On April 15, as Americans were scrambling to get their tax returns in the mail, an op-ed letter written by London Stock Exchange (LSE) boss Clara Furse appeared in the Financial Times, criticizing NYSE.Euronext’s derivatives division, Euronext.Liffe, and the Intercontinental Exchange (ICE) for setting up Liffe Clear and ICE Clear, respectively.
These new entities will give the two futures exchanges their own European clearinghouses, although Liffe’s will outsource the actual mechanics to its longtime clearinghouse, LCH.Clearnet, making it possible for them to create so-called “vertical silos” of trade execution, clearing and settlement. Exchange bosses say they’re doing it to enable true straight-through processing (STP) for their customers and reduce cost, while Furse and other critics say they’re doing it to maintain monopolies in their own respective products. Furse has called on Brussels to intervene.
VERTICAL vs. HORIZONTAL
LCH.Clearnet was formed in 2003 through the merger of the London Clearing House (LCH) and Paris-based Clearnet. It’s a for-profit entity that clears and settles both equities and derivatives transactions for LSE, Euronext.Liffe, the London Metal Exchange (LME) and ICE,among others.
Having so many exchanges clearing their trades via one entity is called “horizontal clearing,” and a key benefit of horizontal clearing, at least in theory, is that it gives end users the ability to cross-margin positions on one exchange against positions on another, although that ability is severely limited on LCH.Clearnet.
Another theoretical benefit to end-users (and arguably a drawback for some exchanges) lies a few years down the road. Under the best-execution provisions of the European Union’s Markets in Financial Instruments Directive (MiFID), futures products should one day be fungible among exchanges and common clearing is the conduit through which such fungibility can be achieved.
“This is the big under-reported story in Europe,” says Kevin McPartland, an analyst with Tabb Group in New York. “There has been a lot of attention on how MiFID will impact equities, but a lot of people are in denial about the fact that it’s intended to carry across the capital markets as a whole.”
There’s no entity quite like LCH.Clearnet in the United States. Almost all securities clearing is handled by the non-profit Depository Trust & Clearing Corporation (DTCC), all equity options are cleared by the Options Clearing Corporation and a handful of derivatives clearinghouses handle clearing and settlement for various futures exchanges, the gorilla among them being the decidedly for-profit
CME Clearing.
LCH.Clearnet, on the other hand, handles clearing and settlement for both equities and derivatives but the issues driving consolidation and competition in equities and derivatives clearing are quite different from each other.
On the equities front, the issue is cross-border clearing and settlement: it costs a fortune for equities investors in one country to buy shares on an exchange located in another country, unless they have an account in that country. Futures clearinghouses don’t face the cross-border settlement issue, but they do face accusations of running monopolies in the products they clear.
EQUITIES CODE OF CONDUCT
For over a decade, Brussels has been threatening to force the creation of a single central clearinghouse for equities if the Continent’s clearinghouses don’t defragment the market on their own either through consolidation or by developing “interoperability,” which is the ability to link clearing and settlement via multiple clearinghouses.
Clearinghouses and exchanges have long countered that a lack of clearing interoperability isn’t the cause of the problem, but rather a symptom itself. The real cause, they say, is regulatory incompatibility, a problem the European Commission is set to tackle via new guidelines for regulators expected in early 2009.
Nonetheless, in May 2006, the LSE promised to work with LCH.Clearnet to deliver interoperability for its listed shares on both LCH.Clearnet and Swiss clearinghouse SIS x-clear, and by November of that year, the Continent’s equities clearers had managed to assuage European Internal Market Commissioner Charlie McCreevy with a voluntary code of conduct promising to deliver Continent-wide interoperability among clearinghouses by this year.
NOT SO FAST
Well, here we are, halfway through 2008, the year of interoperability, and the only project even close to being on the books is the LSE-SIS x-clear link, which has now been on ice for over two months.
LCH.Clearnet says it and SIS x-clear are ready to throw the switch, but the LSE says it needs to reconsider in light of unspecified recent changes in the Continental clearing landscape. One of those changes may be its own purchase, in 2007, of Borsa Italiana, which owns its own clearinghouse, Cassa di Compensazione & Garanzia.
But Furse also is pressuring Deutsche Boerse to honor its interoperability pledge, and the fact that she’s now capable of developing her own vertical silo may simply be a rear-guard action to protect herself if the whole move towards interoperability backslides even further.
On the futures front, it’s a slightly different game, one centered now on LCH.Clearnet. It therefore makes sense to take a look at how we arrived at this point.
