16 September 2019

Blocking Hong Kong’s bid for the LSE would be a disaster

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Hot on the heels of the London Stock Exchange’s proposal to acquire financial data firm Refinitiv, conventional wisdom was that there would soon be rival bids for the company. Few were expecting a bid to acquire the London Stock Exchange Group (LSEG) itself.

The bidder is the Hong Kong Exchanges Group, a veritable titan of the bourse business which has long sat in the elite top tier of three or four exchanges. By comparison the London SE Group only ever been a distinctly second tier player during the digital age. This may surprise those who read only British media, which continues to lack perspective on the bourse business in both international and product terms. In essence, the LSE, while fairly substantial, is a lot less significant than the media and many analysts perceive.

Despite many in the City and UK financial media viewing the LSE as some form of totemic symbol of capitalism, the blunt truth is it was never that large a business entity. Certainly not in the modern ‘for profit’ era where the Dickensian exchange clubs abandoned mutual ownership for, well, free market capitalism. An undisputed cash stock market titan, LSE missed the true growth areas of exchanges for decades on end.

In recent years LSE began a long overdue catch-up. Dame Clara Furse kickstarted the process by buying Borsa Italiana in 2007. Her successor Xavier Rolet enjoyed a frenetic dealmaking spell in his early years as LSEG chief executive with some astute purchases in indexing and clearing amongst other areas.

However, the LSEG has suffered the legacy of past failures. For example, it doesn’t settle its own share trades thanks to the Taurus debacle 30 years ago which resulted in a spin-off utility outside the exchange’s remit. This is a useful source of profit. (At the same time, the settlement database being owned by a separate utility reduces the risks that some nefarious act by Hong Kong could endanger London stock trading). This helps undermine the curious case of ‘reds under the bed’ which appears to have energised the traditionally populist tabloids along with other jingoistic media and even the Guardian, in an early show of unthinking opposition to what is a very sound proposition to develop the LSE’s potential globally. With an Anglo-Pacific alliance and a gateway to China.

In what has been a derivatives world for 20 years or more, the LSE stubbornly stuck to cash markets and failed on various occasions to purchase or build transformative futures and options markets. Attempts at the latter still continue and may yet bear fruit. However, competitors with greater foresight have meanwhile racked up decades of compound growth in the 15-25% range and higher from their derivatives products, leaving the LSE a good stock market franchise but lacking in the higher margin end of the exchange traded derivatives business.

As a result, the LSE, despite  a valuation almost perma-pumped by seemingly never-ending deal speculation, is a respectable $30 billion  company. However this is far short of the top tier of three exchange operators: CME Group ($73 billion) InterContinental ($50 billion) or indeed Hong Kong ($40 billion).

Hong Kong is a bigger business than LSE because it encompasses listing, trading and settlement on a stock exchange which has been the biggest IPO market for five of the past 10 years. HKEX comprises a futures exchange with clearing house. Significantly, for the past decade and more it has been assiduously following the path of becoming a trusted gateway to China. A key reason Hong Kong remains an attractive location for doing business (full disclosure: the author has some modest investment there) is the British-derived legal system which is guaranteed to last until at least 2047 under the “one country two systems” principal.

Of course LSE has already proposed the deal with Refinitiv, which may now be endangered. For one thing, the hubris of LSE having stolen a march over its competitors by bidding for Refinitiv has proven palpably false. There are currently no other eager bidders for Blackstone’s pricey assets in need of major modernisation. Blackstone may yet need to roll their sleeves up and at least start the job themselves.

True, the lure of turning Refinitiv into a big data goldmine remains a tantalising prospect. However, that endeavour has already defeated several generations of management and, indeed, Blackstone are trying to sell their asset without even making a serious attempt at reforming the 18,500 strong workforce of what was formerly Thomson Reuters’ financial division. Thus, a simply enormous execution risk remains. Worse still, the LSE has a poor record in maximising its integration of acquisitions from the Rolet era. That leaves LSE hugely exposed. With even a mediocre integration, it may end up becalmed for the next five years or more trying to digest the Refinitiv business.

Against that background of holistic and granular execution risk, the HKEX-LSE integration is relatively painless by comparison. Adding the LSE equity market to HKEX creates a potential listing powerhouse. Where for instance Saudi Aramco, the world’s largest upcoming IPO, baulked at the Brexit risk of London and wasn’t quite convinced by Hong Kong alone, the lure of a dual platform across the world’s two largest international financial centres is a stunning prospect. Your IPO simultaneously in two vast international financial centres is a mouthwatering concept for many IPO candidates.

