APPENDICES TO THE MINUTES OF EVIDENCE
Memorandum submitted by Deutsche Bourse AG
Deutsche Bourse (DB) welcomes the opportunity to submit written evidence to the Treasury Select Committee's inquiry into the implications of the proposed takeover of LIFFE by Euronext.
DB is a leading international exchange and provider of exchange-related services. It has customers in (18) countries worldwide and is engaged in cash markets, derivatives, clearing and settlement, market information products and exchange technology. It has an international shareholding base, with UK-based shareholders holding the largest proportion of shares after German shareholders. Our international perspective is exemplified by the fact that our staff are drawn from 35 nations.
Our cash market business is conducted on the Xetra electronic trading platform. Xetra has 424 members, of which 50 are located in the UK. UK business currently represents around 14 per cent of trading on Xetra.
DB operates in derivative markets through Eurex, a fully electronic international futures and options market. Eurex was formed in 1998 following the merger of the German and Swiss derivatives exchangesthe first cross border merger of its kind. Eurex has grown to become the largest derivatives exchange in the world, with over 450 million contracts traded in 2000. 68 of Eurex's 438 members are based in the UK, these members account for around a third of the exchange's business.
DB does not regard itself as a "stock exchange" in the traditional sense, but as a technology company, providing technical solutions to meet market demands.
This note explores key issues in relation to the proposed LIFFE/Euronext deal:
This merger has been driven by the introduction of a new commercial reality to the business of operating financial markets. This has emerged because of the split between ownership of exchanges and their members.
DB believes that if it were to link up with LIFFE it could offer consumers and shareholders greater benefits than the Euronext proposals. However, in the final analysis Euronext has placed a higher value on LIFFE than DB could justify to its shareholders.
The important point is that the future of LIFFE is determined by shareholder issues, not other non-market factors.
London with its strong track-record in innovation, will get significant benefits from this focus on market driven solutions to delivering exchange services.
BACKGROUND TO THE LIFFE DEAL
The proposed takeover of LIFFE by Euronext is just the latest episode in the restructuring of financial markets. Globalisation and technological advances now mean that investors can continuously monitor market developments and respond to them instantly. This has created pressure for easier market access and more efficient market mechanisms able to deal quickly with large volumes of trades. Demands for lower transaction costs and greater liquidity have accompanied pressure for more efficient securities processing.
The evolution of markets has led to institutional reform. For example, demands for consolidationto increase competitiveness and increase liquidityhave grown in Europe. There are only (five) major national exchanges in the United States, Europe has (24) national exchanges. The drive for market reform has been accompanied by developments in the ownership structures and corporate governance of exchanges. Traditionally their members have owned exchanges. Under this structure the priority was naturally to serve the interests of the existing members, rather than to search for new customers and markets.
In the last year DB and Euronext have made successful Initial Public Offerings that have broadened their respective shareholding bases. The shares of the LSE were also publicly listed for the first time on the main market last July. LIFFE has also traditionally been a member-owned institution. New shareholders primarily motivated by return on capital invested were introduced following a recapitalisation and reorganisation in 2000. Not only has this process increased resources for pursuing acquisition opportunities, it has also provided managements of exchange companies with the greater flexibility and the incentives to grow their markets with a premium placed on generating returns for shareholders.
The success of Euronext's proposals for LIFFE will be judged ultimately on whether or not they deliver increased shareholder value.
THE COMPETITION FOR LIFFE
It is a matter of public record that the LSE, Euronext and DB, through Eurex, all made proposals to the LIFFE board. The LIFFE Board outlined that proposals would be judged in the context of how they would:
enhance shareholder value;
extend opportunities for LIFFE's derivatives market, its related technology business and LIFFE's customers.
DB strongly believes that its own proposal to link up with LIFFE offered the potential to deliver the greatest benefits for shareholders and consumers. A Eurex/LIFFE merger would offer:
A complementary product range: the degree of overlap between the products offered by Eurex and LIFFE is slight. Nearly two-thirds of Eurex's turnover is estimated to come from fixed income products. By contrast three-quarters of LIFFE's turnover is estimated to come from money market products. A combination of Eurex and LIFFE would have provided the most complete range of derivatives products in the world.
Access to an enlarged customer base: as the largest derivatives exchange in Europe, LIFFE had the opportunity to cross-sell its products to Eurex's large customer base, not already part of LIFFE's own customer base.
Global expansion: combining LIFFE'S product strengths with those of Eurex and marketing them jointly would facilitate the expansion of both organisations in US and Asian markets, with the prospectgiven its status as a global hubof using London as the base for global expansion.
Maximising liquidity: the combination of LIFFE and Eurex provided the opportunity to maximise available liquidity where the products of the two exchanges overlapped or were identical.
Distinct and separate management: the Eurex proposal was that the current LIFFE management structures would be maintained with the management team based in London.
