Few outsiders have as much history with the London Stock Exchange Group as onetime investment banker Xavier Rolet. In 2005, while he was working for Lehman Brothers International (Europe) in London as co-head of global equity capital markets, Rolet became a senior relationship banker to the London Stock Exchange — and helped advise Clara Furse, the LSE’s then CEO, in the aftermath of a series of rapid-fire takeover bids from Deutsche Börse Group, Euronext, Macquarie Group and the Nasdaq Stock Market.
Now, as her successor, Rolet faces the challenge of trying to undo Furse’s chilly, combative legacy and strengthen the LSE’s competitive position by being more nimble and responsive to the banks and brokerage firms that constitute its core customers. He has no choice but to act quickly, because the LSE is losing ground to a new generation of rivals: high-speed, low-cost alternative trading venues that are attracting increasing trade flows, winning support from the LSE’s traditional customer base and challenging the very model upon which the LSE’s business was built.
The global economic crisis may be waning, but these are apocalyptic days for once-dominant European exchanges, whose share of overall trading volumes are plunging fast. That trend began in 2007 with the implementation of new panEuropean legislation that stripped the largest European exchanges of their national monopolies and deregulated the equity markets. In its wake the complexity of trading equities across European markets has increased exponentially.
No longer are national exchanges like the LSE the only sources of liquidity: Alternative trading platforms, known as multilateral trading facilities, or MTFs, are attracting greater trade flows. So, too, are new electronic dark pools: pan-European trading facilities with nondisplayed order books that allow for the matching of large, institutional blocks of shares. Virtually every aspect of the exchange industry is feeling the heat, and the major incumbents, like the LSE, are struggling to adapt.
“So many parts of the industry are moving so quickly, in directions that are hard to model and forecast, this is an extremely challenging time for all major exchanges — and for the London Stock Exchange in particular,” says Rolet, 50, a tall, bespectacled Frenchman whose affable charm belies a fierce competitive streak. “We have a long list of strategic challenges that are coming home to roost, and we need to address all of them at the same time. The only thing we don’t have, however, is time.”
The speed of the revolution in equities trading sweeping across Europe is forcing traditional exchanges, like the LSE, to regroup. This is, arguably, what the European Commission sought when it implemented the Markets in Financial Instruments Directive, or MiFID, in November 2007 as a means of spurring bare-knuckle, American-style competition — but even regulators have been surprised at the violence of the transformation. The legislation’s success is evidence that regulators should be careful what they wish for, because they might just get it: Equity trading is being commoditized.
Markets are fragmenting as order flows move off the exchanges. Pricing is becoming more opaque. Those incumbent national exchanges that survive the process will be those that maintain footholds in their home markets even as they begin to compete on a pan-European basis with the MTFs — and with each other. Those that hope to thrive, however, will have to develop market-leading technology, diversify their sources of revenue and provide cutting-edge data services to a global client base.
A rough blueprint of the future already exists in the U.S., where national regulation compels traders to route orders to the venue that offers the lowest price, regardless of which one offers the quickest execution or most reliable platform. Although Europe doesn’t yet have a mandate to route order flow, trading patterns are dispersing along similar lines as brokers attracted by the speed of execution and price improvements available on the MTFs route away from the main exchanges. In the U.S. the New York Stock Exchange and Nasdaq countered the effects of such competitive pressures by buying out some of their high-speed electronic challengers and merging with other large, diversified exchange groups to broaden their trading platforms beyond North America.
The 2007 merger of NYSE and Euronext not only created the first transatlantic stock market but also gave the NYSE exposure to the London International Financial Futures and Options Exchange, or Liffe, which had established futures and options markets in Amsterdam, Brussels, Lisbon, London and Paris. Nasdaq, rebuffed repeatedly by the LSE, took over Nordic exchange group OMX in 2008 and now has an extended footprint in Sweden, Finland, Denmark, Iceland and the Baltic states.
“The European market has begun to look like the U.S. in many important respects,” says Eli Lederman, CEO of Turquoise Services, a London-based pan-European MTF financed and supported by nine global banks. “But the incumbent exchanges here still have a higher market share than Nasdaq and NYSE combined — suggesting that the new platforms have a ways to go and that there is more fragmentation to come.”
