Memorandum submitted by the London International Financial Futures and Options Exchange (LIFFE)
LIFFE (Holdings) plc (the "Company") welcomes the opportunity to make this written submission on the background to, and implications of, the takeover of the Company by Euronext UK plc, a wholly-owned subsidiary of Euronext NV.
Over the last three years, LIFFE has rapidly developed a world-leading screen-based trading system, LIFFE CONNECTTM, and successfully transformed itself from a floor-based, open outcry market into a wholly electronic screen-based market, which can now be accessed directly from more cities in more countries than any other financial market in the world.
Every day more business by value, over £550 billion, is entrusted to LIFFE CONNECTTM more than any other electronic exchange in the world. Furthermore the system also supports trading in the broadest range of products of any electronic exchange worldwide, and is the only electronic system in the world capable of successfully trading highly complex short-term interest rate future and options.
Once LIFFE had migrated its products from the market floor to LIFFE CONNECTTM, it embarked on a strategy to commercialise the technology assets it had created and, in 2001, agreed three major sales of LIFFE CONNECTTM and associated market solutions expertise to third parties.
LIFFE's success in implementing its overall strategy, in converting into a wholly electronic market and in marketing its technology, as well as its return to profitability, prompted interest in LIFFE from a number of parties. Following a structured process designed to allow each interested party to make its case, and to enable the Board to consider whether any of these proposals would achieve greater value for shareholders compared with the alternative of continuing to pursue LIFFE's strategy as an independent exchange, the LIFFE Board unanimously endorsed Euronext's offer.
The acquisition of LIFFE by Euronext, a non-UK business, underlines the international nature of London as a financial centre and confirms to the international financial community that London is open for business.
The combination of Euronext and LIFFE's derivatives operations will treble the volume of business conducted through LIFFE CONNECTTM. This will enable LIFFE and Euronext to respond to customer needs by providing, through a single trading platform, access to a much deeper market with a wider product range more quickly and effectively than either could otherwise have done independently.
This consolidation also creates a favourable framework for co-operation between the London Clearing House and Clearnet, Euronext's clearing subsidiary, which could optimise clearing and settlement arrangements for the benefit of all market users.
The wider distribution of LIFFE CONNECTTM will increase the volume of derivatives business transacted through London, building on LIFFE's and Euronext's existing momentum in this growth area of financial services. This early consolidation of derivatives markets in Europe, ahead of the United States in particular, will benefit customers and put European markets as a whole at a considerable competitive advantage. It means that, for derivatives business, Europe now leads the world in terms of market consolidation, use of trading technology and customer service generally.
This submission is divided into five sections. Section one sets LIFFE in the context of London's international financial markets. Section two provides a brief background to the organisation and character of LIFFE. Section three charts the success of LIFFE in transforming itself from a floor-based, open outcry market into a world-leading fully electronic market through the development of a new electronic trading system, LIFFE CONNECTTM. Section four explains the process the Board followed to see whether any of the expressions of interest it had received could be recommended to shareholders or whether LIFFE should continue as an independent organisation. Section five addresses the implications of the offer by Euronext, which was unanimously recommended by the Company's Board, has been accepted by shareholders, and was declared wholly unconditional on 27 December 2001. It explains why this offer is good for LIFFE and LIFFE's customers, good for London and good for Europe as a whole.
SECTION ONE: LIFFE IN THE CONTEXT OF LONDON'S INTERNATIONAL FINANCIAL MARKETS
1.1 LIFFE plays a central role in promoting liquidity and price discovery in London's financial and commodity markets. The markets in London are predominantly international and are large in comparison with other financial centres.
1.2 Each day over £4,000 billion is traded in those major London markets which have no central exchange: the foreign exchange markets, the money markets, the bond markets and the over-the-counter markets in related derivatives. To put their size into context, the daily value of turnover of these markets is seven times larger than that of LIFFE and 170 times larger than that of the London Stock Exchange.
