Post-Brexit questions loom over Europe

The post-Brexit environment is still quite hazy, but the politicians and regulators in the EU are trying to lay markers for future discussions and negotiations. There have been several comments that betray a fear of further demands for exits from  the EU by the politicians and citizens of other countries that have high levels of Euro-scepticism, such as the Netherlands, France and Greece. 
The French president recently stated that clearing for Euro-denominated securities would no longer happen in London and this "could serve as a lesson" to those who are questioning the need for the EU. Strong words indeed for a market that currently gets jittery at the drop of a hat. In a similar move, the president of the German financial regulator, BaFin, has  also expressed doubts on the possibility of the LSE-DB merger if the resultant entity is based in London. The exchanges themselves have mentioned their intention to go on inspite of the added complexity due to Brexit, but I am sure they are keeping an eye on the political headwinds that are developing around them.
On their part, the British politicians and regulators are trying to calm the markets down and lull them into believing that little has changed in the aftermath of Brexit. The desire to delay invoking Article 50 to officially confirm UK's demand for exit is an example of this strategy, although EU leaders are opposed to this move. The claim by the politicans who supported Leave that there would not be any major and immediate economic or financial change after the referendum is another attempt of this nature.
While both these parties would probably be interested in discussing the issues that have arisen behind closed doors, in public they have to make the right noises to ensure damage control. There is also anger and resentment in the EU at the UK's decision and this shows from time to time in some of the comments. The German Chancellor Angela Merkel has a very balanced attitude to Brexit, but she has also conceded that the UK cannot enjoy access to the EU single market the same way as it did earlier, something that was suggested by Boris Johnson. There is a genuine concern in the EU to prevent cherry-picking in this regard. 
The various questions that have arisen post-Brexit will take a while to be answered. But what is clear is that there is going to be a significant parting of ways and the separation is going to be less than amicable, at least in public. For capital market professionals, in this landscape the discussion ends up being about political rather than economic or financial issues, in spite of trying otherwise. The latter have to take a backseat at time like this and this might continue for the weeks and months to come.

A New Black Swan

So the latest Black Swan was spotted in the last few days in the UK when the outcome of the Brexit vote took everyone by surprise. While many are still trying to make sense of the whole situation and figure out what it means for the future, the only thing that is certain at this moment is there will be a lot of uncertainty in the coming weeks, months and possibly years.

In question is the constitutional and political arrangement of the United Kingdom and broader EU, but how is it going to impact the financial services industry? The future of the “bank passport” that allowed financial institutions to do business easily across Europe will be a topic of much interest. Restrictions in ease of doing business might result in them moving out of the UK, and some have already started the process. This would not only result in shifting (if not loss) of banking jobs, but could also balkanize the markets. Technology requirements, for example hosting of data centers within national jurisdictions, could similarly balkanize operations. This would also impact adoption of centralized operations, like cloud services, and slow down the growth of start-up culture and innovation. Balkanized operations and restricted market access would deter or slow down smaller players in designing and launching innovative solutions, and help larger incumbents.

Then there is the question of pan-European regulations and initiatives like Target2 Securities. T2S entailed firms with significant European presence to restructure their operations across Europe. While UK never decided to join the T2S project, firms with European operations were so far busy designing their optimal operational mix within continental Europe. If the UK vote now requires further restructuring that may force them to rethink their current plans and impose additional resource constraints. Also of interest would be the LSE-DB merger; even though both parties have said the deal is not threatened by the vote, politicians might have other ideas.

The political negotiations in the coming weeks would therefore be closely watched as market participants look to navigate their way through the latest developments. All in all the level of complexity and uncertainty in the system has suddenly grown manifold. All blame the Black Swan.

To Brexit and beyond!

