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LSE-Deutsche Börse tie-up faces major challenges despite possible LCH SA sale

London Stock Exchange Group Plc is edging closer to selling off its French clearing operations as it seeks to appease European regulators over its potential merger with Deutsche Börse AG, but the sale may not go far enough to solve major challenges facing the proposed $28 billion tie-up.

The potential merger has been the focus of a European Union antitrust investigation, with regulators voicing concerns about clearing, saying the combined company would create a margin pool of €150 billion — the largest in the world.

LSE responded by offering to sell off LCH SA, the French operating arm of its clearing business LCH.Clearnet Group Ltd., saying Dec. 20 that it had entered into exclusive sales negotiations with Euronext NV whose outcome, however, is far from certain.

"Despite fears that the EU Competition Commission may reject the […] merger between LSE and Deutsche Börse, the parties clearly still believe the deal is viable," John Colley, a professor at Warwick Business School, said in an emailed statement.

Other exchanges, including CME Group Inc., have been interested in buying LCH SA, but for Colley, a sale to Euronext would be the most logical step. "As half of Clearnet's trade is with Euronext, it makes sense to start there as they can probably achieve the greatest benefits from the purchase, and hence will probably pay the highest price," he said.

A Euronext spokesperson declined to comment further, as did the London Stock Exchange.

More sales may be needed

The potential sale of LCH SA "may prove to be part of the solution" to facilitate the LSE-Deutsche Börse merger, "but I am not sure it solves all the issues put forward by the European Commission," Quirijn Bongaerts, a lawyer for the Dutch Investors' Association, which works closely with the European Investors' Association, told S&P Global Market Intelligence. "In the field of clearing, issues have been raised, and there may be more parts of the merger that need to be untangled."

A merger between the London- and Frankfurt-based companies would combine stock exchanges in the U.K., Germany and Italy and result in what would easily be Europe's largest exchange operator. The size of the potentially merged company has raised concerns about competition, and the EU has narrowed its investigation to focus on derivatives clearing.

The companies have viewed combining their clearinghouses as a key synergy of the merger. Deutsche Börse's Eurex has a dominant position in exchange-traded derivatives, while LSE's LCH.Clearnet represents 95% of the cleared swap market. Concerns over creating too large a player in derivatives markets were responsible for the failure of Deutsche Börse's 2012 attempted merger with NYSE Euronext.

Eric Compton, an equity analyst at investment research firm Morningstar, said the sale of LCH SA would not address the issue of combining the margin pools from Eurex on the Deutsche Börse side and SwapClear LCH Group's clearing platform for interest rate swaps — on the LSE side.

"It will solve some of the issues […] but it does not solve the major problems," Compton said. "There are the regulatory concerns, but there are a lot of political issues, too, and it seems like there are a lot of headwinds there."

But even if the two parties do make it home dry through the European Commission's investigation, the latter is not the only regulator they will have to answer to. German regulators have voiced their concerns about the merger, with tensions over the potential location of the merged company since the U.K. voted to leave the EU in a referendum in June.

"Even if the European Commission does say yes, they have to convince the regulator [in Deutsche Börse's home state] of Hesse," Patrick Young, CEO of crowdfunding platform Hanza Trade, said in an interview.