February 2010

CLEARING & SETTLEMENT: like clockwork

Traders are calling for interoperability among Europe’s various clearing houses. Nicholas Pratt examines developments in the cash equities space

watch.jpgCentral counterparties (CCPs) have never featured prominently on the radar of most fund managers, but as Europe’s securities environment continues to be overhauled, this attitude is changing. Regulators are keen to open up the opaque world of over-the-counter (OTC) derivatives by enabling fund managers to use CCPs rather than relying on bilateral arrangements between counterparties. And fund managers seem largely receptive to the idea.

“We’re looking closely at developments in the OTC derivatives clearing space and the idea of buy-side clearing through CCPs,” says Xavier Hoche, chief operating officer at Axa Investment Managers. “There are some obvious advantages in that it will significantly reduce counterparty risk and make the collateral process easier and more transparent.”

There will, of course, be some cost involved in terms of clearing fees, higher collateral requirements and system changes. And there are still many unknown elements, not least concerning who exactly will be authorised to offer buy-side clearing.

Reasonable demand
Another big concern among asset managers is the issue of interoperability.

“We would like to see a common legal and operational framework and to have all the exchanges and clearing houses talking between each other,” says Hoche. “The ability to switch between venues and not worry about the differences between exchanges would be very welcome and seems quite a reasonable demand to me. But from the conversations we’ve had with the exchanges and the CCPs, they are far too busy sorting out their own solutions to be looking at interoperability this year, unless there is a strong push from the regulators and the market.”

Fund managers would be well advised to keep an eye on developments in the cash equities space where the issue of interoperability is becoming pressing due to the proliferation of CCPs. When the regulators introduced the Markets in Financial Instruments Directive (Mifid), the intention was to create competition in Europe’s securities market, giving traders and investors a choice of venues for executing their trades. An unintended consequence of the directive has been the proliferation of clearing houses and CCPs.

In the pre-Mifid market, execution venues had dedicated CCPs but the new MTFs, or multilateral trading facilities, have spawned a number of new CCPs with pan-European ambitions – the likes of London-based EuroCCP, which is owned by the US-based Depositary Trust and Clearing Corporation, and the Euro Multilateral Clearing Facility (EMCF), which is currently owned by the Dutch government and Nasdaq, but is expected to be acquired by the London Stock Exchange in the next few weeks.

“Mifid brought in competition but not all of it was anticipated,” says Alan Cameron, head of clearing, settlement and custody solutions at BNP Paribas Securities Services. “The multilateral trading facilities became kingmakers for the CCP industry.” Consequently, trading firms and broker/dealers now need to have links to all of these different clearing houses.

The EU’s recent CCP code of conduct was a helpful step, says Cameron, but what is now needed is a level of interoperability across Europe. “At the moment the CCPs are making bilateral agreements but there are presently 18 members of the European Association of Clearing Houses (Each) and although they do not all clear equities, it could become very difficult to keep track of them all and to properly assess the level of risk attached to these CCPs.”

The CCPs are acutely aware of the importance of interoperability. “It will enable multiple central counterparties to service the same markets and platform – in other words, create real competition between CCPs,” says Willem Mooijer, EMCF’s director of sales and client relations.  “Customers will be able to net all trades, saving costs. Interoperability will play a vital role in the strategy to increase efficiency and lower costs in European securities markets.”

But there are significant barriers, particularly regulators’ concerns that linking all CCPs together creates a significant risk to the financial system. Is each CCP robust enough to withstand a major default? If all of the CCPs are connected, is there a greater risk that one failure may bring down all of the CCPs? As Marco Strimer, CEO of SIX x-clear, a CCP which provides clearing for the London Stock Exchange and the Swiss Exchange, says: “Interoperability must be allowed but it must not compromise the safety of the system.” And while he acknowledges that the bilateral arrangements in place with the likes of LCH Clearnet have never been a problem since they were forged back in 2003, there is little experience of linking multiple CCPs together in this way.

Consequently, the regulators are looking for further details of the inter-CCP margin arrangements and the collateralisation of the risks between CCPs. In October 2009 a proposed link-up between LCH Clearnet, EMCF and x-clear was postponed pending further investigation. The CCPs expect these investigations to be completed by February and to hear what links the regulators are willing to authorise.

