Efficiency gains from the integration of exchanges:Lessons from Euronext’s “natural experiment”

Dr. A. Jorge Padilla

LECG Europewww.lecgcp.com

Leuven, 7 November 2006

2

The theory

The integration of exchanges produces a number of significant efficiency gains:

Cost savings– Eliminates the duplication of costly infrastructure …– … which may lead to a reduction in trading fees– … and brokerage fees

Direct user benefits– Savings on operating and capital costs– Trading more diversified portfolios– Increased cross-border trading …– … leading to increases in liquidity, as reflected by lower bid-ask

spreads, greater volume and lower volatility

3

Euronext’s natural experiment

Integration between the French, Belgian, Dutch and Portuguese stock exchanges to form Euronext (September 2000 – 2003)

“Before and after” analysis on costs and user benefits …

… controlling for confounding factors (i.e., time-variant effects that have nothing to do with integration)

LisbonAmsterdamBrussels Paris

CashTrading integration

May 2001

October2001

November2003

BrusselsParis

AmsterdamBrusselsParis

Chronology of integration of cash trading business

4

Euronext’s natural experiment

This experiment makes it possible to:– Evaluate the cost savings achieved through the integration process; – Investigate the pass-through of those savings; – Identify other sources of direct user benefits, and – Test the impact of integration on liquidity and, hence, on the implicit

trading costs faced by the users of the exchange.

5

Cost savings

Significant reduction in operating costs:– Overall, the total annual costs of Euronext’s continental operations fell by

137 million euros (25%) between 2001 and 2004. – IT cost savings: Euronext’s total continental IT costs fell by 29% between 2001

and 2004. – Headcount reductions: Euronext reduced the staffing levels of its continental

operations by 24% between 2001 and 2004.

0

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40

60

80

100

120

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160

2001 2002 2003 2004

m€

Development CAPEXInternet IT costsOffice automation IT costsIT running costs

143127 128

103

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40

60

80

100

120

140

160

2001 2002 2003 2004

m€

Development CAPEXInternet IT costsOffice automation IT costsIT running costs

143127 128

103

Evolution of continental IT costs following Euronext integration

13381218

11101012

0

200

400

600

800

1000

1200

1400

1600

2001 2002 2003 2004

Euronext continental staff numbers 2001-2004

6

Trading fees

The evidence shows that the average trading fee charged in Paris fell by about 30% (in real terms) in the period from December 1999 to December 2004.

Average trading fees also fell in Brussels and Amsterdam.

– From January 2002 to December 2004, the average trading fee in Brussels fell by 30%.

– From January 2001 to December 2004, the average trading fee in Amsterdam fell approximately 45%.

11.

21.

41.

6E

uros

Source:Euronext

December 1999-December 2004

Paris

Our econometric results show that those fee reductions were to a large extent the result of the creation of Euronext

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Direct user benefits

Improved access: – Integration has allowed Euronext members directly to access all the different

Euronext markets – The process of integration has expanded the set of securities accessible to

a Euronext member. – Investors now benefit from greater inter-broker competition.

9% 8%

20%

14% 15%

33%

24%

36%

18%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Paris

Amsterdam

Brussels

2002 2003 2004 2002 2003 2004 2002 2003 2004

Share of cross-border trade undertaken by Euronext members (% of total trades of

members at each location)

8

Direct user benefits

Members have benefited also from reduced internal operating costs.

Increased liquidity– Lower bid-ask spreads;– Greater volume; – Lower volatility.

9

Panel data estimation We aim to estimate the impact of integration on liquidity. In order to do so, we have estimated a panel data model that relates liquidity measures with Euronext integration dummies. Liquidity is measured by:

- Volume: the higher the liquidity, the higher the volume.- Bid-ask spread: the higher the liquidity, the lower the spread.- Volatility: the higher the liquidity, the lower the volatility.

Therefore, we have tested whether Euronext integration had a positive impact on volumes and a negative impact on bid-ask spreads, and volatilities. In this analysis, we assumed that Euronext integration took place in the following dates:

- 21-May-2001: Brussels and Paris trading- 29-Oct-2001: Amsterdam, Brussels and Paris trading- 7-Nov-2003: Lisbon, Amsterdam, Brussels and Paris trading

10

itiititity Control nIntegratio

• Liquidity (volume, bid-ask spread and volatility) of security i in period t, or

• A dummy variable that takes the value of 1 if the security i is traded in an integrated market in period t and 0 otherwise.

