25 October 2000
CAPITAL MARKET EFFICIENCY -
THE ROLE OF THE LONDON STOCK EXCHANGE
Don Cruickshank, chairman of the London Stock Exchange, today addressed a Securities Institute seminar at the e-Financial Show at the Barbican Centre. The meeting was organised to raise funds for the charity, One World Action.
In a speech examining the key issues currently facing stock exchanges - including the London Stock Exchange - as they respond to market pressure for rationalisation and further globalisation, Don Cruickshank discussed:
Don Cruickshank said: "Together we should focus on campaigning for the liberalisation of securities trading, for effective application of competition law across the EU, for getting rid of productivity stifling tax in the UK, and for the writing of objective based directives followed by fierce implementation.
"In this operating environment, a stronger London Stock Exchange will thrive to the benefit of everyone in the UK, and foster the development of a single capital market in Europe and efficient globalisation. That's what is at stake through supporting the London Stock Exchange as it plays its part in improving the efficiency of capital markets."
The full text of Don Cruickshank's speech is attached.
Schroder Salomon Smith Barney, which is regulated in the United Kingdom by The Securities and Futures Authority Limited, is acting for London Stock Exchange plc and no one else in connection with the offer by OM and will not be responsible to anyone other than London Stock Exchange plc for providing the protections afforded to its customers or for providing advice in relation to the offer by OM.
Speech to the Securities Institute
25 October 2000
I was asked to talk about the future of the London Stock Exchange - a long time ago!
Many of you will have heard my present articulation of where we are. No harm in repeating it. However, this evening it may be helpful if I tackle some of the key issues which affect our industry generally and the implications for exchange rationalisation.
But before I do that, let me touch on the here and now, the immediate future of the London Stock Exchange.
First, the future is not as a subsidiary of OM or, as far as I can judge, as the subsidiary of any other organisation. As I have said, the London Stock Exchange is not up for sale.
Second, whatever the longer-term strategy, there are a lot of things we can do better. There are strengths the London Stock Exchange can develop.
We owe it to our customers and shareholders to become more commercial - remember we were an industry service-providing mutual until March this year. The better the financial performance, the better will be our position in negotiating our role in European rationalisation and globalisation - something most of our customers want.
So, as set out in our most recent Defence Document, and already under way, we are building on our existing strong business in several ways: by developing a pan-European market by admitting the leading European equities to trade on our existing systems. By repositioning techMARK and AIM as international markets. By enhancing our strong competitive position through further investment in our trading systems, including the introduction of a central counterparty service in February 2001. By developing new initiatives specifically to support private client brokers. And by developing a range of competitively-priced information products to meet the needs of our customers.
Add to that:
Management structure. New CEO certainly (I'm not going to continue - the roles need to be split), but also a management structure focused on our three main revenue and profit-generating activities: broker services; issuer services; information services; supported by two core business areas of market supervision and systems plus the usual central services.
New board structure - governance la combined code.
And better consultation procedures, the Exchange Markets Group and its supporting specialist working groups - so that we're better equipped both to deal with immediate market and customer needs, and to plan and implement the next steps.
So, to the meat of tonight's lecture, the next steps - the longer-term structure of the exchange industry, and the London Stock Exchange's position within it.
First, to disappoint you. I'm not going to talk about a corporate deal with X or Y or a technology partnership with A or B. It's inappropriate even to speculate before some big strategic issues are sorted out, and the true degree of practicability and value of such transactions are much clearer. And a word en passant to those who say 'you haven't got a strategy' because a corporate deal hasn't been done. Not so. That view represents signs of very narrow thinking on a very broad subject. And also - importantly - a view borne of misunderstanding of the real strategic issues in this market.
So, what are these strategic issues we are faced with?
First, is the absence of a single market in the trading of financial products within the EU. The single market is absent in other segments of the European financial services market too - my recent review of banking services for retail and business customers demonstrated that. The segment I've called 'trading of financial products' is not out of step, and some of the issues are common to the whole financial services market. But why start with this?
Because the London Stock Exchange is a commercial company - in due course a listed company - subject to the ordinary commercial disciplines of the market economy. Or rather it is in the UK. Competitor entry is easy - there are five competitors in cash equities trading alone, many more in other financial products. There are no public interest or national strategic objectives that the London Stock Exchange in particular has to meet. It has no special public policy regulatory role. It can be taken over, and the regulatory terms for any new owner are clear, relatively easy to meet - as the OM offer illustrates. We are the most open economy in the world on these counts.
The market for trading in financial products in the rest of Europe is not fully open, nor subject to market economy disciplines (neither is the market in the US - which I'll come to in a minute). Those who demand that we 'take the initiative' should realise this. Just to run through them:
The ownership and control of each of these companies can be effectively controlled by their boards not - unlike the London Stock Exchange - shareholders.
