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Clearing Conundrum

Growing competition among Europe’s futures exchanges is thwarting EU efforts to reduce the costs of securities clearing.

Streamlining Europe’s maze of na- tional securities clearing organizations to bring down the high costs of cross-border equities trading has been a dream for more than a decade. Two years ago the European Union’s Internal Market commissioner, Charlie McCreevy, drew up a code of conduct calling on clearing and settlement bodies to provide price transparency and open access to one another’s systems. But his vision of interoperability in posttrade services faces a growing threat from futures exchanges, which increasingly regard proprietary clearing systems as a key competitive tool.

Last month Atlanta-based Intercontinental-Exchange received approval from the U.K.’s Financial Services Authority to set up its own clearing house in Europe, wresting the business away from its current clearer, LCH.Clearnet Group. ICE’s move follows the April announcement by NYSE Euronext’s futures subsidiary, Liffe, that it will set up a separate facility within LCH.Clearnet, dubbed Liffe Clear, to clear its trades. That initiative will enable Liffe to prevent customers from netting their trades in its contracts with similar products offered by competing exchanges. It is aimed at thwarting Rainbow, a venture by a group of investment banks that plans to launch a rival low-cost electronic futures market. “It’s never been easier or cheaper to start a futures market,” explains Liffe deputy CEO John Foyle.

Liffe and ICE say the changes are needed if they are to vie with Chicago-based CME Group and Deutsche Börse’s Eurex, both of which operate clearing systems. Futures exchanges contend that the proprietary nature of their products and the fast pace of innovation make in-house clearing beneficial. Technically, the new plans don’t fall afoul of the EU code of conduct, which covers only equities, but the growing importance of futures for stock exchanges is eroding distinctions between the two markets.

The London Stock Exchange, which, unlike its rivals, doesn’t control the clearing of its trades but acquired Italy’s clearing system last year when it bought the Borsa Italiana, argues that the futures exchanges are acting in an anticompetitive manner. “They’ve driven a coach and horses through the spirit of McCreevy’s code,” LSE chairman Chris Gibson-Smith said last month at a news conference on the company’s results.

For LCH.Clearnet, which provides posttrading services to seven futures exchanges and five equity exchanges, including Euronext and the LSE, the new ventures pose a double threat. Futures exchanges are the company’s biggest breadwinner: It cleared 1.41 billion derivatives trades last year, compared with 314 million equities trades. Indeed, last month Standard & Poor’s downgraded its outlook on LCH.Clearnet’s AA credit rating from stable to negative because of the threat from the new clearing ventures.

The segregation or removal of large pools of liquidity from LCH.Clearnet’s central counterparty default fund also reduces its ability to offer risk diversification and generate capital savings.

“Nobody wants to straitjacket the exchanges” and dictate how they reduce clearing costs, says Anthony Belchambers, chief executive of the Futures and Options Association. But he says users want to ensure that new clearing initiatives don’t stifle competition.

LCH.Clearnet is fighting back. Last month it struck an agreement to provide clearing services for ICE’s archrival, New York–based Nymex, which has agreed to be bought by CME. The company is also reported to be holding merger talks with Depositary Trust & Clearing Corp., the U.S. clearer that is seeking to expand in Europe.

The failure so far of the voluntary code of conduct to foster interoperability could force the EU Commission to consider legislation to promote open access among clearers and reduce costs, says Oliver Drewes, a spokesman for McCreevy. Warns the FOA’s Belchambers, “If they go to the trouble of bringing forward legislation through the European Parliament, they’re going to look at widening the scope to all listed products,” including futures and options. Such a move could lead to the separation of clearing services to be run on a utility-type basis. That would be the last thing that Europe’s vertically integrated exchanges, which derive a large portion of their profits from clearing, would like to see.