• Alternatively, we define three different dummies in order to differentiate the impact of each integrated market:

1.“Integration Brussels” takes the value of 1 if if the security i is traded in the (at-least) integrated market Paris – Brussels in period t and 0 otherwise.

2.“Integration Amsterdam” takes the value of 1 if if the security i is traded in the (at-least) integrated market Paris – Brussels – Amsterdam in period t and 0 otherwise.

3.“Integration Lisbon” takes the value of 1 if if the security i is traded in the fully integrated market (Paris, Brussels, Amsterdam and Lisbon) in period t and 0 otherwise.

Methodology: specification

11

Specification (continued)

itiititity Control nIntegratio

• Monthly dummies.

• Dummies related to relevant economic events (similar to the ones used in the first stage).

• A deterministic time trend.

• Other controls (depend on data availability):

- In the volume regression: the volume of an index traded in non-integrated markets (FTSE 100 and DAX).

- In the volatility regression: the volatility of the index of the own market to net out covariance risk.

• Fixed effects to control for differences across securities.

• This control is specially important when using data at the security level. Panel data models allow to include a fixed effect per security, therefore, netting out differences across securities.

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Direct user benefits

Lower bid-ask spreads – The bid-ask spreads of the securities included in the main Paris index fell as

a result of the creation of Euronext: approx 40%.– The analysis also shows that integration led to a reduction of the bid-ask

spreads of the securities in the main indices of Brussels (25%-30%) and Amsterdam (approx. 10%)

0.1

.2.3

CAC 40

Source:Euronext

3rd January 2000-28th February 2005

Weighted Average Spread

13

Liquidity effectsBid-ask spreads (Bloomberg)

Our main findings, using Bloomberg data, are:

– In general, Euronext integration had a negative, and statistically significant, impact on bid-ask spread.

– Our results show that Brussels, Amsterdam and Lisbon integration had a similar impact on the bid-ask spreads, as measured by Bloomberg.

SPREAD (1) (2)

Integration - 0.0010* * *[0.000]

Integration Brussels - 0.001* * *[0.000]

Integration Amsterdam - 0.000* * *[0.001]

Integration Lisbon - 0.001* * *[0.000]

Constant 0.002* * * 0.001* * *[0.000] [0.000]

Monthly dummies Yes YesEconomic events dummies Yes YesObservations 127,082 127,082R- squared 0.38 0.387Robust p values in brackets

Source: Bloomberg

* significant at 10%; * * significant at 5%; * * * significant at 1%

14

Liquidity effectsBid-ask spreads (Euronext)

Our main findings, using Euronext data, are:

– In general, Euronext integration had a negative, and statistically significant, impact on bid-ask spread.

– Our results show that Brussels, Amsterdam and Lisbon integration had a similar impact on the bid-ask spreads, as measured by Bloomberg.

WEIGHTED SPREAD (Paris market) (1) (2)

Integration - 0.054* * *[0.000]

Integration Brussels - 0.029* * *[0.000]

Integration Amsterdam - 0.007* *[0.012]

Integration Lisbon - 0.050* * *[0.000]

Constant 0.166* * * 0.170* * *[0.000] [0.000]

Monthly dummies Yes YesEconomic events dummies Yes YesObservations 1,316 1313R- squared 0.482 0.674Robust p values in brackets

Source: Euronext

* significant at 10%; * * significant at 5%; * * * significant at 1%

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Direct user benefits

Greater volume – Trading volume in Paris, Brussels, and Amsterdam increased as a result of

the creation of Euronext. – According to our estimations, the creation of Euronext led to an increase in

the traded volume of the main securities listed on the Paris, Brussels and Amsterdam exchanges of approximately 40%.

