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Trading Shakeup in Europe

Banks should benefit from these new rules because the cost of trading stocks will fall. But exchanges will see more competition and price pressures

From Standard & Poor's Equity ResearchNew regulations covering the financial markets in the European Union (EU), known as the Market in Financial Instruments Directive (MiFID), went into effect November 1. This directive is an attempt by regulators to unify the EU capital markets, open up national share-trading monopolies, and inject more competition into the exchanges' clearing operations.

The new regulations are also aimed at creating lower prices for investors. They allow securities firms to match buy and sell orders internally, without channeling the trades through an exchange. As a result, they will eliminate rules in France, Italy, and Spain that force share trading through the local stock exchange and lead to higher prices.

Banks will now be able to establish their own trading systems to rival the major domestic exchanges, which include the London Stock Exchange, Deutsche Bourse, and NYSE Euronext (NYX). Citigroup (C), Credit Suisse Group (CS), Deutsche Bank (DB), Goldman Sachs (GS), Merrill Lynch (MER), Morgan Stanley (MS), and UBS (UBS) are already involved in setting up their own trading platform, known as "Project Turquoise," which is expected to launch late this year or early in 2008.

The banks, which control 50% of the order flow in European equities, have formed this new trading system as a way to reduce their costs. The investment banks estimate that total trading costs on the new system will be less than half the costs on the traditional European exchanges.

S&P equity analyst Jason Willey believes there will be more pressure on exchanges in a number of regional markets to lower fees due to the rule changes, but he is not convinced the pressure will come from initiatives like Turquoise. He notes there is also the possibility of increased trading volumes, driven by the lower cost to transact, which could partially offset the lower pricing. He believes whatever pressure does arise will play out over time, giving NYSE Euronext and other European exchanges an opportunity to adjust.

Under the previous system, investment firms were required to settle their trades within the country where the transaction took place, but under MiFID, they will have the right to settle trades through other clearinghouses.

This will break the monopoly that many domestic exchanges have in securities settlement in Europe. Exchanges, including the Deutsche Bourse in Germany and the Spanish and Italian stock markets, operate both trading and clearing and settlement businesses, which has resulted in less competition and higher fees for the banks. Under MiFID, competition should increase, resulting in lower post-trading costs.

MiFID also aims to increase the level of transparency for the region's markets. Pre-trade and post-trade information will be made more readily available, with both exchanges and investment firms that trade internally or "off-exchange" having to report trading data. Investment firms will have more choice as to where they publish post-trade data and will have the option to form their own trade reporting platforms and charge for the dissemination of that data.

A group of nine investment banks have established Project Boat, which is an initiative to create a pan-European, pre-trade data publishing and posttrade reporting platform. ABN AMRO (now controlled by Royal Bank of Scotland (RBS), Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC (HBC), Merrill Lynch, Morgan Stanley, and UBS are involved in the initiative. The platform will allow banks to save money on trade reporting fees, while also giving them the ability to sell the data to third parties.

Boat has already forced the London Stock Exchange to reduce fees for those firms reporting trades to it by more than 80%, effective November 1. Exchanges that depend heavily on market data revenues, such as the Nordic exchange OMX AB, will likely be most impacted by this new venture.

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