1.3 Whereas a traditional stock exchange principally focuses on trading in one relatively straightforward product ie company shares LIFFE provides a central exchange for investment and risk transfer in a diverse range of 50 highly complex products that are derived from, and support, the larger markets in bonds, money, and over-the-counter derivatives, as well as the equity market. LIFFE trades an average of £550 billion every day.
1.4 LIFFE's major customers are the international broker dealers, financial institutions and proprietary trading firms, who are seeking to maximise their access to markets on a global basis while reducing their cost base by efficient utilisation of market infrastructure. In this highly competitive, cost conscious environment, these customers see no room for a myriad of exchanges and clearing and settlement services, each with its own practices and overheads, systems and IT investment. The process of consolidation of infrastructure providers is central to the provision of efficient services to the investment community as a whole.
1.5 Contrary to a widely held impression, derivatives exchanges, and LIFFE in particular, have led the way in the technology revolution. LIFFE provides the platform distribution and functionality that takes the market to its customers. LIFFE CONNECTTM revolutionised LIFFE's business, and exchange-traded business generally, by doing just that. It has created a market which is unrivalled for speed (99.972 per cent of trades in December 2001 were processed within two seconds) and which is fully interactive on a globally-distributed basis. This means that market participants can trade on the system from their own offices, whether they are located in London. New York, Tokyo or one of 57 other cities in 25 countries around the globe. Moreover, the complex and diverse nature of LIFFE's products require highly sophisticated trading technology which has far greater functionality than that which is required, for instance, to trade shares.
1.6 Crucially, LIFFE pioneered the use of the "open architecture" approach to the provision of electronic trading services to market participants around the world. Under this approach, LIFFE provides the electronic order matching system, the distribution network and the software through which a market participant's trading application is able to communicate with the order matching system, while the market participant itself provides its own workstations and trading application software. This approach is highly flexible and efficient. It allows market participants to tailor their trading application software to their specific needs and it enables them to link their workstations to other systemssuch as those dealing with the electronic routing of orders from customers and risk managementto facilitate a far wider distribution of the market and more efficient processing of business.
1.7 LIFFE CONNECTTM has been continuously upgraded to maintain its competitive edge. Version 6 of the system is now scheduled to go live later this year. To date, LIFFE has invested almost £60 million in developing, distributing and upgrading the system.
1.8 The derivatives business climate has changed fundamentally in a short space of time, with the competition being keenest in Europe. It is no coincidence that the two pre-eminent electronic exchanges in the world are LIFFE and Eurexboth European and both derivatives exchanges. The system that LIFFE developed remains unrivalled in the trading of short term interest rate products: a significant British technological success.
SECTION 2: THE ORGANISATION AND CHARACTER OF LIFFE
2.1 The principal operating company of the LIFFE (Holdings) plc Group is LIFFE Administration and Management ("LIFFE" or the "Exchange"), which operates the market known as The London International Financial Futures and Options Exchange (the "LIFFE market"). LIFFE is a Recognised Investment Exchange under the terms of the Financial Services and Markets Act 2000 and is overseen by the Financial Services Authority (the "FSA"). LIFFE has a statutory duty, among other responsibilities, to operate its markets so as to afford proper protection to investors and to ensure that trading is conducted in an orderly and fair manner.
2.2 The LIFFE market opened in 1982. The Exchange's purpose is to provide market participants with a mechanism through which they can transfer financial risk to others who are prepared to take on such risk. It has developed a diverse range of financial instruments which enable market users to protect themselves against, or to take on exposure to, movements in short-term and long-term interest rates, equities, and non-financial (commodity and weather) products. It remains a market where risk is exchanged in a safe and fair environment.
2.3 From the outset LIFFE has had an international outlook. Its product range has always been tailored to suit an international membership and international users. Since LIFFE opened, between two-thirds and three-quarters of its members have been non-UK owned or subsidiaries of non-UK parent companies. Today the demands of its global business mean that LIFFE's technology is designed for international distribution, and to support its global business the Company has offices not only in London, but also in New York, Chicago and Paris.
