Memorandum submitted by Euronext NV
1. We warmly welcome the invitation of the Treasury Committee to submit evidence on the background to, and the implications of, the takeover of the LIFFE Holdings plc ("LIFFE") by Euronext UK plc, a wholly owned subsidiary of Euronext NV ("Euronext").
2. The purpose of this submission is to provide some background and history on Euronext before outlining the rationale for the combination and how it will reinforce and further enhance London's position as a pre-eminent financial centre in Europe. We look forward to answering questions on these and other relevant issues at the oral hearing scheduled for 22 January 2002.
3. Euronext operates exchanges in France, Belgium and the Netherlands. A variety of financial instruments, including derivatives, are traded on those exchanges. LIFFE operates an exchange on which only derivatives are traded.
4. There are several major European derivatives exchanges. The largest, by volume of trading, are Eurex (the merged German and Swiss derivatives exchanges), Euronext and LIFFE, in that order. Eurex, on which 674 million contracts were traded in 2001, is in fact the largest derivatives exchange in the world by the number of contracts traded, and is larger than both Euronext and LIFFE put together (399 million and 216 million contracts in 2001, respectively). With the exception of one of Euronext's exchanges, all of these exchanges are now operated electronically rather than by "open outcry" so that traders no longer need to be located in the same city as the exchange on which they trade.
5. Because of this dismantling of technical barriers to cross-border trading in Europe, as well as the dismantling of regulatory barriers, traders in one European country are now faced with the choice of a number of derivatives exchanges. Partly because of this, and partly because of the reduction in the number of derivatives products resulting from the introduction of the Euro, financial institutions increasingly seek out the European exchange where the largest quantity of trading is taking place (ie they seek out so-called "pools of liquidity"), which has the effect of reducing their costs.
6. Thus, in 1997/1998, traders in futures of the German government bond (the "Bund") on LIFFE decided to move to what they believed would become the largest pool of liquidity, Eurex's predecessor the Deutsche Terminbörse ("DTB"). The result for LIFFE was catastrophic. Bund trading on LIFFE fell by 68 per cent in a matter of months. LIFFE's subsequent recovery, due in large part to the immediate introduction of a screen-based electronic trading system, is a remarkable tribute to its management.
7. The combination of LIFFE with Euronext will ensure that both LIFFE and Euronext have the necessary "critical mass" to allow them to attract sufficient liquidity, and thus compete effectively with the "giant" Eurex.
8. Ensuring LIFFE competes effectively and vigorously against Eurex is not the only advantage that the combination presents for London. By giving members of LIFFE access to the products traded on Euronext's exchanges, and by offering the improvements in service and product development that will result from increased size and scope, the combination will provide London's financial institutions with very distinct and tangible advantages.
9. The combination will ensure there are no significant changes in the way that LIFFE operates. The management of LIFFE will continue to be assured by its current management team, with Brian Williamson remaining Chairman and Hugh Freedberg Chief Executive. LIFFE will continue to use the same trading system that it currently operates, LIFFE CONNECTTM, which will in fact also be adopted by Euronext's existing derivatives exchanges. London will continue to have a leading role in the development of new derivatives products. Moreover, it is intended that clearing of trades carried out on LIFFE should continue to be carried out by the London Clearing House ("LCH").
10. The combination of Euronext and LIFFE will create a pan-European derivatives business with a broader product offering, customer base and geographic scope than either entity has alone. The new entity will have the scale and scope necessary to reduce trading costs and fund investments in advanced computer software required and demanded by the world's major financial institutions. Ultimately, this will have enormous benefits for end-users.
11. Euronext strongly believes that the new entity will reinforce and further enhance London's position as a pre-eminent financial centre in Europe.
12. Euronext is the first cross-border exchange business for the trading of all equities, bonds, derivatives and commodities. It offers a complete and varied range of services encompassing all exchange activity, including the listing of financial instruments and trading in securities and derivatives. Through its subsidiary Clearnet, it also provides clearing services.
13. Euronext is Europe's largest exchange organisation in terms of cash trading volumes through the central order book, and the second largest organisation in terms of both number and total market capitalization of listed companies. It was created in September 2000 by the merger of the Paris, Brussels and Amsterdam bourses. Its shares are listed on Euronext Paris (with trading facilities for Euronext Amsterdam and Euronext Brussels).
14. Following completion of certain integration and harmonisation procedures, which are currently expected to be fully completed by late 2002 or early 2003, Euronext will operate a fully integrated cross-border electronic exchange for trading in securities, clearing, settlement and custody of securities.
