EUROPEAN STOCKMARKETS–GENERAL TREND
Competition among Europe’s securities exchanges is fierce. Yet most investors and companies would prefer fewer, bigger markets. If the exchanges do not get together to provide them, electronic usurpers will.
How many stock exchanges does a Europe with a single capital market need? Nobody knows. But a part-answer is clear: fewer than it has today. America has eight stock exchanges, and seven futures and options exchanges. Of these only the New York Stock Exchange, the American Stock Exchange, NASDAQ (the over-the-counter market), and the two Chicago futures exchanges have substantial turnover and nationwide pretensions.
The 12 member countries of the European Community (EC), in contrast, boast 32 stock exchanges and 23 futures and options exchanges. Of these, the market in London, Frankfurt, Paris, Amsterdam, Milan and Madrid–at least–aspire to significant roles on the European and world stages. And the number of exchanges is growing. Recent arrivals include exchanges in Italy and Spain. In eastern Germany, Leipzig wants to reopen the stock exchange that was closed in 1945.
Admittedly, the EC is not as integrated as the United States. Most intermediaries, investors and companies are still national rather than pan-European in character. So is the job of regulating securities markets; there is no European equivalent of America’s Securities and Exchange Commission (SEC). Taxes, company law and accounting practices vary widely. Several regulatory barriers to cross-border investment, for instance by pension funds, remain in place. Recent turmoil in Europe’s exchange rate mechanics has reminded cross0border investors about currency risk. Despite the Maastricht treaty, talk of a common currency is little more than that
Yet the local loyalties that sustain so many European exchanges look increasingly out-of-date. Countries that once had regional stock exchanges have seen them merged into one. A single European market for financial services is on its way. The EC's investment services directive, which should come into force in 1996, will permit cross-border stockbroking without the need to set up local subsidiaries. Jean-Francois Theodore, chairman of the Paris Bourse, says this will lead to another European Big Bang. And finance is the multinational business par excellence: electronics and the end of most capital controls mean that securities traders roam not just Europe but the globe in search of the best returns.
This affects more than just stock exchanges. Investors want financial market that are cheap, accessible and of high liquidity (the ability to buy or sell shares without moving the price). Businesses, large and small, need a capital market in which they can raise finance at the lowest possible cost If European exchanges do not meet these requirements, Europe's economy suffers.
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In the past few years the favoured way of shaking up bourses has been competition. The event that triggered this was London's Big Bang in October 1986, which opened its stock exchange to banks and foreigners, and introduced a screen-plus-telephone system of securities trading known as SEAQ. Within weeks the trading floor had been abandoned. At the time, other European bourses saw Big Bang as a British eccentricity. Their markets matched buy and sell orders (order-driven trading), whereas London is a market in which dealers quote firm prices for trades (quote-driven trading). Yet many continental markets soon found themselves forced to copy London's example.
That was because Big Bang had strengthened London's grip on international equity-trading. SEAQ's international arm quickly grabbed chunks of European business. Today the London exchange reckons to handle around 95% of all European cross-border share-trading It claims to handle three-quarters of the trading in blue-chip shares based in Holland, half of those in France and Italy and a quarter of those in Germany—though, as will become clear, there is some dispute about these figures.
London's market-making tradition and the presence of many international fund managers helped it to win this business. So did three other factors. One was stamp duties on share deals done in their home countries, which SEAQ usually avoided. Another was the shortness of trading hours on continental bourses. The third was the ability of SEAQ, with market-makers quoting two-way prices for business in large amounts, to handle trades in big blocks of stock that can be fed through order-driven markets only when they find counterparts.
A similar tussle for business has been seen among the exchanges that trade futures and options. Here, the market which first trades a given product tends to corner the business in it. The European Options Exchange (EOE) in Amsterdam was the first derivatives exchange in Europe; today it is the only one to trade a European equity-index option. London's LIFFE, which opened in 1982 and is now Europe's biggest derivatives exchange, has kept a two-to-one lead in German government-bond futures (its most active contract) over Frankfurt's DTB, which opened only in 1990. LIFFE competes with several other European exchanges, not always successfully: it lost the market in ecu-bond futures to Paris's MATIF.
