Around the time of London’s Big Bang in 1986, Jeffrey Knight, then CEO of the London Stock Exchange (LSE), was quoted as saying that the title of Europe’s stock exchange was London’s to lose. Mr Knight has been proved unwittingly prescient. The current bids for the exchange, from Deutsche Börse and Euronext, signal the end of independence for a 200-year-old institution but the question is whether they are a sign that the LSE brand has been squandered or of the LSE’s success. And this goes straight to the heart of the debate about the nature of a stock market.
If the role of the stock exchange is to maximise the pool of liquidity and extend users’ access to the greatest number of global equities in an efficient and orderly manner, then the LSE is a roaring success: it is the most international exchange and is the biggest and most profitable standalone stock exchange in Europe.
If a stock exchange should be run as any other business, to maximise shareholder value by adding other complementary products and services, then the LSE has done a less impressive job. The Deutsche Börse Group, encompassing trading in stocks and derivatives, as well as clearing and settlement services, far outstrips the LSE in size and revenues.
The Börse’s success outside of the stock market then begs another question: does the vertical model, as championed by Deutsche Börse, or the horizontal model, as represented by the LSE, serve the market best?
Many people believe the LSE has frittered away its lead over its continental rivals, and frustration that London is the target rather than the bidder is common. The LSE may still be the biggest European stock exchange by far, but it is no longer a big enough business to even negotiate a merger of equals.
LSE stalwarts, by contrast, argue that a takeover of a continental exchange is not a practical option and that selling out is best for shareholders in terms of current and future returns and will also usher in a European-wide market. They argue that the LSE is being courted because Frankfurt and Paris regard it as a superior model that they have been unable to replicate at home. The story of how the LSE arrives at this position is long and involved.
Since Mr Knight’s stewardship, the LSE has been stripped of its regulatory authority, lost ground to more dynamic European rivals and has overseen a series of high profile business gaffes. It bungled technology projects that would have enabled it to capitalise on opportunities, help it maintain lucrative revenues and compete effectively. By the time it identified the growth potential offered by exchange-traded derivatives and, conversely, the limited growth potential of a business model that relied on equity trading alone, it was too late. While other exchanges have merged by products, geographies or operations, the LSE has been left a one-hit wonder – and it may now be too late to stage a comeback.
How has this happened and who is responsible? The LSE’s detractors say that it is a sad tale of mismanagement over a 20-year period. Even if it was more by accident than design, Big Bang’s deregulation – which ended single capacity (enabling banks, brokers and market makers to exist within one firm) and fixed commissions – cemented London as the home of Europe’s international capital markets and as the continent’s pre-eminent financial centre. Since then, say critics, successive CEOs and chairmen have presided over the institution’s decline.
Taurus project flounders
Central to the detractors’ case is the perceived weakness in the LSE’s technology management, in particular, the humiliation of the failure of Taurus – a project now used as a case study in technology and management incompetence. Many believe that its failure was primarily due to an excess of ambition but it also highlighted the tensions between the various constituents in the exchange and the failure to resolve their differing interests.
By August 1987, there was an estimated backlog of unsettled transactions to the tune of £3bn-£4bn and it had become imperative for the exchange to improve its settlement processes. Therefore, it aimed to replace its Talisman system with Taurus (Transfer and Automated Registration of Uncertified Stock). The ambitious Taurus settlement system was intended as a computerised database of investors and their holdings that would lead to paperless trading and lower cost for share registrars, institutions and brokers. It was scheduled to be operational by 1989.
From the outset, the LSE failed to strike a balance between the interests of the powerful institutions that made up the market. So-called Taurus 1, a centralised database register maintained by the exchange, was ruled out by some of the main banks – including NatWest, Lloyds and Barclays – which controlled more than 80% of the share registration business and stood to lose valuable revenues when the new system was launched. The project was riddled with compromise to accommodate different interests, leading to endless design changes and layers of complexity, and to the creation of multiple committees which lobbied for conflicting interests. Competing management consultancies became involved: the now defunct Andersen Consulting running the stock exchange’s day-to-day computer operations and Coopers & Lybrand, as it was then, working on Taurus.
Those who were in the market at the time say that the costs could not be managed because the design was uncertain. Even when the project was terminated, they say, fundamental aspects of the design had still not been finalised.
Furthermore, the market for which the system was designed was changing, becoming increasingly dominated by international business and integrated banks and finance houses. The protracted delays forced members to revamp their own settlement processes to remain competitive and prevent settlement delays. By 1989, when the system was supposed to be fully operational, the cost of the delays to member firms was estimated to be £150m-£200m every year.
In March 1993, then CEO Peter Rawlins halted the project, wrote off the LSE’s investment of £75m, made 350 staff redundant and resigned. The LSE also said goodbye to a large chunk of revenue. It was estimated that member firms had invested £320m in preparation for Taurus’s introduction. The independently operated Crest settlement system was launched in 1996 for a total cost of less than £30m.