15. In 2000, Euronext's revenues were around £458 million and it had worldwide assets valued at around £2.1 billion. It derived in total around 12 per cent of its revenues from derivatives transaction fees and other derivatives trading income with Amsterdam accounting for 78 per cent of its derivatives revenues, Paris for 21 per cent, and Brussels 1 per cent. It employs some 1,300 staff in offices in Amsterdam, Brussels, Frankfurt, Paris, London, New York and Chicago.
16. Euronext is currently operating five derivatives markets:
Euronext Amsterdam Derivative Markets for financial derivatives and Euronext Amsterdam Commodity Markets for commodities, both operated by Euronext Amsterdam;
The MONEP ("Marchédes Options Négociables de Paris"), which comprises single-stock and equity index derivatives, and commodities and interest-rate derivatives trading on the MATIF ("Marché a Terme International de France"), both operated by Euronext Paris; and
The Belfox (the "Belgian Futures and Options Exchange"), which is operated by Euronext Brussels.
Once certain harmonisation and integration procedures have been completed, all of the above will be placed under the LIFFE umbrella with overall management based in London.
17. Currently, Euronext's derivatives exchanges operate different trading systems: Euronext Amsterdam operates SWITCH ("System Which Introduces Trading Choices"), an integrated system that supports screen-based trading for futures and a technologically sophisticated form of "open-outcry" trading for options Euronext Paris uses the NSC-VF system for futures trading and the NSC-VO system for options trading. Euronext Brussels uses the Belfox Trading System ("BTS").
18. After the deal completes and after a transitional period, it is intended that all Euronext's derivatives exchanges should operate the same trading system. Until a few months ago, Euronext had intended to develop a new system, NDS which would have combined NSC-VF and SWITCH. With the combination with LIFFE, however, it is now intended to develop and enhance LIFFE's trading system, LIFFE CONNECTTM, adding certain functionalities, and to use this for all Euronext's derivatives exchanges.
19. The management of LIFFE will provide information on LIFFE separately. For the purposes of this submission it is sufficient to say that, unlike Euronext, LIFFE operates an exchange on which only derivatives are traded. It is the third largest derivatives exchange in Europe (by volume), specialising in particular in short-term interest rate ("money market") derivatives.
RATIONALE FOR THE COMBINATION
20. The creation of Euronext was a major breakthrough in the history of exchanges and the combination with LIFFE represents another step forward in ending the fragmentation of European markets. It shows that partners sharing the same European vision are able to team up to create an innovative structure.
21. Euronext has always had, for good business reasons, a strong and specific interest in the derivatives business of LIFFE and its state of the art electronic trading platform, LIFFE CONNECTTM as was expressed publicly at the press conference when the formation of Euronext was announced in March 2000. Such an interest has been driven by the fact that the enlarged entity would be a leading market player benefiting from the complementary strengths of the two companies, with an enhanced product offering, a broader customer base and a competitive clearing solution for exchange-traded derivatives transactions. Euronext has always believed that such a combination would significantly enhance the ability of each entity to compete with other leading European and global derivatives exchanges.
22. There are also three (interrelated) general economic reasons for Euronext's desire to combine with LIFFE which directly relate to derivatives trading:
First and foremost, exchanges must be above a certain size (ie to have a "critical mass") in order to be able to attract the level of trading, and thus have liquidity, that will result in trading costs being reduced to the level required by cost-sensitive financial institutions. Greater liquidity results in reduced trading costs because it reduces the "dealer spread"(ie the difference between the highest price at which dealers are prepared to buy and the lowest price at which they are prepared to sell). It also gives traders a greater level of certainty of being able to close their positions. Because of the importance of liquidity, financial institutions tend to seek out "pools of liquidity".
Secondly, certain scale and scope is required in order to be able to justify the level of investment that is necessary to achieve (and maintain) the state of the art trading systems that financial institutions require. To give an example, the sums required to upgrade LIFFE's trading system (which was only introduced in 1998 and is considered to be one of the most state of the art trading systems) are believed to run into tens of millions of pounds over the coming years. To keep this sum in perspective, the revenues of Euronext's derivatives businesses in 2000 amounted to £53 million, while LIFFE's total revenues (all of which were from derivatives) amounted to £89 million.
Thirdly, scale and scope are needed to bring transaction fees down to the level required by traders. Because they often compete for very small margins, traders are highly cost-sensitive. Given the importance to exchanges of attracting liquidity (as explained above), given that the traders are well placed to compare exchange-related costs on different exchanges and given that they always have the possibility of trading OTC derivatives (or of simply not trading derivatives at all), traders are able to obtain competitive terms from exchanges. Derivatives exchanges have thus come under considerable pressure to lower transaction fees. In order to be able to do so, exchanges need to have the size and scale to allow them to absorb the very considerable level of investment in trading systems (see above) and in product development.