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European exchanges armoured themselves for this battle in three ways. The first was to fend off foreign competition with rules. In three years of wrangling over the EC's investment-services directive, several member-countries pushed for rules that would require securities to be traded only on a recognized exchange. They also demanded rules for the disclosure of trades and prices that would have hamstrung SEAQ's quote-driven trading system. They were beaten off in the eventual compromise, partly because governments realized they risked driving business outside the EC. But residual attempts to stifle competition remain. Italy passed a law in 1991 requiring trades in Italian shares to be conducted through a firm based in Italy. Under pressure from the European Commission, it may have to repeal it.
New Ways for Old
The second response to competition has been frantic efforts by bourses to modernize systems, improve services and cut costs. This has meant investing in new trading systems, improving the way deals are settled, and pressing governments to scrap stamp duties. It has also increasingly meant trying to beat London at its own game, for instance by searching for ways of matching London's prowess in block trading.
Paris, which galvanized itself in 1988, is a good example. Its bourse is now open to outsiders. It has a computerized trading system based on continuous auctions, and settlement of most of its deals is computerized. Efforts to set up a block-trading mechanism continue, although slowly. Meanwhile, MATIF, the French futures exchange, has become the continent's biggest. It is especially proud of its ecu-bond contract, which should grow in importance if and when monetary union looms.
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Frankfurt, the continent's biggest stock-market, has moved more ponderously, partly because Germany's federal system has kept regional stock exchange in being, and left much of the regulation of its markets at Land (state) level. Since January 1st 1993 all German exchanges (including the DTB) have been grouped under a firm called Deutsche Borse AG, chaired by Rolf Breuer, a member of Deutsche Bank’s board. But there is still some way to go in centralizing German share-trading. German floor brokers continue to resist the inroads made by the bank’s screen-based IBIS trading system. A law to set up a federal securities regulator (and make insider-dealing illegal) still lies becalmed in Bonn.
Other bourses are moving too. Milan is pushing forward with screen-based trading and speeding up its settlement. Spain and Belgium are reforming their stock-markets and launching new futures exchanges. Amsterdam plans an especially determined attack on SEAQ. It is implementing a McKinsey report that recommended a screen-based system for wholesale deals, a special mechanism for big block trades and a bigger market-making role for brokers.
Ironically, London now finds itself a laggard in some respects. Its share settlement remains prehistoric; the computerized project to modernize it has just been scrapped. The SEAQ trading system is falling apart; only recently has the exchange, belatedly, approves plans draw up by Arthur Andersen for a replacement, and there is plenty of skepticism in the City about its ability to deliver. Yet the exchange’s claimed figures for its share of trading in continental equities suggest that London is holding up well against its competition.
Are these figures correct? Not necessarily: deals done through an agent based in London often get counted as SEAQ business even when the counterpart is based elsewhere and the order has been executed through a continental bourse. In today’s electronic age, with many firms members of most European exchanges, the true location of a deal can be impossible to pin down. Continental bourses claim, anyway, to be winning back business lost to London.
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Financiers in London agree that the glory-days of SEAQ’s international arm, when other European exchanges were moribund, are gone. Dealing in London is now more often a complement to, rather than a substitute for, dealing at home. Big blocks of stock may be bought or sold through London, but broken apart or assembled through local bourses. Prices tend to be derived from the domestic exchanges; it is notable that trading on SEAQ drops when they are closed. Baron van Ittersum, chairman of the Amsterdam exchange, calls this the “queen’s birthday effect”: trading in Dutch equities in London slows to a trickle on Dutch public holidays.
