On 1 February 2012 the European Commission (the "Commission") announced its decision to prohibit the merger between Deutsche Bӧrse and NYSE Euronext. The Commission concluded that the merger would bring together the two largest financial derivatives exchanges in the world, Liffe and Eurex. The Commission determined that the merger would result in the establishment of a quasi-monopoly in relation to European financial derivatives traded globally on exchanges (European interest rates, single stock equity and equity index derivatives).
Market Definition
The Commission determined that the relevant market for derivatives depended upon the level of standardisation of the product. Therefore derivatives traded through a dealer network called over-the-counter derivatives ("OTC" derivatives) and exchange-traded derivatives ("ETDs") formed separate markets.
Furthermore, contrary to the parties' arguments that this was a global market, the Commission identified that the relevant geographic market depended upon the underlying asset upon which the derivative was based, therefore the relevant market was that of European ETDs.
Competitive Assessment
The Commission found that Liffe and Eurex were each other's closest competitors in the market for ETDs based on European interest rates or equities as this formed the focus of both parties' business. Both are also of a similar size, possessing a large membership base and a large portfolio of contracts which they offer to trading and clearing. The Commission also found that Eurex and Liffe exert strong competitive pressure on each other in relation to those contracts where they compete as well as those contracts where the liquidity has settled on one of their platforms. The mere threat of customers switching from one of these exchanges to the other has in the past prompted fee cuts and innovation. This would be lost post-merger.
According to the Commission, no other competitor can match the parties' offering or margin pool. Other companies which provide similar services worldwide exert a weak constraint on the parties. Chicago Mercantile Exchange ("CME") for example, has a limited presence in derivatives based on European underlyings and only competes marginally in certain asset classes. In particular the CME could not provide comparable collateral savings to those offered by the parties. The Commission therefore considered it unlikely that CME would be a credible competitive force to constrain the merged entity. Post-merger, users of these contracts would therefore have no choice but to use the merged entity. As a result of the loss of competition between the two exchanges, the merged entity would be able to raise prices and reduce innovation in derivatives products and technology solutions.
Vertical Foreclosure
In addition the Commission found that the merged entity would be able to raise barriers to entry which were already high by refusing rival derivatives platforms access to its post-trade clearing facilities. This was because Eurex and Liffe both operate closed vertical silos linking their exchange to their own clearing house. The merger would have resulted in a single vertical silo which would have traded and cleared over 90% of the global market for European ETDs. Post-merger, entry by a competitor would have been more difficult as customers would prefer the advantages offered by the merged entity of clearing similar contracts in a single clearing house. This would reduce the possibilities for fee competition and have a negative impact on customers such as mutual and pension funds, professional brokers and investment banks as well as retail banks.
The Commission was also concerned about the effect of the transaction on equities trading and settlement and index licensing.
Pro-competitive benefits of the merger
The Commission rejected the parties' arguments that the merger would benefit customers by offering greater liquidity and by reducing the collateral they have to post as security, considering that there was no evidence that liquidity would be likely to increase as a result of the merger and in fact evidence suggested that competition rather than consolidation generated liquidity gains. It acknowledged that the merger may lead to some collateral savings as a result of increased cross-margining opportunities, but these savings were not significant enough to outweigh the harm to consumers and could partly be achieved without the merger. This is because the relevant measure for actual cost savings is not the collateral savings but the benefits that can be gained by using this money for the best alternative purpose.
Remedies offered
Remedies offered by the parties were rejected as insufficient to allay the Commission's concerns, difficult to implement and unlikely to be effective.
- The Commission considered that a divestment of Liffe's European single stock derivatives business was too small and not diversified enough to be a viable stand-alone business. There was also a likelihood that customers would trade out of their positions rather than transferring to a new acquirer, thereby eroding the transferable open interest.
- The parties offered access to the merged entity's clearing house for materially new interest rate, bond and equity index derivatives contracts. However the Commission's market test revealed that no contracts would satisfy the criteria for access.
- The parties also offered to licence Eurex's interest rate derivatives software. The Commission considered this remedy of little use as most competitors already had their own software.
- (The parties also pledged not to increase prices for three years, although this was not offered as a formal commitment. The Commission rejected this pledge as ineffective as it was based on list prices while actual prices are based on rebates. In any case, this commitment would be difficult to implement and monitor).
The Commission did not identify significant competition issues in other areas but noted that if the parties had offered suitable commitments in derivatives markets, the merger would have been cleared and the suggested benefits in cash markets safeguarded.
Comment
The merger was blocked due to a fundamental difference of opinion on a number of points, focussing mainly on market definition.
