The mysteriously monikered Project Turquoise sent a shiver through the European exchange world last month by announcing that the big-bank-backed trading platform had chosen its plumbers: the US-based Depository Trust and Clearing Corporation for trade clearing and Citigroupfor settlement. (Broadly, clearing reduces the number of transactions by netting trades across participants and settlement consummates them.) Much like my itinerant parents who cannot occupy their new Florida home until the water pipes are working, traders cannot move orders to Turquoise until the clearing and settlement pipes are in place. This is a big deal in Europe, where lack of common or interoperable trade plumbing has been the biggest barrier to the emergence of an efficient pan-European trading market.
The US exchange world has had a single plumber, DTCC, available to all for over three decades. The result is plug-and-play trading systems and plenty of competition between them. Europe, on the other hand, is a morass of national settlement systems, some owned and controlled by a single national exchange, and a broken web of clearers—some national, some international; a few linked, most not. This has had a big impact on competition. The London Stock Exchange and Euronexthad a brief but bloody price war on Dutch stocks in 2004, thanks to use of a common clearer: LCH.Clearnet. However, virt-x, the UK platform now owned by the Swiss Exchange, was unable to make an effective run at German stocks because of Deutsche Börse denying access to the settlement provider Clearstream, bought in 2002.
Can Turquoise have a go? Created by seven big banks that have bristled at the trading fees they have been forking over to the exchanges, thanks to rocketing volumes, Turquoise revives the old mutualised exchange structure and will charge its owners no more than they need to keep the platform afloat. Between them they account for about half of all European trading volume and can divert it at a keystroke.
But Turquoise faces three big challenges. First, the banks do not control most of their volumes. Their customers do. These include hedge funds and other active institutional traders. “Best execution” obligations mean that the banks can divert these volumes to their new platform only if they can offer the same or better stock quotes, or persuade their customers to put their own quotes there. This will be tough. The exchanges are earning fat margins and have plenty of room to cut fees. This is the second big challenge. The big exchanges, such as Euronext, already count big hedge funds, such as Citadel, as direct members. So the banks willbe in fierce competition with the exchanges for investor patronage.
The third challenge is the plumbing. The Turquoise banks have raised eyebrows in bypassing big European operators, such as LCH.Clearnet and Euroclear, in preference for euro-novice DTCC and plumbing client Citigroup. DTCC can claim all the big banks as clients in the US and has had a European clearing subsidiary, EuroCCP, in mothballs for years. They are plausible competitors to homegrown incumbents. DTCC will net trades down before passing them to Citigroup for settlement, which will significantly reduce the cost of settlement. But Citigroup is an extra middleman between the clearer and the national settlement systems and as such generates an additional cost to pass back down the chain. If this were such a simple, cost-effective solution to the European plumbing puzzle, one can only wonder why the banks did not try it many moons ago when they controlled the pan-European exchange Tradepoint and its successor, virt-x.
Turquoise promises competition to the fat and happy exchanges and should be welcomed by investors and regulators. Whether it succeeds or not is much less important than that it establishes that the European stock trading market is contestable; that there is viable competition to the exchanges lurking in the wings. One of the great contributions of industrial economics in the 1980s was to demonstrate that it is potential rather than actual competition that disciplines the pricing of incumbents. The greatest contribution the European Commission can make is to continue its push to dismantle the vertical integration of exchanges and settlement systems, which has acted as a barrier to exchange competition and to a much-needed consolidation among settlement platforms.
This article appears in full on CFR.org by permission of its original publisher. It was originally available here.