Such competition-through-diversity has encourage European exchanges to cut out the red tape that protected their members from outside competition, to embrace electronics, and to adapt themselves to the wishes of investors and issuers. Yet the diversity may also have had a cost in lower liquidity. Investors, especially from outside Europe, are deterred if liquidity remains divided among different exchanges. Companies suffer too: they grumble about the costs of listing on several different markets.
So the third response of Europe’s bourses to their battle has been pan-European co-operative ventures that could anticipate a bigger European market. There are more wishful words here than deeds. Work on two joint EC projects to pool market information, Pipe and Euroquote, was abandoned, thanks mainly to hostility from Frankfurt and London. Eurolist, under which a company meeting the listing requirements for one stock exchange will be entitled to a listing on all, is going forward–but this is hardly a single market. As Paris’s Mr Theodore puts it, "there is a compelling business case for the big European exchanges building the European-regulated market of to-morrow" Sir Andrew Hugh-Smith, chairman of the London exchange has also long advocated one European market for professional investors
One reason little has been done is that bourses have been coping with so many reforms at home. Many wanted to push these through before thinking about Europe. But there is also atavistic nationalism. London, for example, is unwilling to give up the leading role it has acquired in cross-border trading between institutions; and other exchanges are unwilling to accept that it keeps it. Mr. Theodore says there is no future for the European bourses if they are forced to row in a boat with one helmsman. Amsterdam's Baron van Ittersum also emphasises that a joint European market must not be one under London's control.
Hence the latest, lesser notion gripping Europe's exchanges: bilateral or multilateral links. The futures exchanges have shown the way. Last year four smaller exchanges led by Amsterdam's EOE and OM, an options exchange based in Sweden and London, joined together in a federation called FEX In January of this year the continent's two biggest exchanges, MATIF and the DTB, announced a link-up that was clearly aimed at toppling London's LIFFE from its dominant position Gerard Pfauwadel, MATIF's chairman, trumpets the deal as a precedent for other European exchanges. Mr Breuer, the Deutsche Borse's chairman, reckons that a network of European exchanges is the way forward, though he concedes that London will not warm to the idea. The bourses of France and Germany can be expected to follow the MATIF/DTB lead.
It remains unclear how such link-ups will work, however. The notion is that members of one exchange should be able to trade products listed on another. So a Frenchman wanting to buy German government-bond futures could do so through a dealer on MATIF, even though the contract is actually traded in Frankfurt. That is easy to arrange via screen-based trading: all that are needed are local terminals. But linking an electronic market such as the DTB to a floorbased market with open-outcry trading such as MATIF is harder Nor have any exchanges thought through an efficient way of pooling their settlement systems
In any case, linkages and networks will do nothing to reduce the plethora of European exchanges, or to build a single market for the main European blue-chip stocks. For that a bigger joint effort is needed It would not mean the death of national exchanges, for there will always be business for individual investors, and in securities issued locally Mr Breuer observes that ultimately all business is local. Small investors will no doubt go on worrying about currency
risk unless and until monetary union happens. Yet large wholesale investors are already used to hedging against it. For them, investment in big European blue-chip securities would be much simpler on a single wholesale European market, probably subject to a single regulator
More to the point, if investors and issuers want such a market, it will emerge—whether today's exchanges provide it or not. What, after all, is an exchange? It is no more than a system to bring together as many buyers and sellers as possible, preferably under an agreed set of rules. That used to mean a physically supervised trading floor. But computers have made it possible to replicate the features of a physical exchange electronically. And they make the dissemination of prices and the job of applying rules to a market easier.
Most users of exchanges do not know or care which exchange they are using: they deal through brokers or dealers. Their concern is to deal with a reputable firm such as S. G. Warburg, Gold-man Sachs or Deutsche Bank, not a reputable exchange. Since big firms are now members of most exchanges, they can choose where to trade and where to resort to off-exchange deals—which is why there is so much dispute over market shares within Europe This fluidity creates much scope for new rivals to undercut established stock exchanges.
