STOCK exchanges have not been lucky in love recently. Deutsche Börse’s proposed merger with NYSE Euronext was blocked by regulators in February. Romances between the exchanges of Singapore and Australia, and between the Toronto bourse and the London Stock Exchange (LSE), have also fizzled.
Tired of such dalliances, the LSE has taken up with the plumber. On April 3rd its shareholders backed its plan to take control of LCH.Clearnet, a big clearing-house. Clearing-houses are the back-room wizards of the exchange-traded securities and derivatives markets. They ensure that once a deal has been agreed upon it will be honored, even if one of the parties goes bust. The 2008 financial crisis proved their worth. Interbank markets seized up because no bank knew how big a risk the other was carrying, but the clearing-houses had a much better idea of their exposures and could rapidly demand more cash or other collateral from counterparties.
Regulators now want clearing-houses to act as central counterparties (CCPs) for as many derivatives transactions as possible. Their biggest target is the mountain of over-the-counter (OTC) derivatives products, whose notional amounts outstanding, reckoned at around $700 trillion in June 2011, easily dwarf the $83 trillion of derivatives on exchanges.
Some OTC derivatives are already centrally cleared: LCH.Clearnet’s SwapClear service has $290 trillion of interest-swaps on its books. Many are not. A G20 resolution in 2009 set a framework for moving standardized OTC products into clearing-houses. This is being applied through bits of legislation worldwide, most importantly via the Dodd-Frank Act in America and the European Market Infrastructure Regulation (EMIR) in Europe, which was voted through the European Parliament on March 29th. Any remaining bilateral deals would be much more expensive for banks to carry on their books.
All of which means that the volume of business flowing to clearing-houses, and the fees they can charge, will rise. For a stock exchange like the LSE, whose trading volume in cash equities is being eroded by much cheaper multilateral platforms, it makes sense to risk overpaying–the deal values LCH.Clearnet at around EUR800m ($1.1 billion)–to secure a business that is almost bound to grow by regulatory fiat.
Others are also crowding round. NYSE Euronext’s merger with Deutsche Börse would have plugged it into Eurex Clearing, the German exchange’s CCP. Now it will work on making NYSE Liffe Clearing, which clears the trades on London’s Liffe futures exchange, a full CCP. On March 28th it announced plans for its continental derivatives-clearing activity to migrate there by early 2014, subject to regulatory approval (its continental cash equities will continue to be cleared by LCH.Clearnet).
This will create new concentrations of risk. If the CCPs consolidate into three or four big players in Europe, and a handful more worldwide, that will be a lot of risk tied up in a few institutions. Since they are involved in cross-border business and meant to be “interoperable”–ie, allowing access to a wide number of counterparties–the responsibility for the bail-out of a CCP may not be a clear-cut geographical one. All this should be sorted out before the game goes much further.
Another looming problem is the quality of collateral that CCPs take. Apart from cash, the most common type of collateral posted with clearing-houses is government bonds. These no longer have the “risk-free” status they used to enjoy. As more deals migrate to CCPs, the pressure to find suitable collateral could intensify (by how much depends on the extent to which clearing enables offsetting transactions to reduce the amount of collateral needed). There is a risk that clearing-houses could expose themselves to assets which are not as stable as they should be.
Clearers swear blind that they would never relax their standards. “We’re not plumbers, we’re risk-management firms,” says Ian Axe, the boss of LCH.Clearnet. This is true, but it and many other CCPs are run for profit, and are bound to steer a course between risk and reward. The European Securities and Markets Authority is supposed to set new capital rules and collateral standards for CCPs by June 30th. What regulators give with one hand, they may take away with the other.