Further, for competition law purposes, the definition of the relevant economic market is likely still to be national. Exchange organisations - not unlike ourselves - are typically nationally dominant. But almost all the others are not subject to effective price competition and, it follows, are reporting profits that are subject neither to normal competition nor price regulation.
All in all, this is not very fruitful negotiating territory for the London Stock Exchange: no - or little - market disciplines on other exchanges; fuzzy governance everywhere; and no firm basis for comparative valuation. Some, if not all of this has to change if an LSE/European exchange (or exchanges) merger were to be part of the way forward.
I am struck - are you not? - by the irony of all of this: that exchanges which are at the heart of the market economy, the very place where capital and ideas come together, representing the most visible representation of the healthy disciplines of the market, are themselves sheltered from these disciplines. I think we all have to think long and hard about how London copes with this irony and whether outside intervention is required to break up these cosy arrangements.
The second strategic issue is that mergers of exchanges alone are not enough to deliver the lower costs and better service that customers want. Trading customers of exchanges across Europe actually see the product as the execution and completion of the transaction, that is secure possession of the security and certainty of payment. The London Stock Exchange alone doesn't deliver that product to our trading customers.
This is not going to be a plea for vertical integration in common ownership. Far from it. In an internet, electronically networked world this is not necessary, as long as the network interfaces are not too complex - which they're not - nor multiply too much - which they need not.
No, clearing and settlement can be owned and managed independently of exchanges. Indeed many market participants talk of them as 'utilities'. But they do so rather innocently, as the basis for justifying: (1) no vertical integration and (2) mutual ownership. Yes, again no exposure to market disciplines!
However, they are instinctively right in the use of the word utility. Clearing and settlement activity does tend to natural monopoly with significant economies of scale. And this would conventionally raise public interest questions of price regulation and terms of access. I'll pass over whether mutual ownership is a valid form of price regulation. It may be. But it's unlikely. For this evening, I want to focus on access. The major European clearing and settlement organisations exhibit the economic features of utilities, each is dominant in their own national market. The required public policy intervention is fair, reasonable and non discriminatory access. OK, they'll all say, 'Anyone who wants to be a member can be. The terms are fair'. Maybe they are, although I doubt whether new entrants always think that. However, I'm talking about wholesale access, that is, the obligation to provide services to competitors - in this case, exchanges and other clearing and settlement organisations from other member states. In practical terms, in order to serve customers from across Europe, the London Stock Exchange should directly, or through its agents - London Clearing House and Crest - have the right on fair terms to access, say, Clearstream or Euroclear.
This analysis reinforces the problem of valuations. Lack of competition, fuzzy governance and direct government intervention serve to enable organisations engaged in the trading of financial products to operate without economies of scale, yet report healthy profits. They say they are 'worth a billion this, or two billion that'. May I make two observations. First, they are not 'worth' anything in particular if there is no market in them. Second, many people estimate that as much as 2 billion euro can to be stripped out of the cost base of the market in trading financial products across Europe. This represents a substantial amount of value. Somewhere revenues and margins have to drop. Where is this surplus value? It's difficult to judge. But little of it is at the trading platform level - and none of it is in the London Stock Exchange's market cap. The development of a central counterparty is a very valuable asset - so not much there then. So it's in settlement organisations where revenues, margins and value are most overstated and unsustainable.
Let me be blunt. This would clearly pose a dilemma for any organisation entering into merger negotiations if it had to throw its open market value into the pot with the inflated values of organisations that are not subject to competition and market regulation.
What would happen if Europe's national clearing and settlement agencies thought increased access on a utility basis might be imposed? It seems likely that access would be volunteered and the real economics would show through, leading to a rapid reduction in the number of systems, to harmonisation of procedures and rules and to the swift reduction in the cost base that trading customers want.
And on the back of this, would London Stock Exchange need to merge with other trading platforms? I wonder?
The third strategic issue, is that if we did again attempt some form of European merger, then the regulation of listing and admission to trading, standards of transparency in trade reporting and publication, and governance would loom as major hurdles as they did - through no-one's fault - in the proposed merger with DBAG. Our customers in the UK, this time including companies and investing institutions - not just intermediaries - want to see systematic implementation of directives into law, harmonisation of the interpretation of the law in public policy regulation, a common rule book being applied to trading, and common, UK, standards of trade reporting and publication.
If our UK customers continue to set these admirable objectives as conditions to be attached to any merger between the LSE and other member state exchanges, we should realise that these are very high hurdles and, unless the position changes substantially, the realistic prospect of merger is in doubt.
