Over the past year or so, almost all the large exchanges have announced their intention to enter, or made moves further into, the over-the-counter (OTC) derivative markets. The Chicago Mercantile Exchange has formed a joint venture in the short-term interest rate markets with broker Tullett-Liberty; Liffe and its competitor, the London Stock Exchange (through its EDX subsidiary), have both ventured into the OTC equity derivatives markets; the New York Mercantile Exchange (Nymex) has entered the OTC energy markets. The list goes on.
Many believe these initiatives will compress margins at banks, yet some of the largest players in the market appear more than optimistic about the challenge they represent.
Patrice Blanc, chairman of Fimat, the brokerage arm of Société Générale, says: “The exchanges are competing with us to an extent – but I am not sure it is really a threat at this point. Most of the competition is between the exchanges themselves – and that can only benefit us.”
Yew Meng Fong, the managing director of securities services at Deutsche Bank, believes the growing involvement of the clearing houses and exchanges in the OTC world has had a positive impact on the way the bank conducts business. “Such involvement ultimately enables us to use our risk capital more efficiently by netting our exposures down,” he says.
Mr Fong points to Nymex’s OTC energy clearing initiative in the US, which, he says, has improved the German bank’s level of comfort in managing OTC operational and risk exposures in the energy and related markets. Nymex expanded into OTC clearing services shortly after Enron’s collapse in a bid to see off rival IntercontinentalExchange and to encourage risk-averse banks back into the market.
He says: “This has been a very positive development for the wider energy markets and may have helped to eliminate much of the squeamishness that surrounded OTC energy trading following the collapse of Enron. If this had not been in place, there may have been a marked fall-off in activity over the past 18 months.”
Blossoming markets
Mr Blanc, meanwhile, highlights the Brazilian swap market – which has been built up almost entirely on the back of the clearing services provided by the local exchange – as a “prime example of how a market has blossomed” on the back of similar initiatives. “This market would undoubtedly be far smaller if there were no central counterparty eliminating the inter-dealer risk,” he says. “There has obviously been less imperative for a similar system to be developed in the US or Europe, where counterparty credit is far stronger. But if it were put into place here, the markets would flourish. Now that Basel II is pushing banks to find better ways of managing their capital, we may well see similar systems emerge outside Brazil.”
Alex Wilkinson, head of listed products at Dresdner Kleinwort Wasserstein, says: “A lot of banks – especially those that are active in the more credit-orientated areas of the market – are, in effect, acting as small OTC clearing houses to their own hinterland of clients. Quite obviously, these will not be the first to welcome the competition from exchanges and clearers as they stand to take away a far from inconsequential amount of income from them.”
Alex Wilkinson: head of listed products, Dresdner Kleinwort Wasserstein
Reduced capital costs
Mr Wilkinson argues that many of these larger institutions – which derive revenue streams from clearing related business – will not want see these pockets of liquidity cannibalised, however much it may lower their own costs of capital. Other institutions that have less well developed income streams from the clearing side of the OTC business will welcome the move. “On the one hand, the market will level out, giving them equal access to a wider range of clients. On the other, their own costs of capital will be reduced significantly,” Mr Wilkinson says.
Terry Boyland, the global business manager for securities settlement and GlobeClear with JPMorgan’s Institutional Trust Services business, represents the larger bank constituency. However, he also welcomes the move by exchanges and clearing houses. Although he admits the exchanges have been making it easier for second and third tier players to become exchange members – and thereby enter a space in which the bank has traditionally operated. He claims that JPMorgan does not feel challenged. “This does not present a threat per se. We welcome their presence,” Mr Boyland says.
Multiple market clearing
Mr Boyland argues there are still opportunities. For example, he says that while many end users might welcome the clearers’ initiatives, often they do not want to have to manage direct relationships between themselves and hundreds of clearing entities around the world. In addition, many such firms do not have the credit capabilities or the infrastructure to be able to deal with multiple market clearing arrangements. “So while they may use direct on-exchange market access, they will often still use us as a general clearing member,” he says. “Others may even set up as clearing members at the clearing houses but won’t want to deal with the central counterparty elements themselves, and will pass this work back to us.”
