Moral victory

The U.S.'s DTCC failed to sell its counterparty service in Europe, but the region has bought into its risk-reduction philosophy.

In the late 1990s cross-border trading took off, catching the European securities industry unaware. By 2000, when the Amsterdam, Brussels and Paris bourses merged to form the Continent’s signature multinational exchange, Euronext, trading had slowed. However brief, the powerful surge in pan-European activity proved that investors were ready to buy stocks on neighboring markets. It was equally clear that the region’s trading infrastructure wasn’t well equipped to support them.

One glaring deficiency was the lack of a comprehensive clearing and settlement system. Europe did not have a centralized processing entity akin to the U.S.'s Depository Trust & Clearing Corp. to facilitate cross-border trades, possibly leading to the creation of a single stock market.

The DTCC, a utility jointly owned by major U.S. exchanges and financial institutions, offered to help. It published a white paper in October 2000 promoting the idea of a European central counterparty, or CCP. By interposing itself in each transaction -- as a buyer to every seller and a seller to every buyer -- a CCP assumes settlement risk, freeing trading firms to put their resources into maintaining a liquid market.

DTCC executives, however, wanted to go beyond this bit of “thought leadership.” In December 2001 the company introduced its own CCP service, European Central Counterparty. It landed with a thud: Its only customer, the Nasdaq Stock Market’s fledgling Nasdaq Europe exchange, closed last year. European exchanges didn’t want to buy an American-bred settlement system, dooming EuroCCP.

Despite all this, the DTCC’s concept survived. CCPs have been sprouting up all over Europe. In the past year Euronext and its archrival, Deutsche Börse, have launched major CCP initiatives with pan-European and even global ambitions. Other exchanges, including Milan’s Borsa Italiana, started CCPs with a more regional scope.

“It took 15 to 20 years for the U.S. market to evolve into its present centralized model,” notes DTCC spokesman Stuart Goldstein. “Europe has made significant progress over a short period.”

Indeed, some wonder whether there are too many CCPs. The business is only slightly less decentralized and fragmented than the trading markets are.

The European Commission, as part of its drive to harmonize market practices, has begun to evaluate the impact of CCPs. A draft directive issued in February called for open, cross-border competition as the best way to ensure clearinghouse efficiencies.

However, securities industry officials differ over whether CCPs are best operated as mutually owned, DTCC-like utilities or as for-profit competitive ventures. A successful profit-making CCP with sufficient economies of scale tends to devour its competition and could grow into a monopoly, requiring regulatory controls, some experts warn.

“It’s very difficult to have sustainable competition between CCPs,” says Ruben Lee, a London-based consultant and author of an influential book on market structure, What Is an Exchange? The Automation, Management, and Regulation of Financial Markets. “The greater the number of traders using a CCP, and the greater the number of assets cleared through it, the greater the benefits in the form of cost savings and other efficiencies.”

Diana Chan, London-based director of Citigroup Global Transaction Services, agrees that bigger, more consolidated CCPs are better but adds, “In the public interest, for-profit monopolies are not a good idea.”

No monopoly or single utility has emerged as yet, but the number of competitors has started to dwindle: The London Clearing House merged in December with Euronext’s Paris-based affiliate, Clearnet, to form LCH.Clearnet Group. It’s competing on a for-profit basis against Deutsche Börse affiliate Eurex Clearing and other regional clearinghouses.

CCPs appeared first in the futures markets -- the Chicago Board of Trade formed its Clearing Corp. in 1925 -- where traders participate in complex transactions that may take weeks or months to be paid and settled. CCPs carry the risk that either party might be unable to cover its settlement obligation.

The need for CCPs has grown in cash securities markets as well, along with the risks arising from greater transaction volumes and increasingly automated matching of trades. “There is now a very significant possibility that companies are dealing with counterparties they never heard of before and therefore do not know their risk profile,” notes Lynton Jones, founder of London consulting firm Bourse-Consult.

CCPs further reduce settlement risk by netting out the end-of-day credit and debit positions of market participants, lowering the amount of money that has to move within the clearinghouse.

