1

Stock exchange consolidation and volatility: the case of Euronext1

Faten Ben Slimane a,*

Department of finance, Champagne School of Management, Troyes, France

Abstract Since the nineties, stock markets have been experiencing significant technological, legal and other kind of changes affecting their organization and structure. This has led to strategic moves in mergers and alliances at a national as well as at an international scale. The aim of this paper is to better understand this phenomenon and analyze its impact on the future of stock markets considered as any operational firm seeking to maximize its profits. To achieve this, we focus on the case of the merger of three out of four stock exchanges now forming Euronext. Our goal being to study that merger and its potential effect on Euronexts market risk (measured by volatility). However, the results obtained are mixed. In terms of volatility, the merger is beneficial only for one of the three markets studied. This leads to the insight that the expected benefits in merging depend on the features of each market, its importance and its degree of integration with other financial places before its effective consolidation.

JEL classification: F36, G15, G32, G34 Keywords: volatility; Euronext Stock Exchange; merger; financial risk

-Work in progress
Corresponding author. E-mail address: faten.benslimane@groupe-esc-troyes.com.

1. Introduction The stock markets are witnessing a profound transformation of their organization. These entities, once considered monopolies, are reacting progressively as would any firm that seeks to maximize its profits in a competitive environment. Hence, a strategy that is being adopted more and more is to cooperate and merge with other international stock exchanges. To mention only the most important examples, we denote the merger in 1997 between the stock exchanges in Copenhagen and Stockholm to create the Nordic stock market - Norex, later renamed OMX. A few years later the stock exchanges of Oslo, Iceland, Riga, Tallinn, Helsinki and Vilnius joined OMX. Also in Europe, we denote the creation of Euronext in 2001, resulting from the merger of stock exchanges in Paris, Amsterdam, Brussels and Lisbon. In 2006, Euronext merged with NYSE. More recently in 2007, two mergers were announced: the first between OMX and Nasdaq and the second between the London Stock Exchange and the Italian stock exchange. However, despite the importance of this phenomenon, its effects remain poorly understood. The purpose of the study is to analyze not only whether the Euronext stock exchange merger has been beneficial in terms of volatility, but also how the gains may be distributed among different types of exchanges. Studying how volatility has changedand for which exchangeis very important to evaluate possible motives for a stock exchange merger and whether such a cross-border merger is advisable. A further motivation is to provide evidence on how a stock exchange merger may influence the competitive market environment.

A literature review has enabled us to identify two "categories" of work: the first concerns studies that examine the link between market structure (market favoring the fragmentation of order flow, or rather their consolidation) and quality (in terms of liquidity, trading costs and volatility). Some of these studies are theoretical (Madhavan (1995) and Mendelson (1987). Empirical studies in this area are mostly non-conclusive; some have found a negative effect of fragmentation of order flow on market quality (Cohen et al. (1985), Porter and Thatcher (1998)), while other studies have failed to highlight this negative effect (Neal (1987), Conrad and al. (2005)). The second category of studies focuses on the consolidation of stock markets. The vast majority of these works are restricted to a descriptive analysis of the phenomenon, especially in Europe (Arlman (1999), Ramos (2003), Lee (2002, 2003), Claessens, Lee and Zechner (2003)) or a theoretical analysis (Pirrong (1999), Di Noia (2001), Santos and Scheinkman (2001)). Other more empirical work has sought to explain this phenomenon by various factors such as technological developments, network externalities, economies of scale and cost reductions (Hasan and Malkamaki (2000), Schmiedel (2001-2002), Hasan and Schmidel (2004), Ramos and Von Thadden (2008)). However, and in terms of empirical studies of the impact of consolidation on market microstructure, we distinguish only three studies: the first concerns the work of Arnold et al. (1999) which assess the impact of three inter-regional mergers in U.S. stocks on their liquidity

