US embassy cable - 04FRANKFURT10640

UNCLAS SECTION 01 OF 04 FRANKFURT 010640 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR EUR PDAS, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY ALSO FOR IMB, Monroe ICN COX, HULL 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, EUN 
SUBJECT:  "King Maker" Deal For Europe's Stock Exchanges: 
Lead or Leave 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
1.   (SBU) Summary:  The German Stock Exchange's (Deutsche 
  Brse (DB)) informal approach to purchase the London Stock 
  Exchange (LSE) has unleashed the next and biggest round of 
  consolidation in Europe's capital market infrastructure. 
  Euronext, DB's continental rival, reportedly has made its 
  own proposal.  Bringing together two of Europe's three 
  largest exchanges would be a "King Maker" of a deal. 
 
2.   Although previous overtures to buy the LSE had been 
  rebuffed, now that the LSE is a publicly traded company, 
  purchase of its shares is more a question of price than 
  sentiment.  DB's "hefty" price at a fifty percent premium 
  for LSE shares and apparent sensitivity not to alter LSE's 
  trading structure seems aimed to win pocketbooks as well as 
  hearts and minds.  DB's self-proclaimed strategic imperative 
  is to be a global player and to either "lead or leave." The 
  outcome of its bid will reveal which it will be for DB. 
 
3.   Consolidation of share trading would have significant 
  implications for integrating European securities markets. 
  Through the EU Financial Service Action Plan, there is now 
  one EU-wide standard for trading rules, prospectuses, 
  reporting and auditing obligations.  Overcoming barriers to 
  securities trading, clearing and settlement infrastructure 
  through a market-driven process would mark another major 
  step toward unifying EU securities markets.  End Summary. 
 
DB Renews its Proposal for LSE:  Courtship before the Bid 
--------------------------------------------- ------------ 
 
4.   (SBU) On December 13, DB confirmed that it had made a 
  proposal to the LSE Board with a view to making a cash offer 
  for the acquisition of all LSE shares.  The LSE rejected the 
  proposal but agreed to engage in talks with DB to "ascertain 
  whether a significantly improved proposal" can be agreed. 
  This launches the next major, and possibly the most 
  significant, round of consolidation in European securities 
  trading infrastructure. 
 
5.   (SBU) DB officials report that the private talks began 
  on the December 15th.  Since DB has not made a formal offer, 
  no official process has begun under UK takeover law to 
  accept or reject the offer within a time certain (within 28 
  days of a formal offer, 60 days if only one offer is 
  submitted, the clock is suspended in the event competition 
  authorities decide to review the transaction).  In its press 
  statement DB cautiously declares that there can be no 
  assurance that any offer will be made.  According to one DB 
  official, results are not expected from the private talks 
  until early in the New Year.  He did seem confident that LSE 
  could not afford to ignore the DB overture. 
 
What Makes This Time Different: Being Public and Being 
Sensitive 
--------------------------------------------- --------- 
 
6.   (SBU) Four years ago DB launched an unsuccessful bid to 
  merge with the LSE.  Why should DB be confident of success 
  this time?  One of the biggest differences is that both 
  firms are now publicly traded.  In this particular case it 
  means the financially stronger can buy controlling interest 
  in the financially weaker firm on the open market.  At the 
  end of 2003 DB's market capitalization was around euro 4.9 
  billion while, judging from DB's bid, LSE's was about euro 
  2.2 billion in mid-2004. 
 
7.   (SBU) One factor in LSE's rejection of the DB bid four 
  years ago was the large portion of local stockbrokers 
  holding interests in the LSE who were loath to see their 
  exchange sold.  Now LSE shares are predominately held by 
  large institutional investors like Fidelity and Threadneedle 
  and even Deutsche Bank.  These investors are more likely to 
  be driven by the bottom line than some of the emotion that 
  characterized the resistance to DB's efforts four years ago. 
 