SECTION 3: LIFFE'S TRANSFORMATION INTO A WORLD-LEADING ELECTRONIC MARKET
3.1 Until the late 1990s LIFFE's success had been based mainly on expertise in developing and running a floor-based market. But by the second half of the 1990s technological change was dramatically impacting the derivatives market. Customers began to gravitate towards screen-based markets which, with advances in technology, could be provided effectively, and at lower cost. Screen-based markets had the advantage of potentially being available to users located anywhere in the world.
3.2 In common with all floor-based markets, LIFFE was slow to recognise its customers' need for electronic trading, not least because its floor-based trading continued to generate record volumes.
3.3 The Ten Year German Government Bond futures and options contracts (the Bund) represented more than 20 per cent of LIFFE's revenue in 1997. In 1998, LIFFE's market share of trading in the Bund contracts rapidly dropped from 70 per cent to nil, as customers moved all their trading in the Bund to the Deutsche Termin Börse (the "DTB", now called Eurex), which could now, through its screen-based trading platform, offer London-based customers remote access to its market at lower cost. Without this major source of revenue LIFFE found it increasingly hard to operate a competitively priced floor-based market in other contracts.
3.4 The loss of the Bund reinforced a growing recognition that screen-based exchanges had a great advantage. LIFFE established a new strategic direction wherein it resolved to develop a new electronic trading platform, first for its equity options market, and to adopt a profit-making objective with a view to introducing greater commercial discipline and focus and generating value for shareholders.
3.5 In August 1998, Brian Williamson was appointed LIFFE's first full-time Chairman. Hugh Freedberg was appointed Chief Executive in October 1998.
3.6 In August 1998, a Fast Progress Group was formed to investigate the options open to the Exchange. Following its report, the Board agreed to deliver rapidly four key initiatives:
an efficient electronic trading platform for financial products which had to be ready for use as quickly as possible;
a restructuring of the Company to achieve a much lower cost base;
an appropriate regulatory regime for electronic trading in an international wholesale environments;
alliances and partnerships designed to deliver additional benefits to LIFFE's customers.
3.7 In November it was agreed that the timetable for the development of the electronic trading platform, LIFFE CONNECTTM, for the Exchange's financial products, needed to be further accelerated. Essential for LIFFE's survival, LIFFE CONNECTTM, developed in-house, was delivered 12 months ahead of the original schedule, which enabled the Exchange's contracts to be successively, and successfully, transferred from floor to screen.
3.8 At the end of 1998, LIFFE announced proposals to streamline its governance and to rationalise its shareholding structure, ending the original form of mutual organisation. In future, LIFFE would be responsible for generating value for its international group of shareholders in the form of profits and capital growth. But many of these shareholders were also customers of the Exchange for whom the future development of the LIFFE market was of particular importance to their own businesses. This was a vital consideration when interest in LIFFE, from third parties, developed during 2001.
3.9 In the run-up to the launch of Stage Three of Economic and Monetary Union, LIFFE prepared to offer trading in derivatives products that would enable users to manage risk related to euro interest rate fluctuations. When the euro came into being on 1 January 1999, LIFFE was ready to offer trading in a range of euro interest rate products, referenced to both the London Inter-Bank Offered Rate (Libor) and the European Inter-Bank Offered Rate (Euribor). In line with general market expectations that Libor-based rates would continue to be the market benchmark, LIFFE opted to convert open positions in its existing interest rate contracts denominated in deutschmarks and lire, to the Libor-based euro contract. In the event, the market rapidly adopted Euribor as the benchmark for euro interest rates. LIFFE's consultation with customers in the first weeks of 1999 had revealed this change of view, and the Exchange acted rapidly to offer customers with Libor-based outstanding business on the market a means of converting it to LIFFE's Euribor-based contract. By continuing to respond to its customers' needs, LIFFE today has a market share of over 99 per cent in euro short-term interest rate (Euribor) futures and options. The LIFFE market is vital to anyone who needs to manage their euro interest rate exposure. During 2001 business on LIFFE in these products alone had an underlying value of
112,000 billion: to put this in context, this is the equivalent every month of the annual Gross Domestic Product of all 15 EU member states.