The bottom line? Eurex, a subsidiary of the derivatives exchange jointly owned by Deutsche Börse and SWX Swiss Exchange, says that after it introduced a CCP for equities in April 2003, liquidity on Deutsche Börse’s Xetra electronic trading system rose by 27 percent. Eurex, which had previously launched CCPs for bonds (October 2000) and repos (July 2001), estimates that the facility reduces Xetra participants’ trading costs by E20 million ($24 million) a month.

That helps to explain why CCPs have been proliferating. Borsa Italiana opened a CCP for cash securities in May 2003, a year after it started one for derivatives. Also last May, Swiss clearinghouse SIS SegaInterSettle set up SIS x-clear for London-based Virt-x, the SWX-owned electronic exchange. Spanish futures and options market Meff followed in September with MeffClear.

Conventional exchanges aren’t the only ones embracing the model. New Yorkbased government securities brokerage Cantor Fitzgerald serves as a CCP to enable anonymous trading on the foreign exchange platform that the firm’s ESpeed technology affiliate rolled out late last year.

A CCP will be in place at the inception of the Dubai International Financial Exchange, which Bourse-Consult’s Jones will run. Scheduled to open in the first quarter of 2005, the fully electronic exchange will use LCH.Clearnet as its CCP. “In Dubai we want to trade a variety of products, such as equities, derivatives, funds and bonds,” Jones explains. “In this environment traders can net products out, which will be very useful. Moreover, Western banks may be reluctant to trade with Middle Eastern banks because they do not know them. If you insert a CCP, you remove the risk element and encourage trading on both sides.”

Mirroring the rivalry between Euronext and Deutsche Börse, LCH.Clearnet and Eurex are taking their CCP battle global. LCH.Clearnet won the first big victory in November, retaining the London Stock Exchange’s business after agreeing to cut its clearing fees by 25 percent. The deal will remain exclusive for no more than three years, the LSE says, to “perpetuate competitive tension between for-profit clearing organizations in the best interests of the U.K. equity market and the exchange’s strategic flexibility.”

LCH.Clearnet already has a broad, multiproduct customer base that includes Euronext and one of its subsidiaries, the London International Financial Futures and Options Exchange, as well as the Intercontinental Exchange, London Metal Exchange and online markets BrokerTec, MTS Group and Virt-x (whose members have the option of using SIS x-clear).

Because of regulatory differences between the U.K. and France, LCH.Clearnet operates a discrete CCP in each country. The clearinghouse plans to integrate the two CCPs gradually and expects to have a common set of membership criteria, single-user accounts across all product lines and a fully consolidated technology platform in place within three to four years. As a “virtual single CCP,” LCH.Clearnet offers firms trading a wide range of products on exchanges and over-the-counter markets the ability to choose where they consolidate their posttrade processing and position-holding -- a key competitive advantage, says company CEO David Hardy. Those choices will widen with additional clearing centers; the company has applied to the Commodity Futures Trading Commission to extend its derivatives clearing to the U.S., where it will compete with Eurex US.

Judging by its recent draft directive, the EC isn’t about to set restrictions on CCPs. It favors “an integrated, barrier-free environment . . . in full conformity with the European Union’s competition rules.”

But competition among CCPs can’t last, predicts consultant Lee, because “once one begins to net most of the transactions in a particular asset class, it will be in the interests of everyone else to send transactions through the same netting machine.” Even a new entrant with lower fees would be unlikely to take business away from a CCP that has achieved critical mass, says Lee.

That’s because costs aren’t the only determinant of CCP choice. Participants might prefer to manage assets and collateral on a single platform, enabling surpluses in one market to cover deficits in another. Citigroup’s Chan envisions “cross-market and cross-sectional netting off of collateral requirements, which means risk can be offset in portfolios across markets and sectors.” For example, a trader could avoid having to post a margin by offsetting a long position in Spain’s Telefónica with a short position in France Télécom.

“The market is still a long way from that,” allows Chan. But if institutions and exchanges agree that they have much to gain from a consolidated European CCP, then they now have every opportunity to vote for it with their feet.