The pace of that transformation may be slightly slower in Europe than in the U.S., as each of the 27 members of the European Union still has its own national financial markets regulator, and the largest member states still have incumbent national exchanges (although consolidation has streamlined their ownership). The sheer complexity and cost of equity trading and clearing in Europe will doubtless moderate the speed of fragmentation and affect its ultimate form, but they clearly won’t stop it — especially in the largest and most liquid markets, like France, Germany and the U.K. There high trading volumes actually help promote fragmentation, disproportionately turning up the competitive pressure on the most powerful incumbent exchanges, such as the LSE, which have the most to lose.
Rolet needs to act swiftly. Although the LSE remains the No. 1 capital-raising platform in the world, generating a total of £106 billion ($151 billion) in the fiscal year ended March 31 through a combination of initial public offerings and secondary issues, its status as the crown jewel of the European capital markets is slipping. In the wake of MiFID, the LSE has seen its share of trading in the constituent stocks of the FTSE 100 index — the U.K. stocks with the largest market capitalizations — drop from 74.3 percent in November 2008 to 58.7 percent a year later, according to Thomson Reuters.
The erosion is a direct result of MTFs gaining power by offering steeply discounted pan-European trading in the largest, most liquid stocks and indexes at speeds measured in mere microseconds. Leading the assault on the LSE is Chi-X Europe — owned by a consortium of shareholders, led by Japanese bank Nomura Holdings — which launched in March 2007. Since then, Chi-X has become the largest MTF by value of equity trading and the fourth-largest European equity market, behind NYSE Euronext, the LSE and Deutsche Börse. Chi-X isn’t the only challenger: Turquoise has also added to the pressure on the LSE, as has Bats Europe, a division of U.S.-based Bats Global Markets, which is owned by an 11-strong group of banks and brokerage firms that includes Citigroup, Getco, JPMorgan Chase & Co., Lime Brokerage and Tradebot Systems.
The threat that the LSE faces is being compounded by the fact that its peers, like Deutsche Börse, Nasdaq OMX Group and NYSE Euronext, are now launching their own pan-European trading platforms. Although the major exchanges have been somewhat slow to launch MTFs (not least because they were concerned about potentially cannibalizing order flow on their own exchanges), they are quickly catching up. In September 2008, Nasdaq OMX launched Nasdaq OMX Europe, or Neuro, its pan-European MTF, which facilitates trading in about 1,000 European blue-chip stocks as well as numerous indexes, including the CAC 40, DAX 30 and FTSE 100. In March 2009, NYSE Euronext launched NYSE Arca Europe, which operates on a new, high-speed trading platform developed in-house and based on the technology of its U.S. equities and options exchange, NYSE Arca. On the Continent, Deutsche Börse launched the Xetra International Market, a pan-European extension of its equities exchange, Xetra, in early November.
“One of the lessons we’ve taken from the MTFs is that there is now a demand for pan-European trading capabilities that didn’t even seem to exist a few years ago,” says Rainer Riess, head of market development for Xetra at Deutsche Börse. “When we see a change like that, we need to be able to offer such a service.”
Rolet is not prepared to let his chief rivals steal any more of the LSE’s market share without a fight. In early October the LSE confirmed that it is in exclusive talks to buy Turquoise, the pan-European MTF financed and supported by Bank of America Merrill Lynch, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman, Sachs Group, Morgan Stanley, Société Générale and UBS. The move made headlines for good reason. Turquoise was essentially designed by the banks as a weapon with which to challenge the LSE’s high trading fees and force the incumbent exchange to become more competitive and responsive to its largest sell-side clients.
Although it has yet to turn a profit, Turquoise now operates across 15 European markets, and its integrated trading platform combines both dark and lit, or visible, order flows. Since the trading service went live in September 2008, the MTF has been able to capture about 6 percent of the LSE’s monthly lit market share in FTSE 100 stocks, according to Thomson Reuters; its dark pool has also been attracting liquidity, given the banks’ vested interest in using it — whether they would continue to drive liquidity to the platform likely depends on the structure of any potential deal. The merger would be a natural fit for the LSE, which introduced a “smart” order routing system in June as the first phase in its launch of a pan-European dark pool, Baikal, named after the world’s deepest lake, in Siberia. The inauguration of Baikal’s dark-order trading book, originally scheduled for November, has now been put on hold, pending the outcome of the talks with Turquoise.