3.10 Short term interest rate futures are particularly complex financial instruments which no exchange had satisfactorily listed on screen. LIFFE successfully transferred all of its short term interest rate futures contracts from floor to screen between August and November 1999. The overall programme of transferring LIFFE's business from floor to screen was a major task, given the breadth of LIFFE's product range: the 50 products comprise about 30,000 sub-products.
3.11 Transferring LIFFE's products from floor to screen was one part of the challenge. Equally critical was securing overseas regulatory approval for LIFFE CONNECTTM to allow LIFFE to build a globally distributed electronic market. In July 1999 following a protracted period of discrimination and protectionism on the part of the US authorities. LIFFE finally broke down the barricade which was preventing it from competing with Eurex on an equal basis when LIFFE CONNECTTM was at last approved for use in the United States. Securing this regulatory approval was an important early step towards achieving a global distribution for LIFFE CONNECTTM. Outside the UK, the United States is the country where LIFFE now has the most LIFFE CONNECTTM sites. Over the last two years the distribution of LIFFE CONNECTTM has rapidly increased, from 161 sites in January 200075 per cent of which were situated inside the UKto 493 sites in 25 countries worldwide by January 2002, 60 per cent of which are located outside the UK.
3.12 From the beginning of 2000, LIFFE began to focus on the commercial potential for supply of LIFFE CONNECTTM to third parties. To realise that potential, further investment was needed. There was also an ongoing need to invest in the continual process of upgrading the technology to improve the market for customers. The LIFFE Board gained approval from LIFFE's shareholders to inject £60 million into the business. The established US investment firms, the Blackstone Group and Battery Ventures, shared LIFFE's vision of the potential in commercialising the Exchange's combined technology assets and expertise as a range of "Market Solutions" which could be purchased by third parties. They invested £44 million. LIFFE's existing shareholders' support for the Board's strategy was demonstrated by their investment of a further £16 million.
3.13 The success of this business strategy was demonstrated during 2001. After substantial losses in 1998 and 1999, LIFFE's return to profit in 2000 was announced in March 2001. LIFFE agreed three major deals to supply LIFFE CONNECTTM and LIFFE's Market Solutions expertise: to Nasdaq, to support a joint venture with LIFFE in the United States to trade futures on shares; to the Tokyo International Financial Futures Exchange; and to "Market Touch", an initiative in the UK equity market. In addition, continuing growth in the distribution of LIFFE CONNECTTM is evidence of customers' strong endorsement of the system LIFFE has built.
SECTION 4: THE BOARD EVALUATES INTEREST IN LIFFE
4.1 Aware of the substantial value which had already been created by its strategy, LIFFE engaged advisers, Credit Suisse First Boston, at the beginning of 2001, to assess the future structure of the Company. Remaining as a standalone business was always a strong option for LIFFE and advice was taken on the preparation for an Initial Public Offering.
4.2 Interest in LIFFE increased during the year for three reasons: the return to profit after two years of heavy losses; the endorsement of LIFFE's business strategy by Blackstone and Battery in 2000; and the proven reliability and unmatched functionality of LIFFE CONNECTTM, which was reflected in the building of global distribution during 2000-01 and the three major market solutions deals agreed in 2001.
4.3 As a consequence, LIFFE received a number of expressions of interest to build further commercial partnerships or to buy a stake in the Company during the first half of 2001. Following the publication of its Interim Results in August 2001, which showed continued profitability growth, LIFFE received formal approaches to buy the business from a number of parties.
4.4 Notwithstanding the continuing pursuit of LIFFE's established strategy, it was the Board's responsibility to the Company and its shareholders to investigate serious takeover approaches. On 28 September 2001 the Board announced that it had received approaches from a number of parties which, it made absolutely clear, "may or may not lead to an offer being made for the Company". Given the number of separate approaches, the Board decided that the best way to evaluate the different proposals, and to achieve the best possible outcome for the Company and its shareholders, was to set in motion a formal process that was designed to enable each interested party to make its proposal and to put its case. The Board aimed to complete that process within six weeks.