23. The combination with LIFFE will create a derivatives exchange that has such size and scope. It will be able to attract sufficient liquidity to compete with Eurex, will be able to justify the necessary level of investment in trading systems and new product development, and will be able to reduce transaction fees to the level required by its powerful and cost-sensitive users.
24. In particular, the combination will provide an enlarged customer base into which an enlarged and enhanced product range will be marketed. The memberships of Euronext and LIFFE are complementary, so that the large number of members of Euronext's existing derivatives markets (524) will be largely incremental to those that currently trade on LIFFE (210). Moreover, the products in which the exchanges specialise are different, LIFFE specialising in short-term interest rate futures while Euronext's exchanges focus on derivatives of single equity options and equity indices.
BENEFITS TO CUSTOMERS
25. Apart from the advantages that the combination will bring to the exchanges, it will also confer some very tangible and significant benefits on the customers of the new entity, both to the existing customers of LIFFE and to those of Euronext. In the first place, the advantages referred to above (ie increased liquidity, greater investment in trading systems and product development, and the ability to lower transaction fees) are ones that will likely be passed on directly to customers.
26. In addition, existing LIFFE members will gain the benefit of direct access to the total range of Euronext's products (and vice-versa). Previously a LIFFE member would have had to become a member of one of Euronext's exchanges, to install (and maintain) a separate IT system and to have a separate broadband telephone connection to be able to access those exchanges. Now it will (once integration processes have been completed) be able to access those exchanges through its existing connection to LIFFE CONNECTTM.
EFFECT ON LONDON AS A FINANCIAL CENTRE
27. The advantages explained above (in particular the increased liquidity, the increased ability to invest in trading systems and the increased ability to reduce trading costs) will allow LIFFE to compete effectively and vigorously with Eurex. It will provide LIFFE with the scale and scope necessary to innovate and develop new capital market products successfully. This will be the first, and perhaps the most important advantage offered to London by the combination of LIFFE and Euronext.
28. Moreover, these (and the other) advantages created by the combination are ones that will be passed on to LIFFE's users, London's financial institutions. If the combination will benefit them then it will surely benefit London as a major financial centre.
29. Apart from these advantages (both to LIFFE and to its users), there will be no significant changes in the way that LIFFE operates as a result of the combination:
It will still be run from London by its current management team, complemented by certain Euronext managers. Brian Williamson will continue as Chairman of LIFFE. Hugh Freedberg will continue as Chief Executive of LIFFE and will be joining the Euronext Management Board. We also intend to ensure the continued presence on LIFFE's board of non-executive directors and user representatives. In addition, two new members will be appointed to Euronext's Supervisory Board and these members will be drawn from London financial community and LIFFE members. London will continue to be a leading centre for innovation in relation to derivatives.
Assurances have been given that existing employment rights, including the pension rights of all employees of LIFFE, will be fully safeguarded.
Rather than changing the trading system operated by LIFFE, LIFFE CONNTECTTM, to one of the ones currently operated by Euronext, LIFFE CONNECTTM will be retained and upgraded for not only LIFFE but also for its other derivatives exchanges. In fact, the derivatives data centre will be located in London with network access points on Euronext sites.
Clearing will be retained through the LCH and Clearnet on a product-by-product basis, with LIFFE products being cleared by LCH and Euronext equity-based products being cleared by Clearnet. There are no plans to remove LIFFE's business from LCH.
30. The combination of Euronext and LIFFE will create a major pan-European derivatives business with a broader product offering, customer base and geographic scope than either entity has alone. The new entity will have the scale and scope necessary to reduce trading costs and fund investments in advanced computer software required and demanded by the world's major financial institutions. Ultimately, this will have enormous benefits for end-users.
31. London will remain at the heart of the market as the derivatives business of Euronext will be placed under the LIFFE umbrella and run on the LIFFE CONNECT TM electronic trading platform. This combination will enhance the competitiveness of the parties' respective exchanges, enabling them to compete more effectively with rival European exchanges, in particular Eurex.
32. Euronext strongly believes that the new entity will reinforce and further enhance London's position as a pre-eminent financial centre in Europe.
1 Traditional "open-outcry" trading is where traders physically meet in the Exchange building to transact business. Each product is traded in a designated area called a pit, where traders stand and shout the price at which they are willing to buy or sell. Back
2 Euronext's derivatives business also obtains relatively small revenues from renting trading space and other activities, including the sale of historical and other information concerning derivatives trading. Back
3 Euronext Amsterdam is today the only major European derivatives exchange that supports open-outcry trading. Back