Unclear on clearing

As new pan-European trading platforms get ready for launch, Heather McKenzie reports on the lack of coherence in European clearing

The row that broke out in July between the Italian central securities depository Monte Titoli and multilateral trading facility (MTF) Turquoise over clearing arrangements has highlighted the turmoil in European clearing arrangements. As European securities settlement is becoming ever more consolidated, the clearing side of the equation is fragmenting.

In a letter to Turquoise members, chief executive Eli Lederman said Monte Titoli, the settlement provider for Borsa Italiana, had indicated it would "not allocate resources" to co-operate with EuroCCP, Turquoise's clearing and settlement provider for its pan-European offering across 14 countries. Under Italian law, said Lederman, Monte Titoli is the only facility where securities can settle for a central counterparty (CCP).

Monte Titoli countered that the letter was "inaccurate and largely incorrect", pointing out that it had never been approached by Turquoise in relation to its trading business in Italy.

EuroCCP was recognised as a clearing house by the UK's financial regulator, the Financial Services Authority in March. The move was a significant step in Europe's fragmented clearing landscape, opening the door to competition from EuroCCP's parent, US central securities depository the Depository Trust and Clearing Corp.

Competition in clearing is developing at a frantic pace, driven by changes in the trading landscape brought about by the Markets in Financial Instruments Directive (MiFID), a European Commission initiative to harmonise investment services regulation. In opening up competition, MiFID has generated a number of new trading venues, or MTFs. These need a clearing house and subsequently, two new operators, EuroCCP and EMCF have emerged. EMCF is a CCP subsidiary of Fortis and will provide clearing services for Nasdaq OMX's pan-European market. This is scheduled to start trading in September.

Bob McDowall, senior analyst, Europe at Towergroup believes the number of new MTFs has been somewhat overstated: "There are only three new trading venues for equities that have emerged to compete with the incumbent exchanges," he says. "I would suggest there is not that much competition in equities trading."

Jeffrey King, head of product development, on-exchange services Emea at Citi Global Transaction Services, says while only two new CCPs have emerged in Europe, since they have come on to the scene the incumbents have reacted and a number have brought down their prices. "Some of the clearing houses have come down to charging a flat fee across all markets. The incumbents have had to react, particularly as EuroCCP announced it would offer market volume discount fees."

Incumbent CCPs have been monopolistic for a long time, says King, and for the first time competition is arriving to clearing. "We have seen another knock-on effect from this as Eurex is changing the way it nets, providing users with an option. I don't think Eurex would have done this without the new competition."

What the market really needs, says King, is more widespread interoperability between the incumbent clearing houses and new CCPs. Interoperability is one of the aims of the European Code of Conduct for Clearing and Settlement, developed by the post-trade industry as an attempt to pre-empt a European Commission directive. Signed by the main trading and post-trading infrastructures on 7 November 2006, the code covers four main areas: price transparency, access and interoperability, service unbundling and account separation, and monitoring of industry action.

On most points, the code has delivered, but when it comes to interoperability it has proved to be ineffective. "The most difficult part of the code is interoperability, particularly regarding clearing," says Diana Chan, chief executive of EuroCCP. "A CCP needs to gain the agreement of two parties: the trading venue to give it the trades and the incumbent CCP to set up a link." Chan says there is one objective for interoperability - to give trading firms a choice as to the CCP they use. Trading firms want the same freedom of choice they have in choosing a trading venue to apply in clearing, but if the trading venue owns the CCP there is little commercial incentive to give the firms this choice.

Market forces are not yet operating in European cross-border clearing, says McDowall. In a research note on the European Central Bank's Target2 Securities clearing and settlement system, he said a number of CCPs are owned directly or indirectly by institutional shareholders, whose primary objective is an investment return for themselves and their underlying clients. "Essentially, the power of the institutional investor reinforces the status quo. Should the governance model be changed or should other factors be addressed?"

Chan agrees that nearly all the CCPs in Europe are vertically owned and a number of exchanges are looking at going down this route, including the London Stock Exchange. "When a trading platform owns a CCP it gains revenue, but it also ensures orderliness of its market. Trading firms using the exchange will have peace of mind that deals will settle at the price agreed and the firms will have anonymity."

The moves towards interoperability will not create a single, pan-European CCP, but will enable CCPs to offset risks between themselves, says McDowall.