4.5 Based on an assessment of the value of the Company, the Board informed possible bidders that it would not consider offers valuing LIFFE's shares at less than £16. On 16 October 2001 LIFFE announced that it had invited three parties to present their plans to LIFFE's Board.
4.6 The primary focus of the Board in assessing the merits of each offer proposal was the maximisation of shareholder value, in accordance with its fiduciary duties and the requirements of the UK Takeover Code. In addition, however, the Board focused on a number of other key elements of each offer proposal, being the extent to which it would:
Give a commitment to LIFFE's existing customers and relationships
Give LIFFE the ability to increase its business momentum beyond that which it could achieve on its own
Reflect a strategic awareness of the role of electronic exchanges in fast-changing markets
Demonstrate an acceptance of the importance of globally accessible and functionally rich technology
4.7 The Board was mindful that many shareholders were also customers whose approval of an offer would depend not simply on price, but on the effect that the offer would have on the consequent quality and potential of the market. Accordingly, these additional criteria were important in the Board's assessment of the various offer proposals and each potential bidder was asked to address them specifically in their presentation.
4.8 LIFFE had made it clear during the process that if no offer matched all of the criteria, LIFFE's agreed strategy would remain in place, with the Company continuing as a standalone business. There was no imperative to sell the Company and the Board felt that only an offer that would realise very substantial shareholder value and lead to a significant enhancement of LIFFE's business would be sufficient to justify such a move.
4.9 The presentations were made to LIFFE's Board on 25 October 2001. Following further discussions with each of the parties after their presentations, the Board announced on 29 Ocotober that it had decided unanimously to recommend Euronext's bid to LIFFE's shareholders. The Board concluded that Euronext's bid of £18.25 in cash per LIFFE share represented better value for shareholders than the other bids which were either for a lower all cash amount or were partly in cash and partly in the bidder's shares. Furthermore, the Board considered that Euronext's bid not only fitted all of the Board's other requirements but it would greatly enhance LIFFE's business plan by bringing the LIFFE CONNECTTM-based market new business. It was clear that Euronext, which had a strong track record in developing and distributing its own technology, shared a vision with LIFFE about the role of technology and the potential for technology-led business growth, based on LIFFE CONNECTTM.
4.10 The key elements of the Euronext offer were:
£18.25 in cash per LIFFE share, valuing the Company at £555 million (
LIFFE, in London, to become the European hub for all Euronext's derivatives business activities
Euronext's derivatives business to be migrated to the LIFFE CONNECTTM trading platform. This transfer will bring LIFFE more customers who will have a single point of access, through LIFFE CONNECTTM, to trade a wider range of complementary contracts on a deeper and more liquid market. The transfer will combine LIFFE's strength in interest rate products with Euronext's expertise in equity derivatives.
LIFFE's management team, complemented by Euronext management, to assume responsibility for all of Euronext's derivatives business.
4.11 Euronext published its formal offer on 12 November 2001. At the first closing date, 3 December, Euronext declared the offer unconditional as to acceptances, having received acceptances or acquired shares representing 80 per cent of the share capital. On 27 December, after the closing date, Euronext announced that the offer was wholly unconditional, having received clearance for the takeover from the Office of Fair Trading on 21 December. On 8 January 2002 Euronnext announced that, having received valid acceptances of the offer for over 90 per cent of LIFFE's shares to which the offer related, it intended to give notice to those LIFFE shareholders who had not yet accepted the offer that it would completely acquire their LIFFE shares.
SECTION 5: THE IMPLICATIONS OF EURONEXT BUYING THE COMPANY
5.1 It is LIFFE's belief that the purchase of the Company is not only good for LIFFE and LIFFE's customers, but also good for London and good for Europe. This section deals with each in turn, starting with the implications for LIFFE.
Implications for LIFFE and LIFFE's Customers
5.2 The combined derivatives business of LIFFE and Euronext will be treble that of LIFFE alone, bringing about advantages of scale to customers much faster than could have otherwise been achieved.