and market share. The second is of Padilla and Pagano (2005) which determine the effect of the harmonization of post-exchange Euronext exchanges on their cost. The third study is of Nielsson (2009) who analyzed the Euronext merger and its impact on liquidity of securities markets. His results show a positive effect only for large listed securities. Our study contributes to the current debate on international competition between financial markets and allows an extension to the existing literature as it analyses the impact of consolidation on market volatility. Using the GARCH GED model (1.1) we test the change in volatility following Euronext merger of major stock market indices of Amsterdam, Brussels and Lisbon, The results are mixed. We havent found any significant effect on the volatility of Belgian and Dutch market. However, the volatility in the Portuguese market has been significantly affected by Euronext integration. The remainder of the paper is organized as follows. The second section describes the process of merger and the creation of Euronext and our data. Section 3 introduces our model for empirical estimation. Section 4 presents the results. Section 5 concludes. 2. The creation of Euronext Euronext is the first integrated European stock market which was created in September 22, 2000 between the French, Dutch and Belgian stock exchanges. During the months following the merger, the priority was to ensure perfect connection between their members. For this, a considerable effort was initiated to develop a single electronic platform, NSC, accessible to all members of the three Euronext markets. Furthermore, and in order to facilitate cross-border transactions, the clearing services were unified. Thus, since February 2001, Clearnet has been the clearing house and the central counterparty for the three Euronext markets. The creation of a single clearing agency has reduced credit and liquidity risks and costs not only on domestic transactions, but also across borders The third condition for full integration was the creation of a single platform for settlement. For this, a significant effort was made to establish a Single Settlement Engine for all Euronext markets. In January 2009, the platform ESES (Euroclear Settlement of Euronext-zone Securities) was introduced. It allows settlement of all shares traded on the three Euronext markets in real time. The launch of this platform eliminated the complexities, risks and excessive costs of cross-border transactions. Euronext is now implementing a Single Platform (SP) that will create a common interface between the systems of Euroclear and the back offices operations of its participants. For these harmonization efforts, Euronext has displayed its early desire to facilitate the growth of the European capital market. This was confirmed by two successive attempts of consolidation announced barely two years after the effective creation of Euronext. The first acquisition took place in January 2002 and concerned Liffe, the London-based derivatives market. The second agreement was announced in February 2002 and allowed the BVLP (Bolsa de Valores de Lisboa e Porto) to join Euronext. These two projects were followed by further efforts in order to migrate these two new entities on the same platform for trading, clearing and settlement of Euronext

The following table summarizes the key dates of migration of different markets:

Table 1: Dates of merger events Migration from/to Amsterdam Brussels Lisbon Londres Paris Trading Cash 29/10/2001 21/05/2001 07/11/2003 operational prior to merger

Clearing Cash 25/10/2002 01/03/2002 07/11/2003 operational prior to merger

Derivatives 29/11/2004 24/03/2003 24/03/2003

Derivatives 03/11/2003 24/03/2003 22/03/2004 08/09/2000

14/04/2003

jan-01

Source : Euronext

The development strategy of Euronext has enabled it to be considered as one of the most attractive markets in Europe and the world in terms of market capitalization, number of listed companies and trading volume (see Fig. 1).

Fig. 1: The top ten markets in the world (2008)

number of companies listed 40000 35000 30000 Billion $ 25000 20000 15000 10000 5000 0 10 000 9 000 8 000 7 000 6 000 5 000 4 000 3 000 2 000 1 000 0

Nbr. Companies
Source: WFE (2009)

Trading value

Market Cap.

Note however that the Paris alone attracts more than half of Euronext flows measured in terms of market capitalization and number of listed companies (see Fig. 2).

Fig. 2: The share of each place in Euronext

80 60 40 20 0 Amsterdam Brussels

Lisbon Market Cap;

Paris

Nb. Companies
Source: Euronext annual report (2008)

Despite these inequalities, Euronext is currently one of the pioneer stock exchanges worldwide. The success of these consolidated strategies has allowed Euronext to seek new targets to expand its size to a European and even global level Thus towa the end level. hus towards of 2004, Euronext launched a battle with the German Stock Exchange (DB) to acquire the London Stock Exchange (LSE). The stakes were high since if any of these offers had been f accepted by the London Stock Exchange, it would have resulted in one of largest stock markets in the world. After several months of discussions, the LSE finally rejected both proposals fter rejected proposals. The collapse of talks with the LSE didnt prevent the DB offering a merger with Euronext Euronext, barely a year thereafter. The objective was to form a large European stock market that could compete with U.S. markets. During the same period and against the German , the American group, the NYSE, Germans, proposed merger with Euronext. This would form the largest and most liquid market in the world. The supervisory board of Euronext finally agreed a merger with the NYSE in December 2006. These development projects were not completed as NYSE Euronext announced its acquisition of American Stock Exchange two years later later.