8.   (SBU) One financial expert recalls the "ABW" feeling in 
  London at the time - "Anybody But Werner."  This refers to 
  DB's CEO Werner Siefert who is has been described by the 
  local German press as "fresh-thinking, power hungry and 
  visionary."  His brashness and aggressiveness is not 
  everyone's cup of tea.  In the view of one London financial 
  expert, Siefert learned from the past and has launched a 
  "charm offensive" this time around. 
9.   (SBU) In appealing to these institutional investors' 
  bottom line instincts, DB was not shy in its proposal, 
  characterized by one analyst as "hefty."  DB indicated an 
  offer of 530 pence per LSE share, a 52 percent premium to 
  the closing share price as October 22 and a 49.6 percent 
  premium to the average LSE share price in the last three 
  months.  The proposal amounts to 2.6 billion dollars.  LSE 
  shares increased 20 percent on news of DB's proposal.  "LSE 
  shareholders will find this hard to resist," was the 
  assessment of one DB official. 
 
10.  (SBU) Another factor at play this time is that DB is 
  not seeking a merger to create a new, joint entity, but a 
  takeover.  Rather than recreate the LSE in DB's imagine, DB 
  appears to be taking a more sensitive approach.  According 
  to a DB official, DB would respect the LSE's "trading and 
  supervisory environment."  Nonetheless, DB states that it 
  aims to drive down trading costs on the LSE.  According to 
  DB's annual report, an equity market transaction at DB 
  typically costs 10.2 basis points but 13.7 basis points at 
  the LSE.    Basis points are hundredths of a cent - that add 
  up in huge daily and yearly trading volumes. 
 
11.  (SBU) What all this really means in practice is the 
  subject of talks between DB and LSE officials.  Press 
  speculation suggests that this could mean that the LSE could 
  retain its contracts with its current clearing (London 
  Clearing House (LCH, now called LCH.Clearnet - see below) 
  and settlement (Crest Co.) agents rather than having its 
  equity trades funneled into a "vertical silo" of clearing 
  and settlement via DB's Clearstream.  However, DB's official 
  statement mentions that it would honor "existing 
  agreements."  LSE's contract with LCH.Clearnet is renewed on 
  an annual basis.  Some London analysts think that the only 
  way DB can justify the premium it is offering for LSE shares 
  while also promising lower trading costs would be to channel 
  trades to DB's clearing and settlement organizations. 
 
 
What This Proposal Is Not 
------------------------- 
 
12.  (SBU) It would be inappropriate to view DB's proposal 
  as a stock exchange deal of bilateral interest between the 
  Germans and British.  First, DB is not German.  Since going 
  public its German strategic investors have sold most of 
  their interests.  At present, only 41 percent of DB shares 
  are owned by German firms.  Fifty percent are owned by UK 
  and US institutional investors - some of the same that hold 
  shares in the LSE. 
 
13.  (SBU) Second, DB is not primarily a stock exchange in a 
  generic sense.  Rather DB regards itself as a "transaction 
  engine," in the words of its annual report.  DB uses its 
  technology that can "trade and settle anything that can be 
  traded and settled at low variable costs."  DB's computers 
  execute trades performed on the Vienna and Dublin stock 
  exchanges, for example. 
 
14.  (SBU) DB's business model is to use its high-tech 
  investments for several lines of business.  DB has balanced 
  sales from equity trading and fixed income/derivative 
  business of Eurex, its joint venture with the Swiss.  It 
  earns nearly as much trading services as it does in post- 
  trade clearing and settlement operations.  And it earns 
  nearly as much on exchange trading as in over the counter 
  business.  LSE, by contrast, is principally an equity 
  trading organization deriving nearly all its sales from 
  exchange trading. 
 
15.  (SBU) What this amounts to is that DB may be flexible 
  in how the final deal is structured, what stays in 
  Frankfurt, what goes to London.  Whether this would mean 
  moving DB's headquarters to London is a delicate question. 
  To date, Siefert has only indicated that if LSE generated 45 
  percent of DB's business, then 45 percent of its management 
  would be based in London. 
 
Enter Euronext 
-------------- 
 
16.  (SBU) Euronext, the French inspired but legally Dutch- 
  based securities organization, has made its own bid for the 
  LSE, according to press reports.  Euronext's equity trading 
  brings together the stock exchanges of Paris, Brussels, 
  Amsterdam, and Lisbon in one trading platform. 
 
