Why the marriage failed

A few hours after its decision to block the Deutsche Börse and NYSE Euronext merger, the European Commission released the details of its ruling (a memo can be found here). The deal’s failure comes down to three disagreements about the competition, actual or potential, between exchanges.

The first is whether OTC - over-the-counter trades indeed compete with ETDs - exchange-traded derivatives. DB and NYSE think they do. If this is right, their joint share (over 90%) in European ETDs looks tiny, as exchange-based trades are a small fraction (around 15%) of the overall derivatives industry.

The Commission takes a different view, arguing that size and specification differences mean that OTC trades and ETDs are not competitors. ETDs are typically around €100,000 per trade, and are standardised. OTC trades (made directly between two investors, without the involvement of an exchange) are typically 2,000 times larger and are customised to meet specific buyer and seller requirements. Trading a contract OTC is up to eight times more expensive than trading a comparable contract on an exchange. All this means that the option of going OTC is unlikely to protect investors facing a significant hike in ETD trading charges. A similar argument could be made about cars: the prices of supercars (low sales, personally tailored) are not going to constrain price increases when makers of budget cars (high sales, standardised vehicles) merge.

A second disagreement is over competition between exchanges providing short-term and long-term derivatives. Those supporting the deal argue that DB’s Eurex and NYSE Euronext’s Liffe specialise in providing different types of derivatives. Eurex is the biggest provider of German two, five and ten year interest rate derivatives, while Liffe operates at the short end of the yield curve. The Commission rejects this argument, arguing that potential competition is as important as actual competition. While actual competition between Liffe and Eurex is limited, it explains, evidence suggests the competitive threat has kept trading charges down. Removing this competitive constraint by allowing the merger could result in higher trading charges, harming investors.

The final leg of the disagreement is the question of global competitors including Chicago's large exchange, CME Group. The Commission recognises that the exchanges industry is global, and should include CME Group. But it argues that non-European exchanges actually have a minuscule presence in European derivatives trading, and so do not currently compete with Eurex and Liffe. This is the Commission's weakest point as it jars with its view on the importance of potential competition. If the merger is damaging because Eurex and Liffe are each other's potential competitors, it is hard to see why this argument does not apply to CME Group, another potential competitor.

What will DB and NSYE Euronext do next? One option is to challenge the decision. History suggests this could be successful. The Commission has blocked 22 corporate marriages so far, but in three cases it was overruled by Europe's Court of First Instance in 2002: the mergers between the travel companies Airtours and First Choice, the electrical components makers Schneider and Legrand, and the packaging firms Tetra Laval and Sidel. Each case was different, but essentially the court's view was that the Commission's competition unit, then led by Mario Monti, now Italy's prime minister, had made the wrong call.

Another option would be to look for other exchanges to wed. Potential partners for NYSE Euronext include the London Metals Exchange, an acquisition where competition concerns are likely to be lower, and LCH.Clearnet, which would boost NYSE Euronext's post trade clearing capabilities. Although there are still lots of smaller players to mop up, today’s message from Brussels is clear: any plans to unite exchanges that are close or potential competitors are likely to be blocked.

(Published by The Economist - February 1, 2012)