Poach or perish: markets invade each other's turf

Investors may be at each other's throats trying to make the best of the dire markets, but the fiercest battle of all is raging between the exchanges themselves.

As times have got tougher, and fewer new companies are braving the torment of listed status, the big exchanges have had to come up with other ways of keeping the revenues rolling in. Now a competitive land-grab is on to snap up market share in the liquidity of Europe's biggest stocks.

The battle has been stepped up not only as a result of the near-dead stream of Initial Public Offerings, but also as a result of consolidation that has created just a handful of major exchange blocks. The London Stock Exchange (LSE) remains the most liquid in Europe, but the Deutsche Börse and Euronext are snapping at its heels.

The competition is especially heated between LSE and Euronext, the group comprising the Paris, Amsterdam, Lisbon and Brussels exchanges that bought the London International Financial Futures Exchange (Liffe) at the end of last year. The deal was a particular blow to Clara Furse, the chief executive of LSE, who is a former board member of Liffe. Since then, LSE has assured investors it can make it without a derivatives exposure. "The business model we have is resilient," said Jonathan Howell, LSE's finance director.

One of LSE's greatest strengths is its technology – another key area in which the battle between exchanges will pan out. In the past 10 years, it has suffered only one break in trading, while Euronext has inflicted a string of glitches on traders – including a 90-minute blackout across all its exchanges two weeks ago.

But having beaten LSE in the bidding for Liffe, Euronext is now touting the way it will use its new derivatives expertise to soak up the investment pouring out of equities and into other assets. For its part, Liffe seems delighted in its new corporate home: "Euronext is giving us the exposure we needed," said Hugh Freedberg, Liffe's chief executive. "We get to create a seamless product and sell it across a pan-European network."

All three groups benefit from the fact that market volatility is high, and that hedge funds are churning stock at a rate of knots. The movements experienced by the major indices in recent months have been the result of heavy volume trading, from which the exchanges have gained steady incomes. A trading update on Friday from LSE confirmed that fact.

But when it comes to delivering real growth, the options are limited. The situation has given rise to the growing practice of rival exchanges "poaching" liquidity. One of the best European examples of this was Nokia. The stock – by far the biggest and best-traded on the Helsinki Exchange – was offered as a tradable option on Frankfurt. As a result, Deutsche Börse "stole" a considerable chunk of the stock's liquidity, as German investors took advantage of the easier trading terms.

As one leading financials analyst explained: "The exchanges are on the brink of what could be a bloody war for liquidity. Exchanges are going to home in on the top 10 of their rivals' members, and start offering to trade the shares. When you look at how well traded BP, Glaxo SmithKline, Vodafone and BT are, there is a huge danger that rival exchanges will steal LSE's core liquidity."

On the Continent, the rivalry is expected to be even fiercer. The fact that all stocks are traded in euros makes it simple to offer trading in attractive stocks from rival exchanges. That is the exact pattern that has hit the Nasdaq exchange. Because of its now antiquated dealing system, the exchange has lost more than half of its liquidity to more nimble online exchanges – known as ECNs.

That is one reason that LSE might steer clear of a merger with Nasdaq – a deal that has been the subject of speculation since LSE's failure to pull off deals with Deutsche Börse and Liffe.

Analysts are now intensely interested in what direction Ms Furse will take her company. One view is that LSE, seeing the value of the Euronext-Liffe offering, will look at ways of gaining an exposure to derivatives.