Analysts who cover the LSE say the combination of Baikal and Turquoise holds tremendous potential. Turquoise, like every other European MTF, has been losing money, but the banks that fostered it want to realize some upside. The LSE, which has been trying to convince major banks to take equity stakes in Baikal, could gain shareholders (and liquidity providers) if Turquoise’s backers agree to roll over their holdings for shares in the combined entity. Given Rolet’s dedication to developing a pan-European platform to compete with external MTFs, the merged Turquoise-Baikal venue might eventually turn a profit. An estimated 10 to 15 percent of all trading activity in Europe is now being executed in dark pools, according to Baikal’s CEO, John Wilson. That translates into £5 billion to £8 billion worth of daily trades that are up for grabs.
“Cutting a deal for Turquoise has the potential to be more positive for the LSE than many people realize,” says Sarah Spikes, an analyst for London-based brokerage firm Arden Partners. “Dark volumes tend to have higher margins than lit volumes, and that would of course be good for the LSE’s shrinking margins. But if they get this done, they’ll be the only exchange to have a pan-European dark pool of any real size and scale — and the only ones whose dark pool is aligned with their own customers, which could be a very big differentiator for the LSE.”
In hiring Rolet, the board of the LSE has put the future of the exchange in the hands of an executive who knows what its clients want, having been one himself. The board also chose the one candidate most likely to seek out crazily competitive, adrenaline-fueled challenges. In January, as the shortlist was being finalized, Rolet was tearing across the Atacama Desert in a Toyota Land Cruiser in the Argentina-to-Chile version of the Dakar Rally. The nearly-10,000-kilometer, off-road endurance race took the teams across the driest deserts in the world, composed of mostly sand dunes, salt basins and lava flows. For Rolet, who alternated driving and navigating duties with his friend Jean-Louis Juchault, co-founder and former CEO of hedge fund firm Systeia Capital Management, the thrill of competition trumped the discomfort of the heat and dust — but he still lost more than 20 pounds in two weeks.
Rolet must now translate his innate competitive drive into strong leadership at the LSE. For a man who grew up in the tough Parisian banlieue of Sarcelles, however, willpower is not in short supply. Rolet has never had the benefit of privilege; his parents served in the French military. For Rolet education was the surest way out of Sarcelles’ back streets. Having completed his initial degree at the Ecole Supérieure de Commerce de Paris in 1981, he served as a second lieutenant and instructor at the French Air Force Academy before setting off to get an MBA at Columbia University in New York.
Rolet’s first job, after completing his MBA in 1984, was at Goldman Sachs, where he worked as a trader on the international arbitrage desk and found a mentor in future Treasury secretary Robert Rubin. He spent ten years at Goldman in New York and London, and then went on to work for Credit Suisse First Boston and Dresdner Kleinwort Benson. In 2000 he joined Lehman in New York and was soon promoted to co-head of global equity trading. In 2001 he moved back to London to head up Lehman’s European and Asian cash equities division; in 2003 he was asked to lead the bank’s newly created European senior client relationship management group. In that context he became the lead relationship banker to the LSE and served on the boards of rival exchanges Euronext and Nasdaq Europe. In July 2007 he was promoted to CEO of Lehman’s French operations, just a year before the parent company went bankrupt.
Meanwhile, the LSE was struggling to strike strategic deals under former CEO Furse, whose autocratic management style won her the dubious accolade “Queen Clara” from London’s dailies. Before Rolet’s involvement, the LSE had launched an unsuccessful attempt in 2001 to acquire Liffe. Even now, analysts and rivals talk about the failed bid as the most damaging strategic misstep in the exchange’s history. Furse had once been a deputy chairman of Liffe, and the deal was seen as a natural for the LSE, but its offer of £575 million in cash and shares did not appeal to Liffe’s board, which in a surprising move accepted a lower all-cash offer of £555 million from Euronext.
“Ultimately, it was a significant strategic error for the LSE, because it would have been a powerhouse combination if the offer had been correctly structured,” says Mark Hemsley, CEO of Bats Europe, who was Liffe’s chief information officer at the time. “But the LSE absolutely missed the opportunity. Clara Furse had a great defense but no offense.”
Not even Furse’s belated decision to acquire Borsa Italiana in 2007 in an all-share deal valued at £1.10 billion dispelled the image of the LSE as a stand-alone equity market — although it did bring the LSE several new assets, including clearinghouse CC&G, equity derivatives platform IDEM, pan-European government bond trading platform MTS and post-trade and settlements business Monte Titoli.