Strategic error
Detractors say that the LSE’s most strategic error was failing to recognise that derivatives would become a larger and more valuable market than cash equities. And what flirtations the LSE has had with the derivatives markets have been characterised by indecision and lack of foresight.
From the 1970s, the LSE failed to take the lead in financial futures because it feared opposition from the Bank of England and was unwilling to compromise on the single capacity and fixed commission rules that defined its operations. When it formed the London Traded Options Market (LTOM), it was a purely defensive move to protect its market share in the underlying securities. Access was restricted to LSE members and no attempt was made to develop the market or meet the growing needs of market participants facing increasing fluctuations in currencies, interest rates and securities prices.
Others were not so timid. Despite opposition from the exchange, a financial futures market was developed – and participants included LSE members. It opened for business in September 1982 as the London International Financial Futures Exchange (Liffe) under the stewardship of Michael Jenkins, a former LSE employee, and 27 of its 261 members were stock exchange firms. As soon as the gilts futures contract was introduced in November 1982, the LSE began to lose some of its business in the underlying gilts (UK government bonds).
The first U-turn
By 1987, Mr Knight and then chairman Sir Nicholas Goodison had developed a grand plan to incorporate gilts, UK and foreign equities and options in its business. A belated decision was taken to achieve a foothold in the derivatives market through a merger with Liffe.
Liffe rejected the bid. It was already established as a successful exchange in its own right and feared the loss of autonomy. Liffe was developing a futures contract based on highly liquid German government bonds – the Bund contract – which was expected to be a great success. Even after the stock market crash of October 1987, when volumes fell dramatically, Liffe believed its entrepreneurial spirit was best preserved through independence from the LSE.
When, in June 1988, the council of the exchange declared that it would not commit the money, time or effort to develop the LTOM further, the LSE had clearly decided to focus on UK and international equities. It abandoned any pretensions to the growing derivatives market when it sold LTOM to Liffe for £1 in 1992.
A second chance
In 1998, the LSE, under the stewardship of CEO Gavin Casey, was given another chance to gain a footprint in the growing derivatives markets. This time it was Liffe – bruised after losing the bulk of the lucrative Bund market to Eurex, which was newly formed by the merger of the Deutsche Terminborse and Sofex, the Swiss derivatives exchange – that was considering a merger. However, the LSE rebuffed Liffe’s advances – and not very diplomatically, said market participants at the time. In another display of short-sightedness, the LSE still regarded financial futures and options as peripheral to its core business.
Within three years, though, the LSE effected a spectacular U-turn. By 2001, Liffe’s fortunes had been reversed under the canny management of CEO Hugh Freedberg and chairman Brian Williamson, and with the introduction of the Liffe Connect platform. From Liffe’s inception in 1982, annual volumes rose from nearly 242,000 contracts traded to more than 215 million at the end of 2001. The value of those contracts rose from €58.17bn to €155,421.9bn in the same period. (In the cash equity markets, volumes had risen from nearly 3.5 million to more than 32 million and annual value from £26.9bn to £1,904bn).The LSE again decided it wanted a piece of this derivatives action.
Many believed, therefore, that the stock exchange had been clever in installing a new CEO, Clara Furse, who, as a former deputy chairman at Liffe, had been part of Liffe’s turnaround team. In the ensuing takeover battle with Euronext, the combined Paris, Amsterdam and Brussels exchange, surely here was someone who possessed the contacts and credentials to win Liffe for the LSE?
Bungled bid
Instead, under the glare of the media, the LSE’s bid for Liffe failed, dealing a massive blow to the organisation’s credibility and, some believed, ending any pretence that it could make it alone.
Critics say that Ms Furse and her advisers made two crucial mistakes: failing to understand what Liffe shareholders wanted from the deal and treating the top executives with perceived disdain. In the first instance, LSE’s combined cash and shares offer did not suit all the Liffe shareholders, some of whom wanted to cash in on their investment and were not interested in paper. Euronext CEO Jean-François Théodore, meanwhile, pitched it absolutely right with a cash-only offer of £808m.
More importantly, say others, the LSE failed to woo Liffe’s two top executives, offering Mr Freedberg the deputy CEO role under Ms Furse, and Mr Williamson the deputy chairmanship under Don Cruickshank in the merged entity. Again Mr Théodore proved more insightful. He pledged to maintain Liffe’s independence once it had been merged with Euronext’s own derivatives operations and to leave both executives in their original roles.
