European futures and options trading, estimated at some $62 trillion in 2011 by the World Federation of Exchanges, is systemically important to the European financial system.

Largely traded on exchanges, futures and options allow institutional investors, such as pension funds, to hedge bets on shares and limit any losses on a stock or index.

The European futures market has long been tied up by the two largest derivatives exchanges in the region, owned by Deutsche Boerse and NYSE Euronext, competing for futures liquidity.

The planned $9 billion merger of the two exchanges, announced a year ago, immediately raised concerns among their customers who said the combined group would have over 90 percent of European stock options and single stock futures trading.

Trading firms typically don't like one exchange to get a monopoly in a single asset class because this allows that trading venue to hike fees.

It was such antitrust concerns that were behind the European Commission's decision to block the planned merger, leaving the exchanges' effective duopoly in place.

But this status quo looks set to change as Europe's regulators, issues raised by the merger ringing in their ears, look to break down the virtual monopolies held by incumbents.

"The attempted merger ... brought competitiveness in European futures to the fore. Regulators now believe the industry needs to become more competitive and they are now determined to drive that through," said Steve Grob, director of group strategy at trading system specialist Fidessa.

TECHNICAL BARRIERS

Europe's top futures markets have been able to see off competition until now for two technical reasons: the proprietary nature of the underlying futures contracts and the closed nature of the exchanges' futures clearing houses.

Futures contracts are based on legally binding licenses which tend to be owned by the exchanges that trade those contracts.

Any new entrant looking to challenge an incumbent needs access to the underlying license to launch a rival contract, so that entrant effectively finds itself having to ask an exchange for permission to go into competition with it.

Clearing is the other problem.

Clearing houses, which tend to be owned by the exchanges which they support, sit between exchange trading clients and demand from them collateral to be used to refund any members left out of pocket if one trading firms defaults.

These collateral deposits, known as default contributions and margin calls, are a huge drain on exchange members' scarce collateral reserves, so they are largely reluctant to use more clearing houses than they need.

New entrants are faced with having to convince trading firms to double their collateral allocation to support a new, rival clearing house that effectively allows the client only to trade a product they already trade.

Alternatively, a new entrant has to convince the exchange to open up its clearing house and allow trades to settle their irrespective of where they are made, in a legal arrangement known as fungibility.

"Naturally there has been resistance to fungibility from the main exchanges. Without the regulators stepping in and compelling them to open up their clearing houses, it's not going to happen" said Grob.

REGULATORS STRIKE BACK

These licensing and clearing issues were at the heart of the debate over whether the Boerse/NYSE merger would hurt competition.

"The exchanges themselves offered to open up to win regulatory support for their merger so ... they can't now turn round and claim it can't be done," said Simmy Grewal, an analyst at research house Aite Group.

European regulators are already on the offensive, passing drafts to force all exchanges to make available their licenses and open up their clearing houses.

"Regulation ... is going a long way towards removing the vertical silos that dominate the European futures market and pave the way for the emergence of new European futures trading venues," said Grewal.

One firm awaiting these new rules is the London Stock Exchange, which has experienced first hand the problems of setting up a new futures market since its Turquoise platform challenged Liffe with a FTSE 100 future in June last year.

"We've always said getting into the European futures space would take a while, given there are large incumbents in Europe," said Doug Webb, the LSE's chief financial officer.

"We said we needed access to the intellectual property and there are still key products where we don't yet have this access and we've always said we needed access to a good clearing system and we have been lobbying for improvements in clearing to make the market more competitive," Webb said.

"There are positive signs from the legislators and we look forward to the relevant changes coming through," Webb added.

LARGE OPPORTUNITIES

Richard Perrott, an exchange analyst at Berenberg bank, believes the LSE's planned 1 billion euro acquisition of Anglo-French clearing house LCH.Clearnet, one of the largest clearers in the over-the-counter (OTC) markets, presents an opportunity.

"In a stroke, a merger would position LSE as the leading OTC derivatives clearing house and provide large cross-margining opportunities for Turquoise derivatives," said Perrott.

Cross-margining is where the margin required from clients trading an asset and its natural hedge, such as a stock and its future, are netted off so an investor only pays margin on the outstanding exposure.

This would dramatically cut collateral requirements, which is attractive to banks and brokers who are struggling for high-grade collateral at a time when it is increasingly in demand.

As well as overhauling Europe's listed futures business, international regulators are looking to force the vast $600 trillion OTC market to use exchanges and clearing, further raising the stakes in Europe.

"Regulation is forcing a whole raft of products on to exchanges and this is crucial because the collateral required as margin increases dramatically in a cleared OTC market, which is potentially lucrative for clearing houses and futures brokers," said Fred Ponzo, managing partner at consultancy GreySpark Partners.

Grewal said the collapse of the Deutsche Boerse/NYSE Euronext deal, coupled with planned regulatory reforms, should be good for competition in European futures.

"Potential new entrants like the LSE or Nasdaq would have been wary of taking on a giant like a merged Deutsche Boerse/NYSE Euronext but will feel more confident about taking them on separately," Grewal said.

(Editing by Alexander Smith and David Holmes)

By Luke Jeffs