Of course, Mr Boyland has the enviable position at JPMorgan of being an active trading participant on exchanges, a major counterparty in the OTC markets and one of the largest clearers and custodians globally. Wherever business is done – and as long as volumes continue growing – JPMorgan will benefit.
Mr Blanc occupies a similarly privileged seat at the high table. Fimat is known mostly for its activity in the exchange-traded markets but it is also active and growing its activity in OTC products. He says he welcomes the clearing houses’ progression into the OTC space.
“The more of this business that is cleared, the more business will be done in the OTC and on-exchange markets, which is obviously good for us,” he says. “If we were purely an interdealer broker, we might not welcome this shift so much. But as an interdealer broker, a general clearing member and a futures commission merchant, we stand to benefit.”
Clearly, few entities worldwide possess the same credentials or size as the global operators. A lot of smaller, capital-poor and credit-sensitive broker dealers will have their margins eroded as their clients grab the opportunity to deal directly on exchange; even some of the smaller clearing entities may be forced to retreat from the business.
Niche area
Mr Boyland is unrepentant when he says he sees the clearing business becoming “an increasingly niche area in which a few large clearers like ourselves” will operate. He adds: “We will provide a link between exchanges, clearing houses and smaller players, and there are a limited number of players that could compete where we do. While some may be able, from a technology or risk management standpoint, to do this, they do not have the credit strength – and vice versa.”
JPMorgan’s and Fimat’s positions could, of course, become untenable if – or when – the exchanges and their clearing partners move a step further down the chain or across the client base. Heinous as the suggestion may seem, it is not unfeasible to suggest that infrastructure players may – in the not so distant future – begin to target hedge funds as clients, competing with banks in the lucrative prime brokerage markets, offering all-in-one clearing and trading services. Mr Blanc and Mr Wilkinson believe this is unlikely, however. “The worst case scenario for us would be the emergence of a single global clearing house, but that is clearly not going to happen,’ says Mr Blanc. “And because hedge funds transact across so many markets, they will continue to want to use prime brokers like ourselves to manage their relationships with the different entities. I don’t see the exchanges or their clearers being able to compete with us in prime brokerage.”
Taking on prime brokers
Mr Wilkinson adds: “The clearing houses won’t move directly down to hedge funds and begin offering prime brokerage-type services – they are already doing so vicariously by actively encouraging general clearing members to provide an enhanced range of clearing and counterparty services to their customers.”
Wishful thinking? Maybe. A recent Mercer Oliver Wyman and Lazard Frčres report, Securities Servicing: Profiting from Outsourcing and Operational Risk, dealt with precisely this issue. In it, Imran Gulamhuseinwala, a sector analyst at Mercer Oliver Wyman, pointed out that the competitive boundaries between custodians, prime brokers and clearers are now blurring.
In Mr Gulamhuseinwala’s vision of the future, fund management servicing needs will converge along with vanilla execution and post-trade processes, while cash and derivative products will become “increasingly fungible”. In such a world, why wouldn’t a clearer begin offering prime brokerage services?
Mr Gulamhuseinwala believes they will. “For the prime brokers, the skew in profitability between large and small players will result in some small players exiting,” he says. “And some of the mid-tier clearers are likely to become acquisition targets as the largest clearers try to build scale.”
Unlike the bankers canvassed, who see scope for niche or large scale general clearing members working alongside clearing and exchange entities, Mr Gulamhuseinwala favours the positioning of only the full-service providers (those that own custody, securities processing, broker-dealer and prime brokerage activities). Regretfully, he sees no evidence of banks harnessing the potential of the exchange and clearing silos to offer a more coherent set of services.