The LSE’s derivatives comeback is regarded as too little, too late. EDX London – the combined equity derivatives offering from the LSE and Sweden’s OMX – offers trading services on three linked derivatives exchanges besides London: Stockholm Stock Exchange in Sweden (offering Swedish and Finnish products), the Copenhagen Stock Exchange in Denmark and Norway’s Oslo Børs. It now offers more than 150 contracts, including standardised and flexible futures and options contracts on indices and single stocks.
Many argue that, in time, EDX will develop into a very successful platform, with its offering of over-the-counter confirmation and clearing service for more than 100 European blue-chip equity and index futures and options via LCH.Clearnet. However, it has a long way to go before it generates anywhere near the sort of business that will make London forget about the loss of Liffe.
Accusations of arrogance
Many saw the offer of second-class roles to Liffe executives as characteristic of the LSE’s arrogance and of its belief that its “City of London ticket” would win the day. Others say that it was also symptomatic of a persistent problem in London of not getting the right people for the job. For too many years its management had lacked a coherent strategy, vision or understanding of the marketplace. A lot of market participants believe that the LSE missed the chance to secure Mr Williamson as a first-class chairman.
Critics cite successive examples of CEOs who looked good on paper but failed to deliver the goods. Peter Rawlins, CEO from 1989-1994, was a former Andersen Consulting partner who was criticised for awarding the LSE’s IT contract to Andersen Consulting without a competitive open tender. He fell foul of the market makers and left because of the Taurus debacle. While other exchanges have leveraged their technology expertise, using the platform as a way to generate revenue, the LSE effectively handed its technology to Andersen.
The accountancy and life assurance background of Michael Lawrence, CEO from 1994-1996, left him equally ill-equipped to appreciate fully the tension between brokers and market makers over whether the London market should be quote driven or order driven – a decision that would profoundly change their businesses. Many argue that he failed to comprehend that as members, not employees, they had to be persuaded of the need for change rather than coerced. When Mr Lawrence tried to force through the electronic order book system in 1995, the members rebelled. He left in January 1996.
Hopes were high for the next CEO, Gavin Casey. Because he came from Merrill Lynch, it was argued that he knew how investment banks worked and Merrill was and is one of the biggest market making firms. Most notably, Mr Casey signed a memorandum of agreement with Deutsche Börse in 1998 and was behind the pair’s ill-fated merger attempt in 2000. He failed to understand that it would generate such vociferous opposition from the smaller brokers who remain an important element of the LSE’s business. When the deal floundered, it sealed Mr Casey’s demise.
One market participant complained that even as the City tried to maintain an open door policy to the LSE’s management, the latter closed it by a combination of high-handed attitudes, lack of market understanding and bad performance.
When Ms Furse lost Liffe to a foreign competitor, critics saw it as yet another example that the LSE had failed to find a CEO who would set the agenda rather than react to one that was dictated by others; who would enable the LSE to play the sort of role in European markets that its size and history indicate it should. While she is lauded for her excellent operational skills, Ms Furse is not commended for her vision or communication skills. If the current vision is for a Europe-wide market based on the horizontal model above all else, then this message has not been put out effectively.
London’s management teams have pursued various strategies: a horizontal model; competing against other exchanges in terms of trading (such as trading in Dutch equities against Euronext); and seeking linkages with other exchanges (such as South Africa). But they rejected an aggressive acquisition policy. Their choices failed to generate major growth outside the domestic market, unlike those of Deutsche Börse and Euronext.
LSE supporters fight back
The LSE’s detractors do not have it all their own way, though. Some people argue that, in terms of the number of companies listed and their market capitalisation, the LSE is the clear winner: it is a profitable, standalone business that is about twice the size of Euronext and three times the size of Deutsche Börse. According to figures from the World Federation of Exchanges (WFE), at the end of December 2004, London had 2837 companies listed, compared with 1333 at Euronext and 819 at Deutsche Börse. The WFE also states that the total value of share trading at the LSE in 2004 was $5176bn, versus $2475bn at Euronext and $1542bn at Deutsche Börse. In those terms, the LSE is a runaway success and that is why it is such a prize.
Supporters also say that it does not matter who owns the LSE: markets are global and all that participants care about is that markets are liquid and orderly. And they argue that what really matters is the success of London as a financial centre and that is not dependent on the success, or independence, of the LSE. One commentator cites Liffe’s acquisition by Euronext as a success for London – where the business has remained and grown – even if it was a disaster for the LSE. Similarly, he points to the pyrrhic victory for Eurex: while it may have wrested the Bund contract from Liffe, the bulk of the traders remain in London.
Political disadvantage
Historically, champions of the LSE say, it has also had less political backing than its rivals. The governments in Paris and Frankfurt have been more willing to support their exchanges’ efforts in a bid to increase the importance of their own financial centres. Some commentators believe that Mr Théodore was installed at Euronext specifically to increase France’s influence in financial markets, whether or not that meant relocating an expanded Euronext to London.