5.3 The greater distribution which will result from the access of Euronext's members to LIFFE CONNECTTM potentially enhances the quality of the market by improving liquidity and price formation, which is good for LIFFE and LIFFE's customers worldwide, who gain access to a deeper and broader market at no additional cost, and without needing to change their technology or clearing arrangements. Euronext has 524 derivatives members of whom only about 100 currently have direct access to LIFFE CONNECTTM.
5.4 By bringing further efficiencies to trading through the use of a single platform, LIFFE CONNECTTM, the purchase also paves the way for efficiencies in clearing and settlement, which have been long awaited by customers.
5.5 A wider range of products will be traded on LIFFE CONNECTTM. Whereas LIFFE is strong in interest rate and UK equity derivatives, Euronext is particularly strong in Continental European equity derivatives: the combination of the two businesses' products is highly complementary. This will bring enhanced opportunities for further growth, by combining resources and distribution to develop and launch new products. There is also the potential for cross-selling to the enlarged customer base, as well as for the marketing of high value data services.
5.6 Although LIFFE expects considerable changes to the market to the benefit of customers, LIFFE's management will remain in place, ensuring continuity. Having built up a world-class technology team, it was important to the Board that this team should be used to build upon its success to date and to take the business to the next stage of development and growth.
Implications for London
5.7 Euronext's choice of LIFFE CONNECTTM to trade all its derivatives business will rapidly bring more business through London, a fact which distinguished it from the other proposals made to LIFFE.
5.8 Euronext were keen to enhance their London presence, and LIFFE offered them the opportunity to do this. The purchase of LIFFE is a strong endorsement of the City as a forum for conducting international business. The fact that this deal was done with a non-UK business has sent a strong signal to the international financial community that London is open to them for business.
5.9 Both LIFFE and Euronext believe that there is considerable potential for growth in derivatives markets. The combination of LIFFE and Euronext creates a consolidated derivatives market. It also makes London the base for further derivatives market growth through the development of LIFFE's existing global partnerships, such as the joint venture in the United States with Nasdaq.
5.10 The purchase also strengthens London's influence in the practical development of a European single market in financial services, in which Euronext will clearly be a key player. Euronext will also invite two senior members of London's financial services community to sit on its Supervisory Board.
5.11 LIFFE users will continue to clear through the London Clearing House ("LCH"): there is no disruption to the existing business of LCH. As noted earlier, the combination of LIFFE and Euronext also creates a favourable framework for co-operation between the London Clearing House and Clearnet, Euronext's clearing subsidiary, to optimise clearing and settlement arrangements for the benefit of all market users.
5.12 As a London-based exchange, LIFFE will continue to be overseen by the FSA.
Implications for Europe
5.13 The transfer of Euronext's derivatives business onto LIFFE CONNECTTM creates a new, larger market which will be available through a single point of access for all LIFFE and Euronext's existing customers, increasing efficiency and reducing their costs. The flexibility of LIFFE CONNECTTM means that many Euronext customers who already trade electronically will have only minor changes to make to trade through LIFFE. A larger and more liquid market, offering improved price formation promises to benefit existing customers of LIFFE and Euronext and attract new business.
5.14 By meeting fundamental customer requirements, this consolidation puts Europe in a very strong competitive position globally, to develop existing business and to seek new customers. Exchange consolidation in Europe is now, as a result of this deal, commercially further advanced than in the United States or Asia.
5.15 Both LIFFE and Euronext believe that the combination of their businesses will create a favourable framework for co-operation between their clearing houses, for the long-term benefit of all market users.
The LIFFE Board unanimously recommended the offer made to shareholders by Euronext because it not only met LIFFE's criteria, but offered far more, against those critieria, than any other bid. Euronext's offer not only brings extra value for shareholders, but enhances the market for LIFFE's existing customers. The purchase is good not only for LIFFE and its customers, but also good for London and good for Eurpope.
The purchase, which creates a larger, more efficient European derivatives marketplace, reinforces the City's position as well as providing immediate and long-term benefits to the financial community worldwide.
11 January 2002