New central counterparties in Europe have brought the costs of clearing down. But a relentless price war could lead to greater complexity and lower standards of risk protection. Nicholas Pratt reports...
New stock exchanges that have emerged in the last two years to challenge stalwarts like the London Stock Exchange (LSE) have been successful in attracting business. The likes of Chi-X and Turquoise – the so-called ‘multilateral trading facilities’ that launched following the MiFID regulations – have led to lower tariffs across the board and for ‘best execution’ to become more realistic for fund managers.
But in parallel to their development, there is also a crop of new central counterparties (CCPs) – the platforms used to clear trades – that has sprung up.
Rather than using the existing CCPs such as Eurex and LCH Clearnet that are used by traditional exchanges, the new exchanges have forged links with the new pan-European CCPs as part of an attempt to offer more competitive clearing for customers.
Currently there are three major new CCPs. EuroCCP provides clearing for Turquoise and is owned by the US-based Depository Trust and Clearing Corporation (DTCC). EMCF provides clearing for Chi-X and Nasdaq OMX, which is owned by Belgo-Dutch bank Fortis (which in turn is under state control). Also there is X-Clear, which provides clearing for the London Stock Exchange and is owned by Swiss-based financial market infrastructure provider, SIX.
However, these new entrants have created a divide in the market.
On the one hand, there are those users that value the benefit of competition and cheaper costs that they have bought; on the other hand are those that fear complexity will result from a proliferation of different CCPs if it means multiple connections to different clearing venues, all with their own unique models, are needed.
More importantly, there is a danger that too many CCPs will increase post-trade and back-office costs, thus negating the savings made by lower trading costs on the execution side.
The coexistence riddle
“The market is trying to create competition at every level and I’m not sure that the price savings are worth it,” says Florence Fontan, director of public affairs for BNP Paribas Securities Services. “The back-office complexity is significant and this means that participants are not maximising the potential savings on offer.”
Other asset servicing firms are in favour of the competitive model. “I firmly believe that we need more than one because competition is beneficial for the market,” says Paul Bodart, executive vice president for BNY Mellon Asset Servicing. However, there is a caveat. “If we are to have multiple CCPs they must be able to interoperate so that two different trading firms can execute on the same MTF and clear with different CCPs, but still be able to communicate for netting purposes.”
The EC’s code of conduct dictates that trading firms should be able to choose their preferred clearing and settlement partners regardless of the venue on which the trade is executed, but as yet the coexistence riddle is yet to be solved.
“Interoperability is easy on paper but technically difficult because it involves too many parties,” says Fontan.
Even if firms are able to consolidate all of their own clearing with one entity, that CCP would have to maintain multiple connections to all the MTFS and all other CCPs, some of which would be pan-European like EuroCCP and EMCF, while others are still domestically focused, such as Eurex.
More importantly, there is also a risk element involved, says Fontan. “All of the CCPs have different risk models. The level of protection offered by one CCP may be consistent with my risk policy, but it then has to link with other CCPs that may not have the same level of protection and this will pollute my risk model.”
The practical aspects of interoperability – getting access to the trade feeds of all trading venues – has not been a particular challenge, says Anthony McGuigan, general manager of SIX x-clear. “Many of the exchanges with incumbent CCPs have to build a router, and legal agreements between all parties need to be signed. This takes time and effort on behalf of all parties,” says McGuigan.
The recent decision by the LSE to have x-clear as an additional CCP competing alongside LCH Clearnet, which went live in December, took two years to get up and running. McGuigan says it was the demands of clients that made interoperability possible.
“Clients have a lot more power than they used to, including the fund managers who sit behind those trades. Exchanges and CCPs have to make their costs publicly available as per the code of conduct that all have signed up to, which means that fund managers should be able to work out the cost of clearing easily,” says McGuigan.
“Clearing fees have reduced dramatically over the last few years but what I suspect is happening is that the settlement banks are often holding or increasing the fee they charge just for sitting there in the middle of the process. It is the elements included in this charge which the fund managers have to start questioning."
But how competitive can the CCP market be? Aside from a price war, what distinctions can be drawn from rival offerings? Service is the oft-quoted feature that the CCPs will highlight – from breadth of coverage to interoperability – but how much room for innovation is there in the back-office world of clearing and settlement?
Too much competition?
Risk management and the guarantee of a high settlement rate is the first thing that clients will look for, but is this in danger if the competition between CCPs gets out of hand and an aggressive price war starts to affect the ability of CCPs to carry out their chief requirement? “The CCPs have agreed to compete on price and service but not risk. Everything has to be covered on that, but there are a lot of different aspects to a service other than risk management,” says McGuigan.
Diana Chan, head of EuroCCP, says that the arrival of new CCPs is just a natural consequence of the post-MiFID dynamics in the execution-venues business and has similarly lowered market prices. “Since the arrival of EuroCCP we have seen the other pan-European CCPs drop their prices by more than 50%.”
However Chan does concede that an ongoing price war has the potential to cause strain on CCPs’ risk management processes.
“Participants want cheaper prices, but are maybe not aware of the value of robust risk protection. Some of them may select to trade on platforms with a CCP that collects the lowest margin – but the CCPs need sufficient margin to protect themselves and other participants against a potential bankruptcy or default.”
Chan argues that a CCP with enough economy of scale can offer low-cost clearing without compromising risk. With the DTCC set to acquire LCH Clearnet, this would create the largest clearing house in Europe. Chan says that the aim is to eventually migrate both LCH and Clearnet onto the pan-European CCP platform.
But there are those that expect this to be a lengthy and costly process, particularly given that the LCH Clearnet merger has still not been completed at operational and platform level.
For BNP’s Fontan, another concern is that the pan-European EuroCCP platform does not offer the same level of protection as the LCH and Clearnet platforms. “The ideal scenario for us would have been a merger between Eurex, EMCF and LCH Clearnet. The DTCC is, in principle, a move in the right direction as it may reduce clearing costs, but the level of protection must remain the same. At the moment there are still lots of open questions about the project.”
The uncertainty around the clearing industry is not helpful at a time when firms want reassurance their trades will not fail rather than to witness a relentless price war. The sooner the industry can agree on the model that offers the most efficiency and protection, the better it will be for fund managers and all other underlying investors. Unfortunately, it does not look like this agreement will arrive any time soon.
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