To date, only SIS x-clear and LCH Clearnet have achieved interoperability, clearing equities trades on SWX Europe (formerly Virt-x), a cross-border trading platform for pan-European blue chip stocks. "Five years ago, Virt-x became the first exchange to offer a choice of clearing venue. It was not a trivial undertaking and the model has worked successfully," says Lee Hodgkinson, chief executive, SWX Europe.

There are more than 80 requests for linkages between CCPs under the code of conduct, but none, apart from the LCH Clearnet and x-clear arrangement, has yet become operational. "The market needs to see interoperability between the new players and incumbents," says King. "EuroCCP and EMCF will cover 14 markets, so having interoperability with these will give you a bigger bang for your buck."

King says he can understand the reluctance of some clearing houses to implement interoperability - who would want to interoperate with an organisation that is cheaper? "The point missed here, however, is that it is the users who want this because it will drive down their costs."

Ruben Lee, chief executive of private research and consultancy company Oxford Finance Group, says while the broad goal of interoperability is to allow market participants and users a choice as to which clearer they use irrespective of the trading platform they are on, in practice, it has different meanings to different players. "Interoperability should mean that incumbent CCPs allow some form of linkage with a new clearing entrant. But if the links are competitive, for example users get a better service at lower cost, then there is no incentive for the incumbent to offer such a link. All the language in the code of conduct ignores this fact."

The fact that there are so many requests for linkages between clearing houses points to the fact that there are too many clearing structures in the European landscape, says Alex Docx, global clearance product executive at JPMorgan. He is also concerned that there are no deadlines for interoperability projects to come into effect nor are there any penalties if clearing houses do not link with each other.

This is a point also made by Tony Freeman, director of industry relations, EMEA, at Omgeo, a US-based developer of post-trade solutions. He says of all the aspects of the code of conduct, interoperability will be the most difficult to achieve, without a mandate or any clear sanction being articulated. "In the US, the clearing and settlement landscape was opened up to competition by a regulatory mandate. This resulted in the DTCC, because it was realised the practical difficulties of interoperation were so great, consolidation was the best option," he says.

Hodgkinson says there are "green shoots" of change in the clearing environment, including increasing potential for mergers which would likely take the industry forward and there also has been more evidence of co-operation in linking market infrastructures. Finally, he says, the new MTFs are galvanising the clearing space. "There's no silver bullet to solving the clearing issue and I think it is likely three or four different models will evolve. On the one hand, a single CCP for Europe would be quite attractive, but on the other, competition is healthy and vital for the industry at large."

In the absence of more linkages, financial institutions are managing to offer services. BNP Paribas, for example, announced in July an extension of its ClearSuite integrated clearing service for firms that will trade on Turquoise. The French bank will offer clients full post-trade support through its status as a general clearing member on EuroCCP. It will provide operational support in all the markets which will be covered by Turquoise. BNP Paribas also offers the same type of service for 14 clients on the Chi-X MTF. Through a single connection, BNP Paribas' broker dealer client base can use their GCM services on all the main European exchanges as well as the new MTFs. The model will be applied to all existing and future CCPs. In addition, to protect their clients from the increase in margin calls arising from the additional MTFs, BNP Paribas has developed centralised margin call and collateral optimisation solutions.

John Gubert, a securities industry consultant, says in the medium term it will be difficult to get results out of the code. "Interoperability is always a big battle and the bulk of use of CCPs and CSDs is at a national, rather than pan-European level. The challenge is that some players believe it will lead to an outflow of business and others see it as a way to capture the business of their competitors. It is difficult to ask an organisation to open its doors to allow another to take its revenues."

Given that the code of conduct was designed to stave-off a European Commission directive, the lack of progress on interoperability does concern some. If the Commission decides too little progress has been made, it may well impose a clearing and settlement directive. Hugh Cumberland, product development manager at BT Global Financial Solutions, believes the Commission is waiting to see "how the dust settles" before it considers a directive. "Cost reduction is very important in clearing and settlement and in many ways, access leads to cost reduction, because if you don't have to participate in every solution your total cost of ownership will be lower."

Cumberland's concern is that there is a ‘me too' approach developing as new MTFs discover there is a business line in clearing, enabling them to keep more of the revenue streams from the market. "Why give anyone else free access to this revenue?" he asks. "It defeats the business case of setting up a CCP. If the London Stock Exchange sets up its own CCP it will be because it thinks there is a business case and it will need to make money because it is a listed company and has to produce a return for shareholders."