literally occupying a single physical space? It is quite simply that, in many instances, the "main" exchange still draws together the bulk of the liquidity; it thus provides the most effective price formation; it ensures uniformity in the conduct of trading (without which the aforementioned characteristics will not be present); and trading firms are assured of the best possible conditions in which to manage their risk. What is more, the market with the majority of the volume of business should still be the lowest cost provider because a major part of any exchange's costs are fixed and the marginal cost of a trade is relatively low. Finally inertia against a fundamental shift to a new way of conducting share trades has probably played more than a small part in maintaining a form of loyalty to the tried and tested supplier. Whilst the grand strategists in the major securities firms may push for change, those who actually use the exchange day in, day out, may well prefer to stick to the present formula as it is more likely to preserve existing employment conditions.

Consider all the factors under the second heading - the appeal of a central market - and it is understandable why traditional customers have stayed with traditional exchanges. Are we therefore at the point of convincing ourselves that the pattern that now exists is set to continue in perpetuity? Or are there even greater forces at work that are likely to refashion the nature of share trading in Europe?

May the force(s) be with you

Advances in technology are clearly capable of benefiting all participants in an industry provided the older, more staid, players fully embrace and apply the concepts in a cost-effective way. Consequently, one has to look for an even more fundamental reason why existing exchanges in Europe are going to be subjected to more radical change. The answer obviously lies in the far closer integration of European economies.

International institutional investors now see Europe as one economic bloc to be invested in by industrial sector, not traditional national boundary. They want all those attributes of a central market: liquidity; effective price formation; the ability to minimise risk; and the lowest possible transaction costs, coupled with the highly efficient clearing and settlement of all trades. (The streamlining of these latter functions matters for their own cost but also because of the need to be able to pool and offset assets of different types for the purposes of capital adequacy.)

The question these international firms ask themselves is why do we need all these different exchanges in Europe, each building and running its own highly sophisticated systems; each with its own regulation processes which, although harmonised to some degree, still differ in other respects; and each with its own headquarters? The answer is perhaps they don't. What, though, is likely to bring about a decisive move to more efficient processes? Are European exchanges going to be forced together by some mixture of governmental and/or customer pressure?

What are the alternatives?

The exchanges themselves have, at least in theory, a number of potential alternative strategies for dealing with these materially changed customer needs, which range from "going it alone", despite the pressure for a "new way", right through to full merger with other markets. What are the pros and cons of each?

Going it alone has appeal to the incumbent in each market but the key issue is whether any one exchange is capable of drawing away from its rivals the liquidity in that rival's shares. This has proved very difficult to do. London came closest to it in the mid-80s but Continental bourses fought back, with much national backing, and it was never feasible for London to hold on to its early gains.

The next alternative is some form of co-operation between exchanges to produce a common platform and to reduce the overlap between the European markets. This has been tried on a number of occasions. Does it work? Not really. Joint ventures in industry generally are dogged by competing objectives and compromise tends to be at a premium as soon as commercial sovereignty seems threatened. Exchanges are still trying this route and we shall see whether any co-operative venture results in major breakthroughs of the sort the customers are keen to see. Quite apart from doubts about effectiveness, joint ventures are not going to reduce the number of underlying exchange organisations which is one of the principal aims of those calling for change.

The senior managers in the firms that use exchanges want rationalisation, certainly for the stocks of Europe's largest companies; (smaller companies may, for some time, continue to be dealt with in a different way). And why not? Isn't that what happens in every other industrial sector in order to remove surplus capacity? And are not mergers and takeovers the usual medium through which more radical change is brought about?

The prospect of M&A activity is becoming far more likely again. As noted earlier, it occurred in the nineteenth century, city-by-city, and in the twentieth, region-by-region. Could the early part of this century be marked by serious mergers across national borders? Indeed the trend has started with Euronext, which has seen Paris merging with/taking over Brussels and Amsterdam.

Merger activity - is it feasible?

The short answer is "increasingly so". Whilst in some European countries one can expect continued government "attention", in others this is likely to be less of an obstacle. Vitally, however, the ownership structures of stock exchanges are being freed up and exchanges are being floated (ironically on their own markets). Assuming the terms of any IPO conform to best international practice that means the shares that are floated should contain no restrictions on transferability or ownership. In such circumstances the climate for merger activity will have been created. If there is excess capacity, in the widest sense of that expression, mergers should eliminate it.

This is subject to two provisos. The first, as touched on in the previous paragraph, is that national governments do not interfere in commercial matters. The second is that the customers of the exchange in question stick to their belief that they must be prepared to go where the service is best - thus keeping each exchange on its commercial toes; it is highly preferable that they do not simply resort to voting their shares in accordance with their preferences as customers. This does not make an exchange more efficient; all it does is push the organisation from pillar to post. Businesses that are owned by their customers are mutual businesses. De-mutualisation is designed to separate the entirely different interests of ownership and "customership". Truly commercial goals can only be pursued by truly de-mutualised organisations.

On the assumption that de-mutualisation of Europe's exchanges takes place widely - and is followed by flotation in each country - the stage will then be set for serious rationalisation.

Will it happen?

Will rationalisation by merger sweep through Europe's exchanges as it has done, or is doing, in virtually every other industry? Or are exchanges immune to normal commercial criteria?

The answer, surely, is that they cannot be. The constant threat is that traditional exchanges will be by-passed by new, footloose, entrants that will look to take the best (business) and leave the rest.

That threat should be enough to ensure that a radical process of change in European markets is started. Furthermore, even if it progresses by stages - through a number of intermediate groupings - the process should, in due course, produce the sought-after results. The only remaining question will then be: is that fast enough for those exchange customers for whom internationalisation means so much?