Exchanging faces

The London Stock Exchange faces overwhelming pressure to make fundamental changes. David Hellier and John Eisenhammer report
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The Independent Online
YOU KNOW it is serious when the City's oldest gentleman's club turns to a no-nonsense young American woman to tell it where it should be heading. But then the Stock Exchange is all too aware, in those now immortal words of financial warning, that the past is no guarantee of future performance. Just 10 years ago, the Stock Exchange was the City, a concentration of unrivalled authority and over two centuries of tradition in one of the world's great financial centres.

Now, in rapidly changing markets, it is searching for a new role as its practices and position come under heavy fire. In September 1994, Fields Wicker-Muirin, a 36-year-old American, was brought in as director of strategy by Michael Lawrence, the chief executive, to come up with some radical answers. Unassuming, but already earning respect in the City for possessing a sizzling mind, Ms Wicker-Muirin is a direct challenge to the old Stock Exchange notables, some of whom would dearly love to soldier on with little regard for the world outside. She is near to completing her main strategic project - setting out the priorities for rebuilding the Stock Exchange's position and hoping to confound the growing ranks of sceptics in the City.

"It is simply no longer a landmark institution in the City," says John Manser, chief executive of Robert Fleming, the investment bank. "The Stock Exchange is finding it difficult to adjust to changed circumstances. It spends far too much time looking over its shoulder and not enough defending its role in the radically different scene of the Nineties."

No one is more acutely aware of the importance of keeping ahead of the times in the increasingly cut-throat environment of global finance than Mr Lawrence or John Kemp-Welch, the Exchange's chairman. But like any trade association with a disparate membership, the LSE is an unwieldy vessel to trim. It is not always easy to win backing for investments that some members do not see of immediate benefit to themselves. It is also an institution redolent with nostalgia; powerful fiefdoms drawing sustenance from the days when respect for the Stock Exchange was automatic and when the British traditions of the City went unquestioned.

The reality of today's City could scarcely be more different. The impending takeover of the third British merchant bank by a foreign institution underscores the international character of London. National dealing has given way largely to global trading, and the outside world - usually meaning the Americans - tends to shape the practices of international financial markets. London, the most open of the big financial centres, is particularly sensitive to these forces as the giant US and continental houses, and international investors, exert their influence.

The markets themselves are also far more fragmented. Ten years ago, if someone wanted equity risk they went to the Stock Exchange. Now there are any number of ways, with different cash markets, convertibles, warrants, to say nothing of Liffe, the London futures exchange and over-the-counter derivatives.

The Stock Exchange is fighting to defend its central role as these other markets and rival exchanges gouge deep inroads. This is not a problem peculiar to London. The authorities at the New York Stock Exchange, the world's biggest, are racking their brains with similar urgency.

"The real problem for the London Stock Exchange is that the very concept of what it is, is increasingly difficult to see any more," says a senior regulatory source. "Is it a settlement system, an information display system, a dealing system? All of these are now functions than can be separated out and done elsewhere. The Exchange is having difficulty defining what it is offering users to justify remaining in the field."

At the heart of the Stock Exchange are the market-makers. These are the powerful firms, such as Smith New Court, which - as the description suggests - drive the London market by continuously dealing, quoting firm sell and buy prices for shares to investors. They commit large amounts of money to making markets and assume big risks. To encourage them to do this, the market-makers have been given certain privileges, principally allowing them to hide big trades for a while from the rest of the market. These are considerable advantages, which also work to the benefit of the Stock Exchange.

This so-called quote-driven dealing system of market-making is peculiar to the City. Most other big financial centres use an order-driven dealing system, where buy and sell orders are automatically and anonymously matched by electronic trading. Many still say that market-making is what made the City great, and gave the Stock Exchange its position. But the supporters are not as strong as they used to be. The last few months have seen a series of broadsides, first from the Office of Fair Trading, and then from the Securities and Investments Board, the City's lead regulatory overseer, against the privileges of the market-makers and the special position they give the Stock Exchange.

Many of these criticisms have received strong, private, backing from the Treasury. Changes have been recommended to rules and privileges that are judged to be anti-competitive. The SIB came down in favour of clearing away the impediments to the development of a rival order-driven system. The first such competitor, Tradepoint, begins operating in August. The SIB also leant towards the complaints of other exchanges, such as Liffe, that its prices are distorted by the privileges of the Stock Exchange.

Accepting the importance of market-making to London and the Stock Exchange, the SIB review has stepped well back from abolishing the privileges. But it has introduced significant curbs and limits. It is now up to market forces to decide which trading system should prevail. Many powerful market- makers and the Stock Exchange did their utmost to avoid even this seemingly even-handed outcome.

"The Exchange is doing everything to ruin the quote-driven system which made it great, by worrying about transparency and shortening settlement times. If it makes life too difficult for market-makers, London will be like any other centre, and where is the advantage in that?" asks a senior City financier.

But others feel this stand-and-resist stance is one of the Exchange's biggest problems. "The Exchange has adopted a blind adherence to market- making as the only way of running the London market. But its weaknesses are obvious. It has not provided liquidity in smaller company shares, and it has to some extent corrupted the issue of true price discovery. Most of the rules are there to protect the market-makers' own profit margins," says David Jones, chief executive of ShareLink and a former Stock Exchange board member.

But these pressures for change are not only coming from regulatory bodies such as the SIB, they are coming from the market itself. The big foreign investment banks and institutions dealing in London appreciate some of the benefits of the market system - that it always offers immediacy of dealing, for example - but they are not wedded to it. They are used to order-driven systems and would like to see something similar develop here too, especially if it would help in these ruthlessly competitive times to shave a few fractions off transaction costs.

Such is the power nowadays of the international players in the City that the Stock Exchange has to listen. Indeed, three representatives of the international community, Masashi Kaneko of Nikko, Robert Metzler of Morgan Stanley and Rudolf Muller of UBS sit on the Exchange's board. It is not without significance that the Stock Exchange is carefully hedging its bets by developing an order-driven capacity as part of its new Sequence dealing system, which will be up and running by 1997.

But the confusion of roles within the Exchange continues to make it difficult for people like Mr Lawrence to define and impose a sense of clear direction. For it is commercial organisation, a trade association and a regulator all in one. As a commercial body, its attempt to introduce a modern settlement system - Taurus - was a spectacular failure, leaving the London exchange trailing its main competitors in efficiency. It has been slow in responding to dealing challenges and in developing links with other European exchanges.

"The Exchange has caused the threat of fragmentation by not embracing trends and not listening to users of the market. The fact that people like Tradepoint are even planning alternative exchanges is a serious threat to the LSE. It is surely only a matter of time before one of them strikes home," says Mr Jones.

Moreover, the City recognises the danger in the Exchange using its regulatory position to boost its own role and chisel competitors. For the SIB, the OFT and more discreetly the Treasury, this was no longer a satisfactory state of affairs for the City's future.

The most notable remark in the recent speech by Mr Kemp-Welch at the Mansion House dinner was that the Stock Exchange now recognises it has no divine right to its position. It is a measure of the scepticism with which the Exchange is regarded in City circles that this admission merited attention.

But the Stock Exchange is now fighting to preserve its role as the central market. In another recent speech to the Association of Private Clients and Investment Managers and Stockbrokers, Mr Kemp-Welch stressed five reasons why a central stock exchange is vital to the City's well-being.

It offers ease of price discovery; deeper liquidity; efficient regulation; ease of entry and strong enough finances to invest in the future.

"These five advantages have been of considerable value to the whole of the securities industry in the UK. But they could be eroded if the market were allowed to fragment - for whatever reason," said Mr Kemp-Welch.

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