Firstly, despite arguments that the OTC derivatives and ETD derivatives were in the same market the Commission found that they formed separate markets because of: i) their specification - ETDs are in a standardised format to enable electronic trading, while OTC trades are often customised and negotiated to meet buyer and seller requirements; and ii) their size (ETD contract values are typically much smaller amounts, around €100,000 per trade, as opposed to OTC trade values which are typically around €200,000,000). In addition, trading a contract OTC is significantly more expensive (up to eight times more) than trading a contract on an exchange.1 Consequently, even if the price of trading derivatives contracts on exchanges were to increase by up to 5-10%, investors would still not be likely to have an incentive to switch to trading OTC. Lastly, there are a growing number of investors which for risk management reasons can only trade on exchanges and therefore cannot switch to OTC.
Had the Commission accepted the parties' point that OTC derivatives and ETDs formed part of the same market the parties' combined market share would have been under 20% rather than the 90% which the Commission identified on a narrower definition.2 This is because the vast majority of derivatives are traded directly between banks and other investors (OTC), or over the counter rather than on exchanges.
The parties considered the geographic market for ETDs to be global as both Eurex and Liffe face competition from other derivatives exchanges world-wide, notably Chicago's CME Group ("CME") and the Singapore Stock Exchange ("SSE"). The decision by the Competition Commission in its in-depth investigation of the LSE/Deutsche Bӧrse and LSE/Euronext merger supports the view that the market is global.3 The European Commission in this case noted however that neither CME nor SSE achieve sufficient volumes of trades to compete with the parties (CME achieved a volume of 2,000 contracts compared with 250million traded by Liffe). Therefore the Commission's conclusions on the effects of the merger would have been the same however the geographic market had been defined. This is because it was the loss of competition between each of the parties which were each other's closest competitors which was at issue in this case.
The European Commission found that as Eurex and Liffe are each other's closest competitors, they help drive innovation. It rejected the parties' claims that the merger would not in fact result in a loss of competition between them as Eurex and Liffe provide different types of ETDs - Eurex is the largest provider of German two, five and ten year interest rate derivatives whereas Liffe generally offers shorter term derivatives. While acknowledging that actual competition between the parties in relation to certain ETDs may be limited, the European Commission insisted that the competitive threat of entry by each of the exchanges into the other's core ETD markets had constrained the parties from raising trading charges. For example "Eurex has been trying to compete with Liffe's Euribor contract while Liffe has been trying to rival Eurex's long-term derivatives business".4 To remove this threat could result in higher charges to the detriment of consumers. Furthermore, the boundaries between short-term interest rate derivatives based on European interbank lending rates and European long term interest rate derivatives based on European government debt securities, are becoming blurred, suggesting the parties' may compete head on in relation to these products in the future. The Commission also determined that the parties do compete head-to-head in relation to European interest rate derivatives and equity derivatives. They are of comparable size and no other exchange can match the Parties' offering and margin pool in relation to these particular contracts. Therefore "Eurex and Liffe exert a significant competitive constraint on each other both as concerns the contracts where they currently compete and the contracts where liquidity has settled on one of their platforms".5
This merger also raised tensions and divided opinion within the Commission. Supporters of the merger like Michel Barnier, the French Financial Services Commissioner, believed that the merger was pro-competitive and indeed necessary in order to create a strong European exchange capable of competing vigorously on the global market. Those against the merger, like Joaquín Almunia, Vice President of the European Commission, considered that the creation of a European Champion would not provide sufficient benefit to outweigh the harm to customers and consumers that the merger would cause through the loss of competition between the parties.6
Press releases from both parties suggest that they will not appeal the Commission's decision and will terminate the merger. While this battle may be over, what is clear is that this is not the last we will hear of the European Commission in relation to European derivatives markets - Almunia has revealed that from the information it has gathered during this merger, the Commission will be increasing its competition scrutiny in this area: "given the number and the value of transactions in interest-rate derivatives, and the crucial role these products play in the management of risk, any confirmed manipulation of these interest rates would probably imply a very significant cost to the European economy."7 On 28 February 2012, Almunia revealed that the European Commission is investigating "....certain banks active in financial derivative products linked to the EURIBOR and LIBOR for several currencies [.]"8 which it suspects may have been operating a cartel, contrary to Article 101 of the Treaty on the Functioning of the European Union. All players in this market should take heed of Almunia's warning and make sure their house is in order.
A memo by the European Commission on the merger can be found here
The Commission's decision has not yet been published but will be found at the following link: click here
Footnotes
2.http://www.economist.com/blogs/freeexchange/2012/02/deutsche-b%C3%B6rse-and-nyse-euronext
6.SPEECH/12/131/Joaquín Almunia Vice President of the European Commission responsible for Competition Policy, Competition policy and growth, European Parliament: Internal Market and Consumer protection Committee Brussels, 28 February 2012. http://europa.eu/rapid/pressReleasesAction.do?reference=SPEECH/12/131
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