Finance

Lionel Laurent is a Bloomberg Gadfly columnist covering finance and markets. He previously worked at Reuters and Forbes.

Mark Gilbert is a Bloomberg Gadfly columnist covering asset management. He previously was a Bloomberg View columnist, and prior to that the London bureau chief for Bloomberg News. He is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”

Xavier Rolet spent the best part of a decade turning London Stock Exchange Group Plc into a stock market that didn’t depend on stock-market trading to grow. Big bets on financial data, indexing and clearing have boosted LSE's market value almost seven-fold during that time, profiting from a boom in passive investing and a regulatory push for transparency. The collapsed merger attempt with Deutsche Boerse AG is barely a blip on the company's stock price.

But going out on a high at end-2018 won't be straightforward. The exchange's latest set of results showed its two prime growth engines -- post-trade clearing and information services -- in fine health, yet facing some big unknowns.

Going Out On A High, But...
Revenue growth rates at LSE Group are set to start cooling down
Source: Deutsche Bank estimates

The clearing business has benefited from a post-crisis boost in regulatory scrutiny, but now faces a big threat in the shape of a chaotic Brexit. The European Union is jittery about London's status as the top trading destination for euro-denominated derivatives and is calling for increased supervision and possibly even forced relocation for the largest firms. Rolet, who finds himself in opposition to his home country of France, has warned of an exodus of jobs and a ramp-up in costs if that happens. There is a key business at stake: LSE's over-the-counter clearing revenues accounted for about 12 percent of the total in 2016, according to Deutsche Bank.

As the debate drags on, the risk is that banks and customers make their move ahead of Brexit's start date in 2019 with a "Brexit-proof" hedge, namely by moving business to LSE's rival and one-time merger partner, Deutsche Boerse. The German exchange is wooing top banks with a revenue-sharing arrangement, and has described Brexit as an "opportunity." This isn't going to be fatal to LSE, which has a dominant market share and whose latest quarterly results showed a 26-percent jump in sales for clearing-house unit LCH. But it could slow the pace of growth. With Deutsche Boerse targeting annual revenue growth of up to 10 percent, it suggests rising competition and the risk of LSE having to overhaul its business structure to meet unpredictable new rules.

LSE's information-services division, which comprises mostly its indexing business, has also prospered as low-cost index-tracker funds suck money away from underperforming and more expensive active managers. The LSE paid $2.7 billion for Frank Russell Co. in 2014, and recently completed its purchase of Citigroup Inc.'s fixed income indexes. The unit now accounts for more than 40 percent of LSE revenue, double its contribution at the start of 2015.

Roaring Ahead
Europe's ETF market has soared in value
Source: Bloomberg Intelligence

But how long can that stellar growth continue? ETFs compete on fees, and there's a race to the bottom among their providers. The subsequent belt-tightening means rather than paying existing index creators, more asset managers are creating their own versions to avoid paying licensing fees.

Earlier this week, State Street Global Advisors said it was abandoning FTSE Russell benchmarks to reduce fees on three of its ETFs to a record low of 3 basis points. State Street developed proprietary U.S. equity indexes to achieve the cost savings it's passing on to investors. WisdomTree Investments Inc., which pioneered self-indexing in 2006, has more than 80 ETFs worth more than $40 billion pegged to its own indexes.

Under Pressure?
LSE's indexing business has seen revenue growth slow
Source: Company filings, Bloomberg calculations

As the above chart shows, revenue growth from indexing at LSE slowed in the third quarter. If the trend continues, it will be harder for Rolet to end his impressive track record on a high note.

Rolet deserves credit for his success in overhauling an old-school exchange model in the face of rising competitive pressures, tech-savvy upstarts and a post-crisis lull in trading activity. But there's a lot that could go wrong in 2018.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Lionel Laurent in London at llaurent2@bloomberg.net
Mark Gilbert in London at magilbert@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net