Much has been said about the need for greater consolidation in the securities industry, especially to bring together the fragmented clearing and settlement infrastructure in Europe but, as Frances Maguire finds, consolidation is not always what it is cracked up to be.

The basic premise that it costs less to run one organisation than it does to run two separate organisations has yet to be proven in the securities industry. Equally, that assumption that having the duplicated costs will halve end users’ costs does not yet hold water. According to Tom Kloet, senior vice-president and chief operating officer of broker Fimat US, merged entities are lucky if they can cut costs to 75% of the total cost of running two entities.

There have been several mergers in the securities industry in the past year or two but the promised benefits of many mergers have yet to transpire. The counter-argument is that consolidation brings efficiencies or greater savings in terms of the amount of collateral needed.

In September 2002, the UK settlement system, Crest, built on a state-of-the-art platform, was merged into the Euroclear empire. There were no staff cuts because the same amount of staff was needed to run both entities. In effect, a small, lean company became the UK subsidiary of a larger operation, with little integration.

No cost savings

A Euroclear spokesman admits that the cost of settlement for UK shares has remained the same. “The savings have been delivered in cross-border settlement in Europe, rather than domestically, where there were already fairly efficient systems.”

For example, Euroclear France, which is the result of Euroclear’s merger with Sicovam in January 2001, has created a link that enables international players to settle French equities at a much lower cost – from anything between E5-E25 through an agent bank to 55c for participants that hold a Euroclear Bank account.

Similar links will be completed in the coming months with Euroclear Brussels and Euroclear Amsterdam. It has not been possible to create the same link for UK shares but there is still hope that an interim solution will be made available sometime between 2004-2008. By 2009, all five settlement systems (if the Euroclear eurobond system is counted) in Euroclear will be replaced with the Single Settlement Engine (SSE). Until then, the benefits of the consolidation of Crest with Euroclear will not be reaped.

Developments of the Crest system were suspended in 2002, with all investment being channelled into the new Euroclear settlement engine. In this case, consolidation will benefit the larger players in 2009 but will bring little or no benefit to the bulk of the smaller Crest users, and even less to investors who have little or no appetite for cross-border investment.

Iain Saville, chief executive of Crest at the time of the merger, and now tasked with finding a common infrastructure for the fragmented global insurance market at Lloyds, says: “The gains from the merger rest on Euroclear creating a single system for five markets. This challenge is very much about how far these markets can be harmonised. If they cannot be standardised enough, the SSE will be very complicated to build, and then complicated and expensive to modify and maintain. Cost savings rely on them getting enough harmonisation to be able to build something to deliver on time and which will last for 10-20 years.”

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Tom Kloet: merged entities are lucky if they can cut costs to 75% of the cost of running two entities

Limited benefits

Likewise, banks will not see any short-term benefits of the recent merger between London Clearing House (LCH) and Clearnet because full integration will not be completed until 2007. Until then, while the merged entity promises to create an annual cost saving of 19% of the two individual balance sheets – estimated to be about E35m – the two companies will continue to function as separate legal entities. A one-off charge of E30m for the merger has wiped out the first year’s savings. Also, while LCH will adopt Clearnet’s system Clearing 21, saving an estimated E23m in merged technology costs, millions will be spent on another system that will be built to clear the LCH contracts that are not currently cleared by Clearing 21 – a system that LCH says it was planning to build anyway.

Although clearing fees should decrease, LCH officials have said that they will remain “competitive”. However, the main benefits that are being mooted are the single interface and, more importantly, the lower collateral needed for products that can be mutually offset with the merged entity.

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Iain Saville: the challenge is how far the markets can be harmonised

Chicago offsets

These mutual offsets will not be as great as those gained by the Common Clearing Link finally agreed between the Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME), however. Mr Kloet of Fimat US says his firm immediately freed up $200m in customer margin requirements from the first phase that went live this year. “This is a cost saving that can be passed directly on to our customers, enabling them to trade more, and a saving that makes our exchange-traded products more competitive against over-the-counter products,” he says.

However, despite the many years that the two exchanges remained rivals while the derivatives industry pressed for common clearing, the consolidation has not reduced the number of clearing houses in Chicago. Fired by the threat of foreign competition from Eurex US rather than any great need to consolidate, the Clearing Corporation, which previously cleared CBOT’s contracts, will now clear for Eurex US.

“It could have been worse: without common clearing, the industry could have had to build interfaces to three clearing houses,” says Mr Kloet. The other savings from common clearing, in the reduction of duplicated efforts, are “not material”, he says, implying that consolidation brings few real benefits.

This is not so much a result of the number of interfaces or the number of organisations to which firms need to connect, but due to the clearing entities being, in many cases, exchange-owned, commercial organisations rather than independent entities.

Craig Smithson, recently retired executive director of UBS in Chicago, says: “When we envisioned common clearing, what we hoped for was an independent clearing entity.” This was not only for the sake of the efficiencies of mutual offsets but the need for organisations to remain competitive. “If you could choose where to clear as well as where to trade, it would result in a much better product.”

Such forces have already resulted in dramatic fee reductions. “Even before Eurex US arrived, CBOT announced two price cuts in 30 days, bringing the cost of clearing a contract down from $1.25 to just 30 cents,” says Mr Smithson, adding that this indicates the vast room for manoeuvre in the face of competition.

Already, there has been a huge climb down on this front in Europe. When the European Securities Forum (ESF) was launched in 1998, representing 23 of the largest banks, it was to push for the creation of a pan-European clearing utility – even with the threat that if the industry could not achieve it, the banks would. Today, the ESF hopes this can be achieved through consolidation and integration, and even pays tribute to the need for competition.

How quickly the need for consolidation turns to the need for competition.

Yew Meng Fong, managing director of securities services at Deutsche Bank, argues that the banks never asked for consolidation. “Why do you need consolidation when the same benefits can be achieved in other ways? It is standardisation and competitive pricing that the securities industry needs and wants,” he says.

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