Europe, Meet Electronics
Consider the experience of the New York Stock Exchange, which has remained stalwartly loyal to its trading floor. It has been losing business steadily for two decades, even in its own listed stocks. The winners have included NASDAQ and cheaper regional exchanges. New York's trading has also migrated to electronic trading systems, such as Jeffries & Co's Posit, Reuters's Instinct and Wunsch (a computer grandly renamed the Arizona Stock Exchange).
Something similar may happen in Europe. OM, the Swedish options exchange, has an electronic trading system it calls Click. It recently renamed itself the London Securities and Derivatives Exchange. Its chief executive, Lynton Jones, dreams of offering clients side-by-side on a screen a choice of cash products, options and futures, some of them customised to suit particular clients The Chicago futures exchanges, worried like all established exchanges about losing market share, have recently launched "flex" contracts that combine the virtues of homogeneous exchange-traded products with tailor-made over-the-counter ones.
American electronic trading systems are trying to break into European markets with similarly imaginative products Instinet and Posit are already active, though they have had limited success so far. NASDAQ has an international arm in Europe. And there are homegrown systems, too. Tradepoint, a new electronic order-driver trading system for British equities, is about to open in London. Even bond-dealers could play a part. Their trade association, ISMA, is recognized British exchange for trading in Eurobonds; it has a computerized reporting system known as TRAX; most of its members use the international clearing-houses Euroclear and Cedel for trade settlement. It would not be hard for ISMA to widen its scope to include equities or futures and options. The association has recently announced a link with the Amsterdam Stock Exchange.
Electronics poses a threat to established exchanges that they will never meet by trying to go it alone. A single European securities market (or derivatives market) need not look like an established stock exchange at all. It could be a network of the diverse trading and settlement systems that already exists, with the necessary computer terminals scattered across the EC. It will need to be regulated at the European level to provide uniform reporting; an audit trail to allow deals to be retraced from seller to buyer; and a way of making sure that investors can reach the market makers offering the best prices. Existing national regulators would prefer to do all this through co-operation; but some financiers already talk of need for a European SEC. An analogy is European civil aviation’s reluctant inching towards a European system of air-traffic control.
Once a Europe-wide market with agreed regulation is in place, competition will window out the winners and losers among the member- bourses, on the basis of services and cost, or of the rival charms of the immediacy and size of quote-driven trading set against the keener prices of order-driven trading. Not a cosy prospect; but if the EC’s existing exchanges do not submit to such a European framework, other artists will step in to deny them the adventure.
NEW ISSUES
Up to now, we have talked about the function of securities markets as trading markets, where one investor who wants to move out of a particular investment can easily sell to another investor who wishes to buy. We have not talked about another function of the securities markets, which is to raise new capital for corporations–and for the federal government and state and local governments.
When you buy shares of stock on one of the exchanges, you are not buying a “new issue”. In the case of an old established company, the stock may have been issued decades ago, and the company has no direct interest in your trade today, except to register the change in ownership on its books. You have taken over the investment from another investor, and you know that when you are ready to sell, another investor will buy it from you at some price.
New issues are different. You have probably noticed the advertisements in the newspaper financial pages for new issues of stocks or bonds–large advertising which, because of the very tight restrictions on advertising new issues, state virtually nothing except the name of the security, the quantity being offered, and the names of the firms which are “underwriting” the security or bringing it to market.
Sometimes there is only a single underwriter; more often, especially if the offering is a large one, many firms participate in the underwriting group. The underwriters plan and manage the offering. They negotiate with the offering company to arrive at a price arrangement which will be high enough to satisfy the company but low enough to bring in buyers. In the case of untested companies, the underwriters may work for a prearranged fee. In the case of established companies, the underwriters usually take on a risk function by actually buying the securities from the company at a certain price and reoffering them to the public at a slightly higher price; the difference, which is usually between 1% and 7%, is the underwriters’ profit. Usually the underwriters have very carefully sounded out the demand is disappointing–or if the general market takes a turn for the worse while the offering is under way–the underwriters may be left with securities that can’t be sold at the scheduled offering price. In this case the underwriting “syndicate” is dissolved and the underwriters sell the securities for whatever they can get, occasionally at a substantial loss.