The current margin requirements used by LCH Clearnet and its interoperability partners involves the bilateral use of collateral, says Wayne Eagle, director of equity services at LCH Clearnet. “We work out how much risk there is versus the CCP on the link, we ask them for collateral and they do the same.” In the event of a default, the collateral posted by the defaulting CCP would be used to close out positions by the non-defaulting CCPs who would then retrieve their collateral. “All of the CCPs that we deal with have signed up to the same agreement and we believe that the fully collateralised approach is the right way – that only the defaulting CCP would lose any money.”

Eagle is confident that the current model can be extended out to other markets, once the regulators are comfortable with it, but the regulators’ reticence has prompted some CCPs to suggest an alternative model. For example, EuroCCP has proposed four key changes to the current interoperability arrangements, one of which involves replacing the current collateral arrangements with an augmented default fund that all CCPs pay into – something which Eagle describes as a ‘survivor pays’ model and which he believes could lead to further defaults.

Eagle also thinks that EuroCCPs proposals run the risk of delaying interoperability yet further by giving the regulators yet another model to be distracted by. “We have a safe, working model today which we can be up and running with, and then, through Each, we can look to fine tune it and suggest alternative models as we move forward,” says Eagle.

According to EuroCCP chief executive Diana Chan, the augmented default fund is both sustainable and scalable and better suited to the market of the future. “Margin exchange works in a non-competitive and bilateral environment where two CCPs are collaborating and are expected to keep a stable population of clients. In a multi CCP environment, this model may no longer be fit for purpose. If we are investing in interoperability and have the opportunity to invest a different model that is more sustainable and scalable, then I think we should use that opportunity.”

EuroCCP has also proposed the creation of a European convention that all CCPs can sign up to that will make the whole interoperability process not only more transparent but also simpler and less costly, says Chan. “The CCPs will need to invest in managing these new exposures to other CCPs – there will be significant legal costs and this is why we are promoting the idea of a convention because we want interoperability to be simple to set up, by replacing all of the different bilateral agreements with a single contract.”

Removing barriers
Perhaps the most controversial of EuroCCP’s proposals concerns the removal of all existing commercial barriers, leaving CCPs free to compete for business at any of Europe’s execution venues. “We are looking at a cluster of CCPs working together – four in the immediate term – and each of these CCPs should be able to clear on any of the platforms within the group, should they wish to,” says Chan. “This would create choice for trading firms that trade on the platforms shared by these four CCPs. It is about breaking that link between single venues and single CCPs and letting true competition in clearing reduce frictional costs in trading. But CCPs have to want to do it.”

LCH Clearnet’s Eagle is against the idea of an interoperability convention and the removal of commercial barriers, believing it will take too long to come to fruition and will actually make the market less competitive. “If a CCP sees its weakness as its inability to connect to new trading venues, then obviously they will call for a convention so that venues have to connect to them, whether they like it or not. If you want competition, you compete across the market. No-one is saying to trading venue participants that they have to connect to every venue in the market so I am unsure as to why every trading venue should connect to every CCP. Trading venues compete for liquidity and CCPs compete for their connections to these venues. That’s the commercial reality – it is not a market where you can order everyone to connect to everyone else.”

New versus old
Do these disagreements over interoperability simply describe what is a battle between the incumbent CCPs eager to protect their market share, and the newcomers, eager to take this share away – as we have seen in the battle between exchanges and MTFs? Not according to the brokers. “There will always be tension between the old and new CCPs but we have seen some helpful work from some incumbent CCPs, for example x-clear has done a lot to promote some form of interoperability, so I don’t think it’s wholly fair to say it is about new versus old,” says Alexandra Foster, head of UK sales at Instinet Europe, the agency broker. 

The idea of every CCP linked to every venue and the possibility of using one CCP for all pan-European cash equities trades may not be of immediate importance to trading firms, admits Foster, but if there were more CCPs linked to more venues, this would be of greater benefit to firms than the current model, she says. “The new CCPs have done a lot on their pricing models and as they have picked up more volume they have brought their prices down, so even marginal interoperability will give firms the option of choosing a CCP that is working optimally for your business and these savings can be then passed onto end investors and fund managers,” says Foster.

As with the savings promised by the MTFs all those years ago but which have yet to fully materialise, fund managers can be forgiven for not getting over-excited at the prospect of savings from an interoperable and competing CCP market. But as an example of how complex interoperability between competing clearing houses can become, and as a foretaste of what they can expect in the next 18 months from the OTC derivatives space, fund managers should indeed be taking note.

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