Even now, more than two years on, however, revenue from equity trading is still absolutely critical to the group: In the LSE’s results for the fiscal half-year ended September 30, cash equities trading alone contributed 23 percent of the group’s total revenue of £310.9 million. Trading on its derivatives and fixed-income platforms, however, contributed a mere 7 percent. Rounding out the LSE’s sources of revenue during that period, information and technology services accounted for 34 percent; post-trade services 19 percent; and the LSE’s annual fees, admission fees and other capital markets activities 17 percent.
By comparison, Deutsche Börse relies far less on income from cash equities, which contributed just 12 percent of its total sales revenue for the six months ended June 30 (the first half of its fiscal year), and far more on the diversity and strength of its constituent businesses, including its wholly owned clearinghouse, Clearstream, and derivatives exchange, Eurex, jointly operated with SIX Swiss Exchange. Eurex — the second-largest global derivatives exchange by volume after CME Group — generated nearly 40 percent of the parent company’s €1,055.4 million ($1,680.1 million) in sales revenue during the first half of its fiscal year.
Unlike his predecessor, Rolet is keen to make aggressive changes in the way the LSE runs its business. In the seven months since his arrival, he has wasted no time in seeking to leverage its Borsa Italiana acquisition to reach a broader audience. He has also fought to make the company more competitive by cutting staff and operational costs, changing the pricing model on the main exchange and preparing to overhaul the LSE’s trading infrastructure.
But the LSE is still undeniably vulnerable. For the six months ended September 30, operating profits for the LSE plunged by 26 percent, to £134.8 million, compared with the same period in 2008, sending its shares tumbling by 7.4 percent, to 754 pence, the day after the November 25 earnings release.
The need to upgrade the LSE’s trading infrastructure is acute. As soon as Rolet arrived, he began a reassessment of the core trading platform to understand its weaknesses. Under Furse the LSE had implemented new execution software, called TradElect, in June 2007, after a four-year, £40 million planning process; but the system is still slower than those of rivals Chi-X and Bats Europe. TradElect has also been prone to problems: In September 2008, at the peak of the financial crisis, network disruptions knocked it off-line for about seven hours; its most recent three-hour failure, on November 26, didn’t boost anyone’s confidence.
In late May, Rolet’s director of information and technology, David Lester, quietly inaugurated a global search for a new trading platform. In September the LSE announced that it was acquiring Sri Lankan technology company MillenniumIT — and that acquisition is now complete. At a briefing for industry analysts later than month, Lester explained that the $30 million deal brings the LSE a high-performance, scalable matching engine to replace TradElect and the capability to conduct in-house software development with MillenniumIT’s team. The 13-year-old company, which is profitable in its own right, is already a market leader in developing trading platforms and financial software for exchanges, depositories, brokerages and market regulators around the world.
To make the LSE more competitive with the MTFs, Rolet has to reduce the cost of trading. He is not alone in that challenge: Pricing for all of the incumbent exchanges remains a sore point, but the problem is especially thorny for the LSE. Even if the exchange group dropped its prices to zero, explains Rolet, the cost of trading on the LSE’s main market would still be about 3.5 times higher than trading on any rival MTF, because the LSE’s total clearing costs, including netting and settlement, are so high. Analysts point to LCH.Clearnet Group, which does most of the clearing for the LSE, as the primary culprit. LCH.Clearnet, in turn, blames Euroclear U.K. & Ireland, which nets all the trades it clears for the LSE, as the source of the problem.
Regardless of how blame is apportioned, the cost of clearing is an issue for Rolet and his deputy CEO, Massimo Capuano, the CEO of Borsa Italiana. Capuano, who now oversees a new post-trade division for LSE Group, is looking to leverage the potential of CC&G, its Italian clearinghouse. At the September analysts’ briefing, Capuano announced that CC&G had just received regulatory approval by the Financial Services Authority to provide an alternative clearing venue for the LSE’s U.K.-based clients.
The MTFs are applying pricing pressure to the LSE by battling to undercut each other on trading fees. Huge discount trading sales come and go in European blue-chips as quickly as high street fashions. Industrywide, the MTFs employ a nearly ubiquitous maker-taker pricing model, which provides a rebate to customers that add liquidity to the market and charges customers to take liquidity. Those fee structures, which benefit the owners of the MTFs by paying them a rebate when they use their own platforms, also help attract new clients — like high-frequency trading firms — to the venues.