Moreover, for LSEG’s Borsa Italiana subsidiary, the optionality is considerable too. Memorably the Italian exchange was powerless to prevent Prada raising over $2 billion dollars in a 2011 HKEX listing. Being able to offer Italian brands a handy valuation pop by being easily accessible via designer-friendly Hong Kong is an elegant solution. That attraction is only enhanced by what has been a central plank of the HKEX ‘gateway to China’ approach in recent years: a series of networked connections giving investors direct access to China via Hong Kong and also into Hong Kong for mainland Chinese investors.

Understandably, some will have political misgivings about the deal, but if the UK were to impede HKEX buying the LSEG the message would be a hammer blow undermining ‘One country two systems’. How could the UK government credibly claim any influence in Hong Kong if it doesn’t trust the well regulated national exchange which boasts many staff formerly employed in London’s financial markets? Equally, as the CEO of influential Brussels thinktank CEPS, Karel Lannoo  has noted: “The UK and even Theresa May went to China after the Brexit referendum was over, trying to lure them into a trading agreement. Why would the UK all of a sudden oppose this?”

Can the UK afford to undermine the Hong Kong settlement it negotiated in 1997? The effect of snubbing Hong Kong would be catastrophic to British influence well beyond South East Asia. That would be felt particularly acutely as the Global Britain strategy gets under way after Brexit.

What’s more, the UK has long maintained liberal takeover rules. It is difficult to see just what would be an issue to preclude an HKEX takeover of LSEG beyond a dubious interventionist government edict based upon little more than fear of foreign capital. After all, HKEX has already proven itself a mature owner of the storied London Metals Exchange, actively investing to upgrade this UK regulated market.

While LME is less well known than the LSE, it is a stunning global benchmark business for industrial metals. With the same license requirements from the FCA as the LSE, it would be highly irregular for the UK FCA to say the HKEX is suitable to be a steward of the London Metals Exchange licence but not the London Stock Exchange. Moreover, when it comes to integration with LSE, the HKEX has already invested in clearing technology for LME in London which could prove very helpful in modernising the somewhat aged IT stack of the LSE subsidiary LCH.

The major lever of protection to preclude a takeover appears to be national security. A sound provision but hardly one which applies to a business such as LSE, which is essentially a series of databases holding partial information (AKA trade data but not the full financial picture of any market participant). There is little or no IP involved in the exchange which is not already known to mainland China’s diverse and pulsating exchange businesses. Actually the cutting edge technology for trading already being deployed by China from the UK right now is not from LSEG but rather private enterprises, such as the Kent-based trading firm OSTC, whose Zishi products are a benchmark for trader training across the world.

Indeed the LSE as it stands doesn’t even own the settlement records of its stock trades. Moreover HKEX has ensured control of LME stays entirely in London. There is no logic to moving that out of London for LSE in the way that various industrial takeovers have ultimately involved somewhat stealthy U-turns to shutter factories after deals close.

True, the Refinitiv deal would have to be abandoned for an HKEX – LSE combination to succeed. While that would involve a 198 million pound break fee, it is less than LSE apparently paid on fees for what was a fatally flawed piece of hubris: ‘the 2016 merger of equal desperation:’ seeking to combine with Deutsche Boerse which never stood a chance of passing EU antitrust provisions.

And when it comes to China, the City of London has long been an open platform for free trade. To that end, it is worth noting that in London the Chinese RMB / US dollar currency pair has over the past year frequently traded more volume than Euro/USD! The Chicago Mercantile Exchange Group (CME) is pushing launches of gold and other futures in mainland China.

As the Chinese move to liberalise their economy and particularly trade in their currency, London needs to be part of that move or risk ceding the volume to other financial centres. Having a gateway through Hong Kong to China could be the ideal way to maximise market access. Blocking an HKEX-LSE deal will not be conducive to securing any forms of Chinese, let alone Hong Kong, transactions.

Moreover, where LSE is a piece of highly competitive infrastructure which could yet be rendered entirely obsolete by fast moving developments in financial markets and technology – think blockchain for instance – it is a platform business where the databases don’t hold the customers’ cash or the ultimate beneficial ownership data of the stocks themselves. Compare that to the British High Street where the HongKong and Shanghai Banking Group is the chosen custodian of millions of mortgages and customer deposits across the UK. How can HKEX not acquire LSEG if HSBC can acquire British clients’ monies?

The knee jerk jingoism of those who still see the London Stock Exchange as some form of monumental national asset will fail Britain. That would be an acute post Brexit disaster. Hong Kong Exchanges ought to be welcomed as foreign owners of bourse assets in the UK alongside multiple other foreign groups, enabling HKEX to build upon their mature stewardship of their existing London Metals Exchange exchange franchise and pushing the Global Britain narrative to deliver a “win win” for the City of London and Hong Kong.

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Patrick L Young is a former exchange CEO. His new book is 'Victory or Death - Reflections on Blockchain, Cryptocurency & Fintech'