3. Estimation methodology : Several econometric and financial models have sought to measure volatility. The most interesting works have been developed by Engle (1982) and Bollerslev (1986) who respectively introduced the ARCH (Autoregressive Conditional Heteroskedasticity) and

GARCH models (Generalized ARCH). These processes define the conditional variance of returns of securities as a linear function of past squared errors. The introduction of these models has led to a better understanding of the financial theory. However, despite the strong statistical significance of estimated parameters of the process, Lamoureux and Lastrapes (1990) and Engle and Mustafa (1992) showed that they were not stable over time and they provided a poor prediction of future. This is due to the fact that the series of returns is affected by shocks that affect the process ARCH - GARCH model (Hamilton and Susmel (1994)). To reduce these biases, several methods have been introduced to better evaluate the volatility of a market taking shocks into account. We distinguish the "breaking" method and the outliers method. Another possible method is difference- in-differences (DID), although this has not yet been used in financial work. The difference-in-differences method: It is generally used in micro-economic studies and more recently in the macro-economic issues to evaluate the effects of the economic liberalization (Giavazzi and Tabellini (2004)) or the political and economic reforms (Persson (2004), Duke (2006)). Despite the simplicity of using this methodology and its benefits in reducing endogenous problems that often appear when comparing disparate individuals, it has not had great success in economic studies because of criticism it receives. The most virulent criticism concerns the serial correlation leading to the bias in the estimated standard errors. Moreover, there is a risk that the variable of interest is itself significantly correlated, which will exacerbate the bias in standard errors. This degree of correlation may be even more pronounced when introducing dummy variables (Bertrand and al. (2002)). The outliers methods: This methodology allows detection of extraordinary and rare events that have had significant effects on the modeling of macroeconomic and financial time series. Thus each shock or event affecting the series studied is an outlier (Box and Tiao (1975), Charles and Darn (2005), Ane et al. (2007)). The main drawback of this method is that it might not detect an event if it occurs in the same period as another more important event. This is our case since the dates of the mergers are very close to the shock of September 11. The Breakpoints method: This method is relatively new and is widely used in the financial and econometric literature. It identifies the breakpoints that occur in response to shocks that affect the volatility of series. Once these points have been identified, the initial sample is divided into sub-samples, and each is considered separately. After that, the statistical changes of the series are tested between the two periods. This method is common in the estimation of the volatility of emerging markets2 and in studying the impact of financial liberalization and crises in financial markets3.

2 3

-For more details, see De Santis and Imrohoroglu (1997), Edwards and Susmel (2001), Aggarwal et al. (2001). - For more details see Cunado, Biscarri and Gracia (2006), Huang and Yang (2000),

We choose to use this method as it is more appropriate here and offers the least biased results. The dates of events correspond to the date of migration of each of Euronext markets on the same trading platform NSC. We consider that these dates correspond to the effective merger of each market to form Euronext. Thus, for the effect of the merger on the Dutch market volatility, we retain the date of October 29, 2001, for the Belgian market, it is May 21, 2001 and for the Portuguese market is November 7, 2003.
4. Econometric study and empirical results

We consider daily returns of major stock indices of the markets concerned (Bel20, Aex25, PSI20). The database used is Datastream. The study period extends from June 1999 until December 2003 for the Dutch and Belgian market. For the Portuguese market, the study period extends from November 2001 to November 2005. The series of daily returns (Ri,t) used for estimation is obtained from the series of prices, Pi,t, such that: Ri,t = ln (Pi,t)- ln (Pi,t-1).

The following table summarizes the descriptive statistics of the returns of each index considered for the periods.

Table 2: Some basic descriptive statistics of the returns

BEL20
Sample

Aex 25
before -0,000203 0,011298 0,401400 6,880532 67,44** 336,306** 415 06 :9905 :01 after -0,000321 0,015223 0,435910 6,967778 57,012** 469,657** 683 05 :0112 :03 full -0,000414 0,017629 0,061803 5,904641 52,681** 421,5543** 1197 06 :9912 :03 before -0,000252 0,013391 -0,525333 6,891057 33,590** 425,734** 629 06 :9910 :01 after -0,000593 0,021375 0,231533 4,604035 43,050** 65,9675** 568 10 :0112 :03