17.  (SBU) While market analysts believe that DB can bring 
  more money to the table (DB might have euro one billion cash 
  available compared to an estimated euro 300 million for 
  Euronext), Euronext has been highly successful in 
  integrating itself into the London markets.  In 2002 
  Euronext acquired LIFFE, London's derivative exchange, to 
  create Euronext.liffe that competes with DB's Eurex.  In 
  2003 the LCH merged with Clearnet, Euronext's clearing 
  agent, to create LCH.Clearnet which is 41.5% owned by 
  Euronext.  Finally, Euroclear, Euronext's associate for 
  settlement operations, has part ownership in Crest Co the 
  settlement organization for the LSE. So even if it loses LSE 
  to DB, Euronext's strong presence in the London market would 
  enable it to offer an alternative-trading venue for LSE 
  listed shares should traders not be happy with new DB 
  management. 
 
Comment: Broader Implications: European Consolidation and EC 
Directives 
--------------------------------------------- ------------ 
 
18.  (SBU) LSE integration in one form or another into 
  either DB or Euronext would mark a major step toward 
  integration of European securities markets.  Joining the 
  efforts of two of the three largest European stock exchanges 
  would be a "King Maker Deal," in the words of one observer. 
  The major exchanges in Spain and Italy, the two principle 
  European exchanges that have not aligned themselves with 
  either DB or the LSE, might seriously consider a 
  relationship with the predominate European exchange. 
  Commented a DB official, "they are sitting on the fence, 
  waiting to see who wins." 
 
19.  (SBU) Integration of major European securities markets 
  would benefit European investors and traders by offering a 
  broader, deeper pool of buyers and sellers and potentially 
  seamless back office operations to process their orders. 
  Capital allocation should be more efficient, contributing to 
  investments with higher returns that could contribute to 
  stronger overall economic performance. 
 
20.  (SBU) Such a result is just what the European 
  Commission has been targeting in its Financial Services 
  Action Plan.  Directives on trading execution, prospectuses, 
  reporting requirements, market abuse, accounting and 
  auditing have created the legal basis for EU-wide rules. 
  Integration of securities market infrastructure would be the 
  next major task.  While the Commission has favored proposing 
  a directive on clearing and settlement to push that process 
  along, a market-driven solution would be a better outcome. 
  Competition authorities may give the deal a close look. 
  However, if the EU is to realize its objective of a fully 
  integrated capital market, competition considerations would 
  need to focus not on the takeover itself but on elements of 
  the deal. 
 
21.  (SBU) One of those elements would be the contentious 
  notion of the "vertical" silo.  Such a silo exists when an 
  investor makes a trade on an exchange and then is obliged to 
  use that exchange's clearing and settlement operations.  DB 
  has such a "vertical silo," arguing that "straight through 
  processing" benefits investors by reducing all-in costs. 
 
22.  (SBU) The Commission, however, wants to make sure that 
  investors can pick and use their own clearing and settlement 
  operations.  Commission competition authorities have had an 
  eye on DB's vertical model.  DB, knowing this is the 
  Commission's objective, could quell concerns by announcing 
  it would permit such switching by investors, according to 
  London's perceived wisdom.  Euronext also boasts potential 
  straight-through processing through its clearing agent 
  LCH.Clearnet and its settlement "associate" Euroclear. 
  Thus, a directive in this area might serve a public policy 
  interest. 
 
23.  (SBU) From Embassy London's perspective, there is also 
  another dimension to the proposed takeover talks that goes 
  beyond the technical benefits and costs.  Some City 
  observers believe a DB purchase of the LSE would remove one 
  of London's last independent financial landmarks, thereby 
  weakening London's role as the leading financial center in 
  Europe, and it also could strengthen the hand of the pro- 
  euro enthusiasts in the UK. 
 
24.  (SBU) For DB, its takeover of the LSE would represent 
  six years of work to become Europe's predominate securities 
  organization.  Failing this time around or winning the LSE 
  but paying a price too dear, could relegate DB to the number 
  two spot in Europe securities operations.  DB's annual 
  report explains that exchanges, clearing and settlement 
  organizations need to operate on a global, not national 
  basis.  DB's self-proclaimed strategic imperative is "lead 
  or leave."  The outcome of this latest round of 
  consolidation will show which it will be for DB. 
 
25.  (U) This report coordinated with Embassies London and 
  Berlin and USEU. 
 
26.  (U) POC: James Wallar, Treasury Representative, e-mail 
  wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
  7535-2238 
 
Bodde