And yet the LSE has had to contend with persistent quasi-government intervention or control. For example, before it could introduce the new rules governing the operation of the new order-driven market in 1997, they had to be vetted by the Securities and Investment Board (SIB), whose role was latterly taken over by the Financial Services Authority. External control also extended to the type of securities for which the LSE could make a market. From the late 1980s on, the LSE was looking for a way to make property assets more tradeable, but it was not until 1996 that it could persuade the SIB that this could be done without exposing investors to too much risk or facilitating tax evasion.
Likewise, when the LSE first wanted to liberalise the practice of stock borrowing, which was a well-established practice in continental Europe, the Bank of England and the Treasury objected because of the possibility of tax evasion.
The SIB also acted as a drag on LSE innovation by inflicting an expensive and inflexible set of rules on the exchange; rules that failed to distinguish between the safeguards required to protect small investors and those to protect but encourage trading between market professionals. While the exchange had lost nearly all of its regulatory powers to external and semi-governmental bodies, it continued to be treated as a publicly accountable institution.
To the management, it may have seemed that the LSE was damned if it did, and damned if it didn’t. In the early 1990s, for example, the exchange was criticised for failing to create a market for emerging biotechnology companies. When it did so, by relaxing its listing requirements in 1993 to enable such smaller, less proven companies to raise capital, it was criticised when several of them proved disappointing.
Strategic successes
Today, the LSE’s market for smaller companies, the Alternative Investment Market (AIM), is regarded as one of the exchange’s big success stories. Of the 92 new issues in the second quarter of 2004, 76 were on AIM and, in January this year, the first Ukrainian company, Ukrproduct Group, was reported to be preparing its entry to the market. In contrast, neither of the LSE’s continental rivals have succeeded in building a lasting platform for such companies. Deutsche Börse shut its Neur Markt in 2002 and Euronext has so far failed to get its planned Alternext off the ground.
The LSE has also built an impressive business in foreign equities. Trading in Europe’s largest global companies was attracted to London because of the city’s internationalism. Global businesses demanded a global market for their securities and London provided it by attracting the European headquarters of international finance firms, including the bulk of the fund management industry.
According to WFE figures, London is second only to New York in terms of the number of foreign companies listed. And in the first nine months of 2004, London accounted for 43% of total cross-border trading in foreign equities, compared with 19% in New York and 3% in Germany – constituting a turnover of $1470bn versus Germany’s $99bn.
The LSE is also doing well in the IPO arena, wooing companies away from the New York Stock Exchange. For example, it began to target Asian companies more systematically when it opened an office in Hong Kong last year and was rewarded when recently, Air China, the country’s flagship airline, chose London and Hong Kong for its $1.1bn IPO, and South Korea’s Kumho Tire opted to list in Seoul and London for its Won430bn ($412m) IPO.
Battle of the models
Many argue that the LSE is also in a position to take the moral high-ground in the debate on whether or not stock exchanges should operate a vertical or horizontal model. The LSE stands firm on the principal that an exchange owning the trading as well as the clearing and settlement elements – the vertical model epitomised by Deutsche Börse and other European exchanges – constitutes a monopoly, locking users into a package of services and restricting competition from other exchanges in the contracts that are traded, cleared or settled on that exchange. (Though cynics argue that the LSE came to that decision because of the Taurus debacle rather than through altruism in choosing the best model for the development of the market.)
The European Securities Forum has also advocated the horizontal model – under which the trading, clearing and settlement are separately owned and operated – as the best structure for the markets. This is partly because the creation of a pan-European clearing and settlement layer would enable financial institutions to minimise the amount of prudential capital that they have to set aside for their business.
The European Commission (EC), too, is currently “considering” ways in which it might introduce legislation next year on clearing and settlement to improve the operation of the pan-European capital markets.
However, until regulators or competition authorities enforce a particular model, Deutsche Börse’s all-in-one business enables the group and its shareholders to reap the benefits of clearing and settlement, and leaves the LSE looking like an also-ran in terms of revenues. Whatever the outcome of the EC’s deliberations, it will be too late to influence the bidding war for the LSE.
Who should reap the benefits?
Since exchanges began to demutualise, they have become commercial entities rather than utilities, and both Deutsche Börse and Euronext have made a better job of running their operations in terms of increasing shareholder value. In commercial terms, it makes sense that Deutsche Börse does the clearing and settlement as well as the trading – it brings the shareholders a lot of money. In such a light, the LSE has been a highly successful stock exchange but a less than successful company. That said, the current bidding war and the outcome of EC deliberations have led some to ask who stock exchanges should be run for: to profit the shareholder or for the benefit of the users and the capital markets as a whole?
This story is based on high level interviews with senior financial executives in London, spanning a wide range of activities. Due to the sensitivity of the subject, The Banker has granted them all anonymity.