Psi 20
full 4,1E-05 0,007899 -0,440305 5,293939 32,131** 267,9198* 1065 11 :0111 :05 before -0,000382 0,009602 -0,340701 4,261931 24,609** 45,07768** 526 11 :0111 :03 after 0,000454 0,005751 -0,32483 4,494232 15,777** 59,62206** 539 11 :0311 :05

full -0,00027 0,013671 0,436676 7,476588 77,578** 1037,529** 1197 06 :9912 :03

Mean SD SK K Q(20) JB N.Obs Period

Full sample : estimate the entire period before (after) refers to the period before (after) the integration of the relevant market in the NSC trading platform SD : Standard Deviation SK : Skewness coefficient k : kurtosis coefficient Q(20) : Ljung-Box statistics ( 20 delays) for the autocorrelation of returns JB : Jarque-Bera normality test N. obs. : Number of observations * and ** denote statistical significance at the 10% and 5% levels, respectively

In dividing our sample between the two periods (before and after the integration of markets), we notice a decrease in average return and increase in volatility measured in terms of standard deviation after the merger for Belgian and Dutch indexes. For the Portuguese market, the merger appears to have the opposite effect with a remarkable improvement in the average return and a decline of volatility during the period following the merger. We then try to verify these hypotheses empirically.

Empirical modeling of volatility Following Engle (1982), we introduce the ARCH models which, unlike other traditional models based on ARMA models, admit that the variance of a series depends on all available information, including time. These models are based on the estimation of conditional variance. Because of their high accuracy, these processes are widely used in financial literature and continue to be the subject of several extensions. To mention only the most used models, we denote the EGARCH process, TGARCH, QGARCH, IGARCH, ARCH-M ... The modeling of our return series allow us to retain the GARCH (1,1) introduced by Bollerslev (1986). As demonstrated by several empirical studies, the process GARCH (1,1) provides very good estimates of the volatility of financial series compared with other models from the ARCH family (Hansen and Lunde (2001). The equation for the mean of performance is: yt = c + ut (eq. 1)

Where c is a constant representing the trend. The random variable ut is white noise as low as: E (ut) = 0, E (utus) = 0 if s t and E (ut | ut-1) = 0.

The variable ut can be written as:

With t is a white noise, a difference martingale unit variance and independent ht. and ut~GED (0,ht,v) The choice of a GED density is dictated by the inability of gaussian GARCH processes to account for the leptokurtosis of our return series. Omitting the subscript i to simplify the notation, the GED distribution is:
,

with

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is the gamma function. The parameter v indicates tails-thickness. For a normal density, this parameter is equal to 2. Where v is less than 2, the distribution of ut has thicker tails than a normal distribution (leptokurtic distribution). Bollerslev (1986) defines the conditional volatility process noise ut as: h h (eq.2)

ht is considered the conditional variance because it is derived from information passed to the period t-1. drives the level of the variance. The other two parameters determine the dynamic behavior of the series: is generally interprated as the persistence and as the impact in volatility of new information. Once we have defined our model estimation, the second step of the method is to estimate the variance of the whole sample, then to divide the sample into two parts. The results obtained are summarized in the following table (table 3).

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Table 3: Estimates of GED-GARCH model (1.1) for the three markets

Aex 25

Psi20

Bel 20

Sample

full

before

after

full

before

after

full

before

after

0.00004

0.000041

-0.00015

0.000466**

0.000032

0.000709**

0.000121

-0.00006

0.000244

4.955E-6**

8.148E-6**

0.000014**

2.597E-6**

8.863E-6**

6.037E-6**

3.445E-6**

4.926E-6**

4.996E-6**

0.879348**

0.849177**

0.825764**

0.839964**

0.777419**

0.693507**

0.819825**

0.772211**

0.81528**

0.10296**

0.105698**

0.145452**

0.121495**

0.128932**

0.129864**

0.168548**

0.201113**

0.167746**

0.00028

0.000181

0.000486

6.73828E-5

9.46406E-5

3.4179E-05

0.0002963

0.000185

0.0002945

1.665289**

1.562584**

1.596549**

1.285629**

1.382813**

1.25263**

1.539599**

1.491237**

1.55674**

is the unconditional variance of the series implied by the GARCH structure

before (after) refers to the period before (after) the integration of the relevant market in the NSC trading platform