So the Brexit has finally happened. The equity, forex and bond markets are still reeling from the news, the volatility probably caused as much by the fact that Brexit was unexpected as of yesterday night in the UK as by the event itself.
While the overall impact will reveal itself over the next several years, in the next few months the capital markets would have to deal with issues such as the future of the LSE-DB merger. Does it make sense anymore, and if yes, how do the two parties proceed? One would expect that now there would be political pressure to ensure that trading and jobs do not move away from either London or Frankfurt. Keeping all stakeholders happy would be a more complicated affair, although it could still be done.
EU wide market infrastructure regulations such as T2S and MiFID II would also now be seen in a new light. London was seen as the financial capital of Europe. The EU would now have to proceed with these significant changes at a time when the UK is preparing to exit, and is weighing its options in terms of how best to deal with the rest of Europe. It could take a middle ground as Switzerland has taken, or position itself even further away with more legal and policy independence but less overlap with the European capital markets.
In an earlier blog that considered the possibility of Brexit, I stated that technologically this might be the best time for an event such as the Brexit. Technology is more advanced and we are better connected than ever before across nations and continents. However, undoubtedly there will still be significant impact from an economic, financial and demographic point of view. As always, there will be winners and losers. As a neutral, one hopes that the people in the UK are able to achieve the goals they had envisioned in making this decision.

Everyone wants the LSE

I cannot imagine that too many people are surprised that there are others who would like to own the London Stock Exchange (LSE); ICE has just confirmed and CME is said to be considering a bid. I do not even want to attempt to count, beyond the three times that Deutsche Boerse has attempted to acquire LSE, the numerous other bids and courtship talks that have arisen over the years. In each case, however, it was a case where the courtship failed to make it to vows. At the same time, any banker worth his/her salt will be making noise around the possibility of other bids, to maximize economic value of the deal. Furthermore, in the case of a freely available exchange (which is mostly not the case given national protection, and the historical pride associated with having a national exchange), they rarely remain single for long. In the regulatory and trading environment in which we live, there is tremendous operational scale in very large exchanges. The technology infrastructure and maintenance cost is high, and global regulation, generally favors a migration to exchange trading and central clearing. And, given the turmoil that blockchain might cause in the exchange and clearing landscape, it will require high levels of R&D budget. Additionally, the continued march toward multi-asset trading, across all asset classes is another factor in this steady drive toward global mega-exchanges. As we have seen the desire for more and more insight, analytics, TCA, and best-execution in equities, we have seen the same call, in FX, and now the clarion is sounding for fixed income. Exchanges with the breadth of product, depth of experience, and vision of a multi-asset future are best positioned to compete with the best product mix, clearing choices, and regulatory insight for their customers. A deal with LSE is not going to be easy as the competitive concerns will have sovereign and European regulators deeply concerned about the implications on equity trading and clearing dominance. Finally, on a European level the deal makes sense; the German and UK exchanges merging under the European flag. However, the UK is not so sure it wants to remain as part of Europe. The Brexit discussion might translate into strong national feelings of pride for the LSE.

