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Survival of the biggest: A new era of mega-exchanges on the horizon?

The prospect of a merger between exchange powerhouses, the London Stock Exchange Group (LSEG) and Deutsche Börse could usher in an era of mega-exchanges, where a handful of providers dominate equity, derivative, fixed income, indices and clearing markets in specific geographies – making them a one stop shop for the entire trade cycle.

Yet the road to that reality is certainly a long one. The unravelling of negotiations between these two trading behemoths to secure a deal in 2000 and again in 2005, demonstrates all to clearly the challenge that lies ahead.

Moreover, possible legal hurdles put in place by anti-trust authorities, combined with political and economic uncertainty surrounding a British exit from the European Union, could yet prove terminal.

The rationale behind this potential corporate marriage is clear. In a statement issued by the LSEG announcing the talks, the Group pointed to “the prospect of enhanced growth, significant customer benefits including cross-margining between listed and OTC derivatives clearing.” The move, which would allow both firms to pool capital, resources and expertise to grow market share and cut operational costs is also consistent with the LSE’s long-term strategy under the leadership of CEO, Xavier Rolet.

Rolet’s commitment to strengthen the Group by completing a string of acquisitions to diversify its offering in the derivatives, indices and clearing market has paid dividends. The purchase of indices providers Russell Group and FTSE in quick succession, as well as a majority stake in LCH Clearnet, one of the largest interdealer clearing houses, has affirmed the group’s position in Europe as a leading provider of trade execution, clearing and data related services.

This strategy has led to a dramatic rise in market capitalisation by as much as fivefold and also transformed the group from being preyed upon by rival firms, to a predator seeking to grow market share, according to a recent article on the proposed deal in the Financial Times.

However, US exchanges are increasingly seeking to secure a global, rather than continental footprint with a move into European Markets. BATS Global Markets, a US operator, now runs the biggest stock exchange in Europe by market share – whilst CME, the Chicago-based group, launched in European markets in 2012 with a multi-asset derivatives offering spanning trading and clearing services – posing a direct challenge to incumbent operators.

Against this backdrop, it is clear to see why these two institutions are seeking to pool capital, technology and people to compete directly with global exchanges, particularly from the US. It is well known that this drive towards exchange consolidation is likely to result in a small number of major operators, reducing market fragmentation, something noted by Rolet in 2011.

“In five years there’ll be three, four international exchange groups with global distribution capabilities,” he said in an article in the Telegraph.

But what about end-users?

Whilst the rationale behind a potential merger has commercial objectives, it is also likely to deliver cost synergies, particularly for core customers such as large investment banks and asset managers.

For example, the introduction of new regulation designed to implement greater risk controls on global derivatives markets has placed steeper margin requirements on banks – creating a glut of capital warehoused in major clearing providers such as LCH Clearnet and Eurex Clearing. Whilst the LSEG statement specifically noted that both firms would remain as separate entities, a merger could allow banks with portfolios in each CCP to reduce net margins and free up capital that can be used more profitably elsewhere.

Whilst a deal will deliver greater operational efficiencies to LSEG, Deutsche Börse and their respective customers, it is likely to trigger further consolidation as smaller exchanges rush to pool resources and as a result, introduce a new era dominated by a handful of major global players.