Last week, the UK Competition Commission released the long-awaited provisional findings of its investigation into the domestic competition implications of a takeover of the London Stock Exchange (LSE) by either Deutsche Börse or Euronext. The report was groundbreaking in highlighting the critical role of a little understood aspect of the plumbing of the securities markets: clearing and settlement.
Clearing houses provide a central counterparty function for trading which reduces risk and lowers costs for market participants. Settlement operators facilitate the delivery of securities in return for cash, among other necessary post-trade activities. The UK Competition Commission’s report concluded that Deutsche Börse’s ownership of Eurex Clearing and Euronext’s 41% stake in LCH Clearnet could represent barriers to competition for UK share trading should either exchange take over the LSE, as they would effectively be able to bar access to necessary clearing services for other exchanges. The Commission was probably right to conclude that Deutsche Börse’s ownership of the Clearstream settlement system did not, as a practical matter, represent such a barrier, at least in the short term. The Commission’s remit, however, was entirely domestic, and it is important to recognize that exchange ownership of both clearing and settlement systems represents a significant barrier to competition on a pan-European basis. This barrier reduces investment returns and raises the cost of capital relative to what they would be if exchanges were barred from owning significant stakes in such systems, as stock exchanges are in the United States, and therefore merit more active intervention by the European Commission.
There are three ways in which the vertical integration of trading systems and post-trade plumbing limit the development of the European Single Market in the securities sector. First, the creation of vertical exchange silos, as these integrated entities are known, prevents the necessary consolidation of European clearing and settlement platforms, the current fragmentation among which is a wholly regrettable remnant of pre-Single Market national legal and regulatory silos. Clearstream, for example, would almost certainly have merged with settlement operator Euroclear had it not been taken over by Deutsche Börse in 2002. Whereas the cost of European clearing and settlement is often comparable to that in the US when examined on a national basis, European costs dwarf those in the US when trading is cross-border. Silo proponents often counter that national laws and regulations inhibit effective consolidation anyway, but this argument ignores the fact that there can be no pressure or blueprint for harmonization as long as there is no effective urge to merge among clearing and settlement system operators. Given the public focus on trading system consolidation in Europe, it is critical to note that settlement consolidation would result in vastly greater savings in trading costs, and therefore cost of equity capital to European firms.
Second, vertical silos are antithetical to exchange competition. Prior to its takeover, Clearstream was, quite naturally, enthusiastic about providing German share trading settlement for non-German exchanges. Deutsche Börse, also quite naturally, was not, thus quelling Clearstream’s ambitions. Given the enormous network externalities in the settlement business, it is effectively impossible for any exchange to compete for German share trading without access to Clearstream. Contrast this impregnable monopoly with the highly effective competition between the LSE and Euronext for Dutch share trading, which resulted in victory for Euronext only after a 30 percent across-the-board cut in trading tariffs. The magnificent price war, a monument to the Single Market in action, was made possible only by the fact that both exchanges used LCH clearing services.
Finally, silos can effectively act as poison pills for management at second-tier exchanges determined to thwart foreign suitors, and thus function as a barrier to further consolidation of both trading and settlement platforms in Europe. The Borsa Italiana paid about 250m euros to take over the Italian settlement operator, Monte Titoli, in 2002. Given the vast surplus of middling settlement operators in Europe, Monte Titoli represents a costly redundant appendage to the Borsa which will deter a larger exchange from absorbing Italian share trading into a larger, and therefore lower cost, infrastructure.
The UK Competition Commission has done a tremendous public service in finally giving the plumbing of the European securities markets the public policy attention it so clearly merits. The dismantling of vertical exchange silos across Europe should now become a priority on the Single Market reform agenda.
Benn Steil is Senior Fellow in International Economics at the Council on Foreign Relations and a non-executive director of virt-x