Technology expertise: Eurex and LIFFE are Europe's leading providers of state-of-the art technology in the derivatives industry. Each has its own platform offering different strengths. Whilst maintaining these distinct platforms in the short-term, there was the opportunity to jointly develop a "best of breed" platform for the future.
In the event, LIFFE's management has recommended that its shareholders approve Euronext's bid.
DB believes that the advantages offered by its proposals outweigh the benefits presented by a link-up between Euronext and LIFFE. However, in the final analysis Euronext placed a higher value on LIFFE than DB felt could be justified to its own shareholders.
PUBLIC POLICY IMPLICATIONS
The public policy implications of this deal relate less to the merits of one potential owner over another and more to whether or not mergers of this type are determined by market or non-market and political factors. This proposed merger highlights the fact that it is no longer desirable, or practical, to try and protect traditional stock exchanges from normal market disciplines. The business that exchanges are in is set to grow and competition will be intense. Exchange organisations cannot afford to stand still, when their competitors (existing and future) will not be.
The takeover of LIFFE is simply an expression of a new commercial reality in the operation of exchanges. This proposed deal exemplifies this new dynamic and has the potential to deliver substantial, and beneficial, public interest outcomes.
In the long term a market-based approach to the organisation of markets will make LIFFE (and other similar exchanges):
more responsive to meeting existing consumer needs;
more innovative in meeting those needs; and
more focused on costs and value for money.
A NEW MARKET DYNAMIC
European, and especially London's, financial markets have historically delivered substantial economic benefits. They have provided companies with an important source of capital and provided mechanisms to facilitate investment. However, these benefits have not yet been fully realised. There is still substantial potential for financial market growth. This growth may be realised in a number of ways:
Growth of traditional capital markets: European capital markets are much smaller than those in the US relative to the size of their economies. This is likely to change as the pressure to fund pension liabilities increases. Investment returns on average in Europe have been lower than in the USA, where historically equity returns have consistently outstripped other lower risk securities. The opportunity for European investors to secure a better risk/return ratio will come from a greater ability to diversify their portfolios in more liberal capital markets. Over the last five years alone trading volumes on European exchanges has increased by 460 per cent. This trend is likely to continue. The new style of exchange management will ensure that these opportunities are fully developed.
Development of new financial products to trade: LIFFE and Eurex illustrate the extent to which creativity and innovation have extended the range of financial products traded in European markets. This process of innovation is infinite. There are continuous opportunities to develop new products that create value for traders, retail customers and issuers. Management that is intent on delivering shareholder value will be actively seeking to innovate to gain market share and competitive advantage.
Opening up new markets: there is the opportunity for exchange companies to leverage the investment in infrastructure, the technology and other skills developed for financial markets. DB is for example supplying a trading platform for the European Energy Exchange.
These growth opportunities, and the benefits they will deliver for consumers, are most likely to be realised if providers of exchange services are treated like ordinary commercial companies. Historically their companies have owned exchanges. Exclusively customer-owned exchanges are more likely to be limited to their current business, whereas public companies are incentivised to pursue growth opportunities that maximise shareholder returns through the provision of efficient markets. The corollary of this is that they will only be able to generate business if they are providing what both existing and potential customers want.
UK political attention on the takeover of LIFFE will focus inevitably on the City of London's position as one of the world's leading financial centres.
London's fundamental attractionsas a well-regulated global hub with a high concentration of leading international financial institutionsremain whoever owns LIFFE. Indeed, it is these features of the London environment, which contribute to the attraction of LIFFE as a potential merger target. It is worth noting that the securities business in Europe is worth around $900 billion. Wholesale and retail intermediaries account for nearly 94 per cent of this, and financial information providers account for a further element. Exchanges and clearing and settlement houses account for less than 2 per cent of it. Many of the intermediaries operating in London reflect an international ownership structure. This has not adversely impacted on London's position as a financial centrequite the reverse. There is no reason why this should not also apply in the case of exchange organisations based in the City of London.
As shareholder value becomes the key determinant of the ownership of exchanges, and influences the restructuring of market platforms, so London stands to benefit. The City of London has secured its leading position as a financial centre because of its dynamism and reputation for innovation. The City's strong track record means that it will inevitably be at the heart of activity to develop market-driven solutions.
The auction of LIFFE is just one aspect of a broader process of restructuring amongst European exchanges that still has some way to go. Capital markets across the world are being deregulated and liberalised. The development of truly global capital markets opens up new opportunities and benefits for intermediaries, investors and issuers. These are most likely to be delivered by competition between exchange organisations that are genuinely cross-border, cross product and cross functional. This competition is best delivered if the market determines the ownership and structures of the securities processing industry.
This focus on market solutions is crucial because it will unlock the potential of markets to deliver benefits for investors. This is the key lesson from the LIFFE.