In September the LSE broke from the pack and abolished its maker-taker fee structure, reverting to a simple, fixed fee whether customers provide or remove liquidity from the market. The goal, Rolet says, is to balance charges applicable to each side of a transaction and to substantially lower the threshold for volume discounts. Although the move was designed to appeal to the big brokerage houses, it came as a surprise to many analysts.
“This is not going to be something that the high-frequency community responds well to,” says Justin Schack, a market structure analyst for New York–based Rosenblatt Securities.
The irony of Europe’s grand experiment in market deregulation is that it is forcing incumbent exchanges to adapt faster than anyone anticipated — and that process still has a long way to go. As commoditized as equity trading has become in Europe, the total volume of trading looks set to rise: Currently, European equity markets have about one tenth the daily liquidity of the U.S., where the average value of shares traded hits about $300 billion a day. Even though MiFID didn’t take into account the frictional costs posed by Europe’s complex, thorny clearing structure — a situation very unlike the U.S., where all clearing is handled centrally by the Depository Trust & Clearing Corp. — volumes may start to climb now that the incumbent exchanges and MTFs are vying to develop faster, cheaper and more capacious trading infrastructure and the clearinghouses are coming under pressure to reduce their costs. Although the FSA recently chose to step in and assess the risks of greater clearing interoperability, it is surely coming, led by European Central Counterparty, or EuroCCP, the European subsidiary of DTCC, and the European Multilateral Clearing Facility, or EMCF, which was established in 2007 to provide clearing services for several MTFs, including Bats Trading, Chi-X and Neuro.
The unintended consequences of MiFID are also becoming obvious, as competition breeds fragmentation — and fragmentation attracts a thundering herd of American opportunists. In August the FSA inaugurated informal talks with a few investment banks, hedge funds and other asset managers to assess the market impact of high-frequency trading firms on equity markets, but no formal probe was launched. Although regulators appear nonplussed by the arrival of high-frequency trading firms, like Getco and Tradebot, their growing presence is a direct result of MiFID.
“The flip side of competition is market fragmentation and inefficiency,” Rolet says. “Regulators need to accept that high-frequency traders are in essence very necessary, because they help arbitrage away the differences among the various trading venues’ technologies, latencies, fee schedules and pricing spreads.”
As difficult as the LSE’s competitive position is, Rolet sees opportunity in the shadow of the global economic crisis, which is forcing companies to re-equitize. Having come off a debt-fueled global binge, financial institutions first have to write down their losses — and then raise new capital. The LSE, which is still the global leader in new equity issuance, is well positioned to reap the benefits.
Even as the LSE battles to retain its market share and win new customers, however, its business will have to evolve. Rolet is clearly looking at the potential of the LSE to play a greater role in trading derivatives as a means of remaining competitive in an increasingly global, multi-asset exchange industry. Had the LSE won Liffe in 2001, the embattled exchange might now look more like Deutsche Börse, whose massive derivatives exchange, Eurex, recently bought U.S.-based International Securities Exchange Holdings, making the two entities — on a combined basis — the global market leader in individual equity and equity index derivatives. Instead, the LSE is lagging far behind. But Rolet is keenly aware of the growing regulatory pressures to process some derivatives currently traded in over-the-counter markets, like credit-default swaps, through central clearing counterparties — and even possibly move them onto exchange-traded platforms — which would create tremendous opportunity.
“Derivatives are going to be key to our future development,” Raffaele Jerusalmi, the LSE’s head of capital markets, told analysts on September 24. “The growth of this market, which is compounding at 35 percent annually, is extraordinary — and that growth is going to continue. Regulatory pressure is going to push to make the derivatives space more and more transparent.”
The question facing the London Stock Exchange, however, is whether the venerable, 208-year-old business can evolve quickly enough to become a global powerhouse on the scale of NYSE Euronext, Nasdaq OMX and Deutsche Börse — or whether it will be subsumed by one of its competitors before it has a chance to diversify its business. The proposed takeover of Turquoise would help buy the LSE some time to maneuver, but if the deal falls through in the coming weeks, Rolet will have to find another way to compete with his rivals for pan-European trade flows. The task won’t be easy; the LSE doesn’t have a ready alternative should the talks with Turquoise stall. But compete, Rolet will. Ceding ground is not in his nature.