The new issue process is critical for the economy. It’s important that both old and new companies have the ability to raise additional capital to meet expanding business needs. For you, the individual investor, the area may be a dangerous one. If a privately owned company is “going public” for the fist time by offering securities in the public market, it is usually does so at a time when its earnings have been rising and everything looks particularly rosy. The offering also may come at a time when the general market is optimistic and prices are relatively high. Even experienced investors can have great difficulty in assessing the real value of a new offering under these conditions.
Also, it may be hard for your broker to give you impartial advice. If the brokerage firm is in the underwriting group, or in the “selling group” of dealers that supplements the underwriting group, it has a vested interest in seeing the securities sold. Also, the commissions are likely to be substantially higher than on an ordinary stock. On the other hand, if the stock is a “hot issue” in great demand, it may be sold only through small individual allocations to favored customers (who will benefit if the stock then trades in the open market at a price well above the fixed offering price)
If you are considering buying a new issue, one protective step you can take is to read the prospectus The prospectus is a legal document describing the company and offering the securities to the public. Unless the offering is a very small one, it can't be made without passing through a registration process with the SEC. The SEC can't vouch for the value of the offering, but it does act to make sure that essential facts about the company and the offering are disclosed in the prospectus.
This requirement of full disclosure was part of the securities laws of the 1930s and has been a great boon to investors and to the securities markets. It works because both the underwriters and the offering companies know that if any material information is omitted or misstated in the prospectus, the way is open to lawsuits from investors who have bought the securities.
In a typical new offering, the final prospectus isn't ready until the day the securities are offered. But before that date you can get a "preliminary prospectus" or "red herring"—so named because it carries red lettering warning that the prospectus hasn't yet been cleared by the SEC as meeting disclosure requirements
The red herring will not contain the offering price or the final underwriting arrangements But it will give you a description of the company's business, and financial statements showing just what the company's growth and profitability have been over the last several years It will also tell you something about the management. If the management group is taking the occasion to sell any large percentage of its stock to the public, be particularly wary.
It is a very different case when an established public company is selling additional stock to raise new capital. Here the company and the stock have track records that you can study, and it's not so difficult to make an estimate of what might be a reasonable price for the stock The offering price has to be close to the current market price, and the underwriters' profit margin will generally be smaller But you still need to be careful. While the SEC has strict rules against promoting any new offering, the securities industry often manages to create an aura of enthusiasm about a company when an offering is on the way On the other hand, the knowledge that a large offering is coming may depress the market price of a stock, and there are times when the offering price turns out to have been a bargain
New bond offerings are a different animal altogether. The bond markets are highly professional, and there is nothing glamorous about a new bond offering. Everyone knows that a new A-rated corporate
bond will be very similar to all the old A-rated bonds. In fact, to sell the new issue effectively, it is usually priced at a slightly higher "effective yield" than the current market for comparable older bonds—either at a slightly higher interest rate, or a slightly lower dollar price, or both. So for a bond buyer, new issues often offer a slight price advantage.
What is true of corporate bonds applies also to U.S. government and municipal issues. When the Treasury comes to market with a new issue of bonds or notes (a very frequent occurrence), the new issue is priced very close to the market for outstanding (existing) Treasury securities, but the new issue usually carries a slight price concession that makes it a good buy. The same is true of bonds and notes brought to market by state and local governments; if you are a buyer of municipals, these new offerings may provide you with modest price concessions. If the quality is what you want, there's no reason you shouldn't buy them—even if your broker makes a little extra money on the deal.
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