Jeremy Warner's Outlook: A revolution in stock exchanges, or simply naked self-interest by the investment bankers?

Deutsche Börse out of Euronext action; BA: lancing the pensions boil; L&G: leading on capital disciplines
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The Independent Online

If you take the view, as I do, that anything that enhances the level of competition in the marketplace must, by definition, be a good thing, then the initiative by seven leading investment banks to set up a rival platform to national stock exchanges for the trading of European equities is very much to be welcomed.

For too long, stock exchanges have enjoyed an effective monopoly of equity trading in their national markets. There is plenty of evidence to suggest that this has pushed rates of return to excessive levels. Indeed, this is the main reason why share prices in the sector have risen so strongly since the national bourses were demutualised. The returns are mouth-wateringly high. What's more, there's nothing in the way of price regulation to keep the exchanges honest.

In the round, exchange transaction costs in Europe are much higher than they are in the US, which in turn is one of the major reasons American exchanges want to buy their rivals over here. Past efforts to set up in competition have tended to founder on regulatory constraints, and on the fact that transaction costs are actually of fairly marginal significance if there is insufficient liquidity in the new market to ensure low spreads. The transaction cost can be as low as you like, but without the critical mass to keep the difference between buy and sell prices to a minimum, the benefit may count for nothing.

In this sense, stock exchanges have a classic networking effect. The more people who use them, the more efficient they become and the more difficult it is for competition to break into the market. What marks this latest attempt from past failures, such as Tradepoint, is that, combined, these seven investment banks account for something over half of all equities traded in Europe. They therefore have the opportunity overnight to create a credible alternative pool of liquidity that could quickly undermine the position of national stock markets. Nevertheless, you have to wonder about their motives. Investment bankers are not known for their altruism. One thing is certain; they won't be doing this for the greater good of the financial markets, or even their own clients. This is not about benefiting poor pensioners.

Rather, what motivates them is the size of the bonus pool, which is undermined by the reduction in spreads - the wider the spread, the more the investment banks as market makers will make - and the success traditional stock exchanges are achieving in disintermediating the bankers. Fund managers increasingly deal directly through the stock-market book these days, rather than through the banks. Conspiracy theorists will therefore see the initiative as little more than defensive, a thinly disguised attempt to counter growing consolidation in share trading into single platforms with deliberate fragmentation designed to protect their own position and profits.

The return on capital generated by stock markets may be high, but the absolute size of the profits is relatively small. The pre-tax profits of the London Stock Exchange last year would scarcely cover the bonuses of the investment banks' top seven earners.

Or put another way, the amount paid by each of these investment banks in transaction fees to the LSE last year would not even cover the annual salary of a top trader. In these circumstances, you have to wonder why they are bothering with the business of setting up a rival stock market. For investment bankers, these are marginal costs, which in any case as a percentage of the total cost of trading equity are eclipsed by settlement, clearing and, most of all, stamp duty.

Yet whatever the motives, the consequences for incumbents will be serious if the investment banks succeed. If they are unable to provide a service with better spreads and lower transaction costs, then quite plainly they will fail. Best execution rules would ensure they would be obliged to continue using the incumbent.

The chances of failure, particularly in the back to the future structure of mutual ownership envisaged for the new platform, would seem quite high. It was mutual ownership by users of the LSE which gave us the disaster of Taurus and a stock exchange which, until it was saved by conversion to plc status, came perilously close to international oblivion. There is something to be said for a stock market which is entirely neutral of the vested interests of its users, even if it is a monopoly.

Deutsche Börse out of Euronext action

Well there's a surprise. Deutsche Börse has finally recognised reality, and pulled its bid for Euronext. It wasn't for lack of trying by Deutsche's chief executive, Reto Francioni. Met by a wall of hostility from Euronext, he's been trying to get the deal through by the back door by lobbying senior politicians in France and Germany. He's been trying to persuade them that the ghastly prospect of Americanisation of European equity trading inherent in the alternative New York Stock Exchange proposals for Euronext makes an all-European solution a necessity.

No doubt he succeeded, but fortunately, the politicians have on this occasion been unable to influence the outcome. It beggars belief that Deutsche Börse could have got a deal that involved folding Euronext's London-based derivatives exchange into that of Deutsche Börse through European competition regulators, supine and beholden to vested political interest though they may be. As it is, Deutsche Börse has been unable to match the NYSE offer on value. The hatred these two organisations have for each other ensures that the only way they could ever come together would be through a brutally destructive takeover of one culture by another. As nations, France and Germany have put old rivalries behind them. As stock exchanges, they remain at war.

BA: lancing the pensions boil

Willie Walsh, the chief executive of British Airways, moved closer to solving the company's pension-deficit problem yesterday - but only at a considerable cost. It is also not clear whether the new deal - which in effect means an extra £350m of company money going into the pension funds on top of the £500m already promised - has got union backing.

The unions won't be easy to win over. Pilots and other workers remain highly resistant to the lower benefits proposed. Still, the trustees have now backed the proposals, so we do seem finally to be approaching the end game.

Until BA solves its pensions problem, it remains frozen in time, unable to return to the dividend lists, its debt rated as junk, its fleet-renewal programme on hold, and barred from anything in the way of corporate activity. The price is a high one, but if it shifts the log-jam in BA's affairs and wins the support of staff, it is certainly one worth paying. The fast-growing airlines of the emerging markets, not to mention climate change and low-cost competition in BA's own backyard, present a potent cocktail of challenges to the company in the years ahead. To compete, BA must be free to act.

L&G: leading on capital disciplines

What's this? A life insurer that promises to return capital to shareholders? The concept is almost unheard of in this capital hungry industry. In recent years, the history has been one of rights issues and dividend cuts, first to shore up solvency and then to finance expansion.

Now along comes Tim Breedon, the chief executive of Legal & General, to say he's identified £1bn of surplus capital in his business which he might return to shareholders. This surely marks a sea change in an industry previously known only for consuming capital, either on misguided overseas and domestic expansion or because of past mistakes in pricing its policies.

The banks were forced to learn about the merits of capital discipline the hard way in the banking crisis of the early 1990s. It has taken a similar crisis in life assurance - the solvency meltdown of four years back - to teach assurers the same lessons. But it is L&G which is leading the way.

j.warner@independent.co.uk

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