** denote statistical significance at the 5% level

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With a parameter v which ranges between 1.25 and 1.66, we can confirm that these markets have returns characterized by thick-tailed distributions. Furthermore, and according to the results found, we note that the three estimated coefficients (, 1 and 2) of the GARCH equation are significant at 5% level. Moreover, in the equation of conditional variance, we observe that 1 is still well above 2. This means that large market shocks affect the estimate of future volatility slightly. The dynamic behavior of volatility also indicates an increase in the volatility persistence (1) only for the performance of the index Bel20. If we look at the parameter that indicates the degree of market sensitivity to new information (2), we note that its value has declined only for the Bel 20 index, whereas it increased for the other two indices during the period following the integration. This means that the Dutch and Portuguese markets reacted more intensively to new shocks after their integration. The integration on the same exchange platform NSC appears to have had negative effects on the volatility of these markets particularly related to their increased sensitivity to information issued: following large shocks affecting them, these markets will react more intensively leading, in the case of the Dutch market, to an increase in the level of its unconditional variance. This situation is better for the Belgian market, which seems to take better advantage of the integration. Regarding the unconditional variance, it oscillates between 6.738E-05 for the performance of the Portuguese index and 0.0002962 for the Belgium index. Market integration has been modeled by dividing our sample into two sub-periods: before and after integration. We subsequently calculated the estimated unconditional variance during each period. According to the results obtained and summarized in the table 3, we note that the value of the unconditional variance increased after integration for the Dutch index (AEX 25) and the Belgian index (Bel 20 ). Conversely, this value was significantly decreased for the Portuguese index (PSI 20).

Empirical test of structural breaks in stock market volatility Once we have estimated our sample throughout the full period and during the periods before and after integration, the breaking method focus on changes in the parameters in the variance equation of the GARCH setting. We write the two equations related to the sub-periods before and after integration: h h h h , avec 1 , avec t T (eq.3)

means the date of adoption of NSC by each merging market. To test the hypothesis of changing the coefficients of the equation of the conditional variance between the two periods (eq 3), we propose a likelihood-ratio test that compares the constrained model (coefficients (, 1 and 2) are constant throughout the period of study-

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hypothesis H0), to the unconstrained model (these factors vary between the two sub-periods H1 hypothesis). The test of H0 is conducted using a likelihood ratio calculated from the variance-covariance of residuals. Statistics follows asymptotically chi-square test with one degree of freedom equal to the number of restrictions. Our test is written as follows: : ,
:

With 1, 11 and 21 refer to the coefficients of the equation of conditional variance on the pre-integration, while 2, 12 and 22 refer to the post-integration period. The results obtained are summarized in the following table:

Table 4: Likelihood-based tests Aex 25 Statistiques Pr>Khi 2 0.00 1.0000 Bel 20 0.00 1.0000 Psi20 33.38 <.0001

For the Dutch and Belgian index, the LR test statistic calculated is equal to 0 (with probability greater than 1). This statistic is compared with the statistics provided from the table of the Law Chi-Two to three degrees of freedom. At a confidence level equal to 5%, we do not reject the hypothesis H0. Thus, integration at the same exchange platform NSC did not affect the volatility markets in Belgium and the Netherlands. In contrast, with regard to the Portuguese market, the results allow us to reject the hypothesis H0 of equality of coefficients of the equation of the conditional variance between the two sub periods. The integration of the Portuguese market into the common trading platform NSC seems to have affected the Lisbon market volatility. 5. Conclusion and remarks In this paper we have looked at the evolution of volatility in three merging markets forming Euronext Stock Exchange and whether it was affected by the merger. Our analysis allows us to see that mergers do not affect merging stock markets in the same way. A positive effect was observed only for the Portuguese place that has a relatively lower size and level of development than the other Euronext financial places. For the Belgian and Dutch markets, no effects were observed following the merger.

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Our study conclude that while no adverse effects were observed following the merger, however, the expected benefits of the merger in terms of volatility seem very unevenly distributed. In this case would the expected effect of the merger depend on the characteristics of each market? And if so, what are the motivations of leaders of major stock groups following their merger? Since such strategies would allow for a size increase now vital to remain competitive nationally and internationally, would these motivations rather be of a strategic or a political order? This would go hand in hand with the idea that the exchanges would have to consolidate to survive. This idea could be the subject of further work which will be based on other cases of consolidation in order to verify these results. We are thinking especially of the OMX merger and more recently the merger between Euronext and the NYSE or between OMX and Nasdaq.

6.

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