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0429

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0407

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04

Amsterdam Brussels

Lisbon Paris

Source:Bloomberg

3rd January 2000-31st December 2004

Volume (Millions of shares traded)

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Liquidity effectsVolume

Ln VOLUME (1) (2) (3) (4) (5) (6)

Integration 0.227* * * 0.144* * * 0.120* * *[0.000] [0.000] [0.000]

Integration Brussels 0.301* * * 0.269* * * 0.240* * *[0.000] [0.000] [0.000]

Integration Amsterdam 0.249* * * 0.233* * * 0.244* * *[0.000] [0.000] [0.000]

Integration Lisbon 0.216* * * 0.340* * * 0.408* * *[0.000] [0.000] [0.000]

Volume FTSE100 0.511* * * 0.542* * *[0.000] [0.000]

Volume DAX 0.402* * * 0.465* * *[0.000] [0.000]

Trend 0.000* * * - 0.000* * * - 0.000* * * - 0.000* * * - 0.001* * * - 0.001* * *[0.000] [0.000] [0.000] [0.000] [0.000] [0.000]

Constant 15.531* * * 4.976* * * 8.472* * * 15.672* * * 4.503* * * 7.524* * *[0.000] [0.000] [0.000] [0.000] [0.000] [0.000]

Monthly dummies Yes Yes Yes Yes Yes YesEconomic events dummies Yes Yes Yes Yes Yes YesObservations 127,286 125,422 126,431 127,286 125,422 126,431R- squared 0.848 0.857 0.857 0.85 0.86 0.861Robust p values in brackets* significant at 10%; * * significant at 5%; * * * significant at 1%Source: Bloomberg

17

Liquidity effectsVolume Our main findings are:

– Euronext integration had a positive, and statistically significant, impact on volume (defined as number of shares traded).

– These results are robust to different specifications of the panel data model, in particular when including the volume of an index traded in non-integrated markets (FTSE 100 and DAX) as control variables.

– Results are also robust when defining volume in levels, except that the integration of Brussels is no longer statistically significant.

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Direct user benefits

Lower volatility – The volatility of the large-cap securities traded in Paris, Brussels, Amsterdam

and Lisbon fell as a result of the creation of Euronext. – The reduction in volatility following integration was between 9% and 18% of

the initial levels

0.1

.2.3

.4

0.2

.4

0.1

.2.3

0.2

.4

Amsterdam Brussels

Lisbon Paris

Source:Bloomberg

3rd January 2000-31st December 2004

Historical 20 days Volatility

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Liquidity effectsVolatility

VOLATILITY 20 days (1) (2) (3) (4)Own Integration 0.072* * * - 0.004* * *

[0.000] [0.001]Integration Brussels 0.002 0.002

[0.272] [0.222]Integration Amsterdam 0.032* * * - 0.017* * *

[0.000] [0.000]Integration Lisbon - 0.083* * * - 0.019* * *

[0.000] [0.000]Volatility 20 days INDEX 1.002* * * 0.987* * *

[0.000] [0.000]Trend - 0.000* * * - 0.000* * * - 0.000* * * - 0.000* * *

[0.000] [0.000] [0.000] [0.000]Constant 0.237* * * 0.105* * * 0.219* * * 0.106* * *

[0.000] [0.000] [0.000] [0.000]Monthly dummies Yes Yes Yes YesEconomic events dummies Yes Yes Yes YesObservations 111,793 111,793 111,793 111,793R- squared 0.314 0.442 0.33 0.443Robust p values in brackets* significant at 10%; * * significant at 5%; * * * significant at 1%Source: Bloomberg

20

Liquidity effectsVolatility Our main findings are:

– In general, Euronext integration had a negative, and statistically significant, impact on volatility (defined as 20-days volatility) when including the volatility of the index of the own market as a control variable.

– Our results show that Amsterdam and Lisbon integration had the highest (negative) impact on volatility, while Brussels integration had no statistically significant impact on volatility.

21

Conclusions

The results of the natural experiment show:– Significant cost savings were achieved as a result of the integration

process; – Those savings were passed on in part to users; – Users also enjoyed other benefits: access to more securities, increased

brokerage competition, lower transaction costs and, perhaps, most importantly increased liquidity.

– The integration of the Amsterdam, Brussels, Lisbon and Paris exchanges in a single platform resulted in a significant increase in liquidity.

Jorge Padilla LECG Jpadilla@lecg.comwww.lecgcp.com

Leuven, 7 November 2006