I believe this is a harsh test that may not be in the interests of shareholders and these same customers. However, the crunch may not come, since the Lamfalussy Group of Seven Wise Men is tackling these very issues, and, pleasingly, not getting bogged down in the 'Europe SEC' debate.
Our preferred option for moving these issues forward is to give the Commission a greater role both in reviewing implementation and monitoring enforcement. What we would like to see is a restatement of Directives in the form of objectives together with associated obligations on member states and regulatory agencies. What is then required is efficient monitoring by the Financial Services and Competition Directorates in order to provide effective delivery of objectives and to prevent distortions to competition.
When I explain some of these European issues there is a common response: 'Do a deal with the US (they usually mention Nasdaq). It'll help with rationalisation in Europe when it comes'. This response suffers from the 'a strategy must include a deal' flaw, and runs straight into the next strategic issue - my fourth
which is that my first, second and - to a lesser degree - my third strategic issues are replicated in the US. Actually, in some respects it's worse. At least in the EU, the LSE has the opportunity to sell remote access and recruit members to trade into its UK-regulated market. I can't do that in the US. There's a trade in services issue here and a lack of reciprocity. Nasdaq, using its SEC approval, could set up in Europe, become an RIE in the UK and its stocks can be traded here. The LSE cannot offer direct remote access to London from the US in the same way, as the SEC would require it to become a fully-regulated US exchange and to trade companies whose accounts comply with US GAAP. It is only the Commodities and Futures Trading Commission that has taken a more enlightened view, allowing foreign futures exchanges to provide remote access into the US, as LIFFE and Eurex do.
I also predict that a US tie up or merger would raise another difficult issue, extraterritoriality - a horrible word meaning the demand by the US authorities - the SEC and Government combined - that their writ should run over all the markets run by the new entity, especially if US citizens were to have direct access to a market in a member state of the EU.
These are not bogey-men, fictions of my imagination. They are, from my media and telecomms experience, the inevitable response from the US to any opening up of trade in services - in this case trading of financial products. And those of us - including NASDAQ - who want to see further globalisation of capital markets will need to work together to face these issues before the detailed proposals of any deal could be considered.
And even if the two issues of access and extra territoriality could be solved or ignored, then both the obvious US candidates for a merger or deal, have fuzzy governance, pose valuation problems and bring different market structures.
So there's just four strategic issues to be resolved or ignored in considering any merger - we could always ignore some of them blindly - before I even get to the terms of a deal, technology choices, social issues - who's going to be chief executive, composition of the board etc - and the toughest question of all: 'Why should this merger work for London Stock Exchange shareholders given the poor record of mergers, especially cross border, between markets that are not open to the same market disciplines?'
And at home, I also have a major strategic problem - stamp duty. It has a huge bearing on the growth and profit prospects of the London Stock Exchange.
Let me talk from a UK economy perspective first, however.
The UK equity market lies at the heart of the Government's productivity and competition agenda.
A tax on equity trading is a tax on:
Companies wishing to raise capital from UK and overseas investors. It adds to the cost of raising capital in the UK, with the real threat that as European capital markets converge, new entrants will seek to raise capital in financial centres that do not suffer such a tax. The level of stamp duty is 150 times the US equivalent. Nonetheless, it is viewed by everyone there as a drag on liquidity, capital raising and personal savings.
It is indeed a tax on investors wishing to save for their futures by directly or indirectly buying shares. It hits ordinary people saving for their old age through pension funds by over 3 a week.
More parochially, the impact on the London Stock Exchange is very, very, substantial. We are already seeing a proliferation of avoidance measures such as spread betting - is this really what the Government wants to encourage - high risk with no benefits whatsoever to the balance sheets of UK companies? We estimate the total loss of trading by 2003 at around 1 trillion - equivalent to 70% of the 1999 value of UK equity trading.
The UK is the only major financial market with such a tax - great care should be taken not to take for granted the UK equity market's ability to cope with the extra cost. Patience is not inexhaustible and it is essential to remember that once markets are lost, they are almost impossible to recapture.
There are other issues facing the London Stock Exchange but five will do for this evening.
Let me finish with a plea to these who commentate and opine on our affairs -especially those who, I believe, share the view that liberal market economics offer the best way forward for markets, economies and people. Let's together raise the debate on the future of the London Stock Exchange beyond merely reporting the conflicting views from our market and beyond the fascination with corporate deals. Let's focus on how to campaign for changes in trade negotiation briefs, for effective application of competition law across the EU, for getting rid of productivity stifling tax in the UK and for the writing of objective based directives followed by fierce implementation. With all that as the operating environment, a stronger London Stock Exchange will thrive and foster to the benefit of everyone in the UK, to the hastening of a single market in Europe and even, who knows, to efficient globalisation. That's what is at stake through supporting the London Stock Exchange play its part in improving the efficiency of capital markets.
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