Until the late 1990s, the London Clearing House (LCH) wasn’t much different from its U.S. counterparts, getting about 80% of its business from one exchange (the London International Financial Futures Exchange, Liffe), with the remainder divided equally between the International Petroleum Exchange (IPE, today’s ICE Europe) and the LME.
In 2001, the London Stock Exchange (LSE) joined the mix, making it possible for LCH to act as central counterparty for futures and equities and kicking the debate over “horizontal” vs. “vertical” clearing into high gear. From that date on, LCH and LSE would be the Continent’s most vociferous proponents of horizontal clearing in the equities arena, while Deutsche Boerse would be the most vociferous proponent of vertical clearing.
In 2003, following the absorption of Liffe into Euronext, LCH merged with its French counterpart, Clearnet and here is where the current clearing and settlement arrangements for futures were laid out.
At the time, MiFID was just taking shape, but ICE — perhaps mindful of the implications that fungibility would have for futures contracts — re-negotiated its clearing contract to prevent LCH.Clearnet from netting initial margin for positions on its exchange against positions on other exchanges, and the LME followed suit.
Liffe, which remained a major shareholder in LCH.Clearnet, didn’t have the policy written into its contract, but maintained the policy through its influence over LCH.Clearnet. Although firms could net maintenance margin, the inability to net initial margin essentially created three virtual vertical clearing silos with one horizontal settlement house.
COST, SPEED, OWNERSHIP
Over the past few years, sources within ICE and Euronext.Liffe have cited
two common complaints with LCH.Clearnet: that it moves too slowly and that it’s too expensive. Last year, after ICE announced it was abandoning LCH.Clearnet to form its own clearinghouse, a third issue emerged: ownership of open interest (see “New Clearing Landscape,” Futures, May 2008).
The speed complaint shows up whenever you engage an exchange executive on the issue of product development. “LCH.Clearnet comes from an era where you would have one new product every six months or every year,” says one former exchange executive. “And the clearinghouse would be the pontificator on whether the exchange’s product would fly or not.”
An exchange that has to wrestle with its clearinghouse every time it wants to launch a new product has a distinct disadvantage when trying to compete with vertical silos like the CME, which can launch new products on a dime. Then you’ve got the pricing structure, which is not only opaque but handled on a per-transaction basis.
All of these factors are driving ICE and Euronext.Liffe to set up their own clearinghouses, although Euronext.Liffe’s will essentially be outsourced to LCH.Clearnet, resolving the issues of ownership and speed while converting cost to a service fee.
THE REAL BENEFITS
Although cross-margining is the most touted benefit of horizontal clearing, it’s also one that doesn’t exist, except for maintenance margining, at LCH.Clearnet. And no one really seems to mind. That’s partly because there really isn’t a huge amount of offset to be gained with today’s product mix, although it would make plenty of sense if exchanges traded offsetting and competing products through one clearing house. What’s more, member firms earn interest on margin funds, not all of which gets remitted to customers. So, while a proprietary trading shop may prefer having the ability to offset initial margin on different exchanges, a standard clearer does not.
What LCH.Clearnet does offer is a single point of settlement (variation margin is consolidated into a single settlement each day for multiple markets, and a member need only make a single payment to keep itself square across the board) and risk management, which is handled not only by monitoring the finances of member firms, but by maintaining a default fund in case a member goes belly-up.
“The overall level of post-default backing is established as the net of the obligations against all contracts cleared,” says a spokesman. “If we calculated our default fund just for ICE, it would be larger than currently, due to diversification effects enjoyed by horizontal clearers.”
In other words, the ability of a clearinghouse to absorb the risk of one of its members defaulting drops if the clearinghouse has predominantly one or two kinds of customer — like, say, energy companies and banks active in the energy sector, which is the case at ICE.
LCH.Clearnet says that it will probably not be able to reduce its default fund when ICE leaves, and — bad news for ICE customers — ICE Clear will need to maintain a default fund almost as large as that of LCH.Clearnet if it can absorb the risk of its customer base. An ICE spokesman denies this, but it’s not clear regulators will agree with ICE’s calculation.
NEW KIDS IN TOWN
Meanwhile, the latest signatory to the clearing code of conduct is London-based EuroCCP, a subsidiary that the DTCC set up specifically to clear trades for pan-European multilateral trading facility (MTF) Project Turquoise. Both DTCC and Turquoise are consortium-owned by the major banks that use the services.
Futures players, however, are keeping their eyes on another newcomer: Project Rainbow, which also is backed by a consortium of global bankers.
“There have been a lot of start-up futures exchanges in the U.S. in the last decade, and almost none of them have succeeded,” McPartland says. “This could be the time where somebody new comes in and makes an impact.”
