As derivatives exchanges come under fire from bank-owned consortiums, similar to Project Turquoise in the equities market, the focus has momentarily turned away from trading platforms towards clearing in the derivatives market, as derivatives exchanges seek to gain or retain revenue from clearing the products that they trade.
Electronic Liquidity Exchange (ELX – formerly Four Seasons) in the US will launch contracts similar to those traded on Chicago Mercantile Exchange Group (CME), although the embryonic Project Rainbow is understood to have its sights set on rivalling Liffe and Eurex.
This is sorely testing the anti-competition issue of building vertical monopolies in the name of innovation. As exchanges argue that control over clearing enables them to innovate, the vertical model is essentially a closed shop that takes away the choice of clearing that the regulators and member firms are pushing for. It lessens the potential for cross-margining and removes any hope of fungibility between contracts.
Shifting ideas
With the announcement that Liffe will take its clearing out of LCH.Clearnet, the once-mooted idea of building a horizontal central counterparty utility structure is fast fading into the distant past.
It was also a well-timed move because Project Rainbow, which, it is understood, would launch contracts to rival those traded on Liffe, had approached LCH.Clearnet about clearing the new venture. The establishment of LiffeClear would scupper any plans to design contracts that could be fungible with those traded on Liffe.
| However, Phil Bruce, senior strategy adviser at NYSE Euronext, says that the exchange has been considering changing its clearing arrangements since the middle of last year to conform with the vertical industry model. Liffe is the only financial derivatives market that does not have its own vertical clearing arrangements, and the establishment of LiffeClear will enable the exchange to gain full control over its clearing operations and revenues. |
Clearing house
Mr Bruce says: “When Liffe started in the early 1980s, there was a clearing house already in existence in London, which it was strongly encouraged to use. Most other start-up derivatives exchanges built their own clearing houses as well. The driver behind LiffeClear is to put Liffe on a par with its competitors.”
Mr Bruce says that the reason for this decision now is because of the merger with NYSE Group last year, when Liffe’s clearing arrangements came to the attention of analysts and were found to be less attractive than the vertical arrangements of its peers.
The agreement means that the company will create its own central counterparty, LiffeClear, to clear and become principle to contracts matched on Liffe.
LiffeClear will call margin, charge fees, operate its own technology; and it will outsource the default management, the payment and collection of margin, via LCH.Clearnet’s banking system.
Mr Bruce adds: “In the event of the default of a LiffeClear member, LiffeClear’s contractual arrangements with LCH will require the defaulting member’s position and margin to be passed to LCH.Clearnet for liquidation management. This will enable the defaulter’s positions in Liffe contracts to be managed along with any of its other positions held by LCH.Clearnet in respect of other markets.”
Possible change
LCH.Clearnet pays and collects one margin daily for each currency. It has not yet been determined whether, following the establishment of LiffeClear, the clearing house will continue to do this, or whether the margin call for LiffeClear will need to be split so that there are two margin payments in place of one.
Mr Bruce says: “In the event that there needs to be two payments, it shouldn’t be a problem for firms. There may be a small cost associated with this but we believe that the other advantages that will be given to firms will vastly outweigh this inconvenience.”
LiffeClear will certainly not be raising clearing fees from the current LCH.Clearnet levels, it will be looking to reduce them. Mr Bruce says: “In addition, from the moment LiffeClear begins, firms will have a clearing service provider committed to investing in, and developing post-trade systems.” This should include investing in an upgrade of the well-established trade registration system/clearing processing system that was developed by Liffe and is used by LCH.Clearnet. This has not been undertaken by Liffe until now because of the expected new clearing platform, which was supposedly being built by LCH.Clearnet but failed to materialise.
A key role
The operation of LiffeClear will preserve a key role for LCH.Clearnet with regard to Liffe business. The LiffeClear proposal does not require LCH members to capitalise to fund a new guarantee structure, unlike Intercontinental- Exchange (ICE) Clear Europe, which is expected to migrate its clearing business from LCH.Clearnet in the summer.
Mr Bruce says: “The LiffeClear approach is much less inconvenient. There is essentially no change for clearing members, other than entering into some new legal agreements. The transition for firms should be all but frictionless.”
Liffe is not prepared to go ahead with the status quo, and instead of implementing the LiffeClear arrangements, it could have terminated its arrangements with LCH.Clearnet and do what ICE is proposing.
Mr Bruce adds: “While this would not be the easiest route forward for Liffe, it would still be better than the status quo.” It is hoped that LiffeClear will be operational by the end of this year.
Needs of the exchange
Kelly Loeffler, the vice-president for investor relations and corporate communications at ICE, says that although alternatives were considered, both the needs of the exchange and of its customers outstripped the existing clearing capabilities.
“End-users are increasingly demanding additional cleared products that ICE wishes to deliver, and we see opportunities for improved risk management processes,” she adds.
By setting up a wholly new clearing house and a new default fund, Ms Loeffler says that member firms will benefit from better and more innovative clearing products, such as the development of cleared over-the-counter energy contracts, enhanced risk management systems and technology.
ICE Clear Europe has completed a successful test of technology and systems in co-operation with all 44 clearing firms in preparation for the launch. Optional testing of a new billing module will begin shortly.
ICE Clear has determined the structure and size of its guaranty fund and other risk protections, and has been actively discussing the arrangements with its risk working group and potential members for some time.
Awaiting approval
Ms Loeffler adds: “Specific details of the guaranty fund have not been laid out publicly as we await approval, but we have indicated that we will fund a portion that would meaningfully reduce the amount required by member firms. We’ve also noted that many firms post more capital with clearing houses than required, so they may be able to efficiently reallocate excess capital.”
In the US, a similar debate is brewing about whether clearing should be vertical or separate from the derivatives exchanges. The powerhouse established by the merger of CME and Chicago Board of Trade is now being questioned with concern being voiced by the US Department of Justice that perhaps clearing should be separated from the exchange, and that a similar clearing structure to the one which exists today in securities options in the US, should apply to futures contracts regulated by the Commodity Futures Trading Commission.
CME Group immediately published a rebuttal to these concerns, arguing that the open interest that arises from exchange-traded derivatives activity is a complicated subject that does not exist in securities – and that such a structure would stifle innovation.
Kim Taylor, the president of CME Clearing, says that in the US the financial intermediaries are favouring a horizontal structure, where they own the clearing, but that the downside of an intermediary-owned industry utility structure is that it directs more of the scale efficiencies of the central clearing model to benefit the intermediary rather than the end user.
Product innovation
Ms Taylor believes that if clearing houses existed only as utilities, product innovation would suffer, as would processing efficiencies, from lack of competitive incentive.
She says: “The market and regulatory environment should not dictate the market structure, but facilitate the operation of different and competing models and allow the market to decide. Competition is created by different market structures. A vertically integrated clearing house will be strongly aligned with the goals of the market and will ensure that new products are brought to market quickly and provide scale efficiencies to remain competitive.”
The same exchanges that seek control of their clearing revenues were once member-owned entities. It is no coincidence that now they are commercial entities, driven by their shareholders, banks are challenging exchanges. There seems no reason why the banks would not one day lay down the gauntlet in clearing and build a clearing utility of their own. They have done it on the trading side, and there seems no reason why they would not, one day, do the same in clearing.