Delhi Stock Exchange: All suited up and (hopefully) somewhere to go

The news that the Delhi Stock Exchange (DSE) might buy a trading platform developed by MilleniumIT (owned by LSE) could be the sign of great things to come for the DSE, or it could be just another headline about the opportunities for growth in an emerging market. The DSE, while being one of only three national equity exchanges in India, has not been operational for some time. The efforts to revive it have been going on for a couple of years and it is expected that it would be able to re-start its operations soon. Until recently, the best candidate to provide competition in the equity market to the incumbent National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) was MCX-SX, an exchange promoted by MCX, the largest commodity exchange in India and Financial Technologies, a capital markets technology and infrastructure provider. But MCX-SX got caught up in regulations that stipulated the reduction of ownership by its promoters, something they failed to do according to the capital market regulator, SEBI, and the courts. So from being a strong candidate to take on the might of NSE, MCX-SX is still cooling its heels on the sidelines. Getting back to the DSE, the use of one of the fastest trading platforms in the world (LSE claims it is the fastest) could be a great advantage. The only problem is it is still not clear what space the exchange would be able to occupy in the Indian markets and how it would utilize such a platform. It’s a little bit like owning a Ferrari and not having a decent road to drive it on. DSE is being positioned as an ideal exchange for small and medium enterprises (SME). The issue here is that both NSE and BSE are in the process of starting their own SME exchanges, which would mean there would be tough competition for DSE. It would be critical for the exchange to ensure that there is sufficient business and liquidity in the market, otherwise the speed of the platform would matter little. LSE might have the fastest platform for an exchange, but that does not prevent it from losing ground to Chi-X in the UK market. Unlike LSE, DSE is going to compete from a standing start in the Indian market. So there are a number of issues it would need to address before the speed of its platform can have a bearing on its performance in the Indian market. But from the point of view of an average investor in the Indian market, that is not something they need to worry about. The very possibility of more competition for the incumbent exchanges is great news. When it also means that they might have access to a globally competitive platform, it is news that they can certainly savor for a while.

Were the proposed LCH.Clearnet and LME takeovers inevitable?

The reform of the financial markets through legislation such as Dodd-Frank Act (DFA) in the US and MiFID II (Markets in Financial Instruments Directive) and EMIR (European Market Infrastructure Regulation) in Europe seems to be creating powerful forces for market infrastructure reorganization. The expected takeovers of LCH.Clearnet and LME are examples of this change. I believe that there is an underlying suspicion that both these organizations would have struggled to compete after the full implementation of the recommendations of DFA and EMIR . The possibility of LCH.Clearnet losing the LSE and NYSE Euronext business due to the creation of in-house CCPs by these exchanges was a cause of genuine concern. Similarly, in the very competitive exchange environment, the tendency for rising consolidation was making the position of LME precarious. From an economic point of view, the rise in consolidation means that a handful of exchange groups have become dominant. These include the Deutsche Boerse/ NYSE Euronext combine, Nasdaq OMX, LSE Group, CME and ICE. How healthy this trend is from a systemic point of view only time will tell, but market regulators must be wondering if all that ‘too big too fail’ talk was having any effect. If anything, exchanges are becoming bigger than ever before. Now we are going to add a lot of the OTC derivatives clearing business to that. It would be interesting to see what plans the regulators have in place to manage a default by one of these groups. One must not tempt fate, but it certainly would not be wise to be unprepared.

Cross-listing alliance for emerging markets derivatives is a positive step

In a significant development, HKEx (Hong Kong), BM&FBovespa (Brazil), Micex & RTS (Russia), NSE & BSE (India) and JSE (South Africa) have created an alliance to cross-list each other’s stock index futures and index options contracts. As part of this agreement, financial derivatives listed on each exchange will be traded in the local currency of every other exchange. This is the next step from the earlier bilateral alliances for cross-listing of derivatives and is also a response by these exchanges to the recent trend for mergers and acquisitions of various global exchanges. While the LSE and SGX moves might not have been successful, they certainly showed aggressive intent on part of these exchanges. Some of the emerging market exchanges have woken up to this threat and are now trying to expand their volumes though alliances rather than acquisitions, which at least some of them might not be able to go for in the short term. There is one caveat though. Just having such an alliance is not a guarantee for success and higher volumes. Many of the emerging markets do not have the maturity yet for investors to trade in foreign securities at a large scale. But this move will certainly offer much more choices to the investors in these markets. It will also help the exchanges to share their technical expertise in creating and developing various exchange-traded derivatives products. These exchanges are also some of the fastest growing in the world and their investors have had an appetite for derivatives products through the recent downturn. So, the move for the alliance is well-timed and it would be interesting to see how it is operationalized and whether it is successful. Finally, although this is an excellent move, it might not be large enough in magnitude to prevent the takeover of some of these exchanges (other than BM&FBovespa, which already has cross-ownership with CME).