Every day, about five million trades executed on trading platforms in Europe are cleared by about 10 central counterparties (CCPs). Equities clearing via CCPs has a relatively short history.
Every day, about five million trades executed on trading platforms in Europe are cleared by about 10 central counterparties (CCPs). Equities clearing via CCPs has a relatively short history. CCPs were widely introduced around 2000 when floor trading on stock exchanges moved to electronic order books. Parties to a trade were no longer able to choose who would be on the other side of their trade as their bids and offers were matched electronically.
Novation—the process by which the clearinghouse becomes the counterparty to the original buyer and seller in a trade—of all trades to a CCP enables counterparty exposure to be centrally managed, as everyone has only one counterparty to worry about—the CCP. The CCP sets rules that protect all clients in the event of any one client’s inability to fulfill its post-trade obligations, such as requiring each client to post collateral with the CCP to guarantee its own performance.
CCP clearing in general has attracted a lot of attention ever since the G20 agreed in September 2009 that standardised OTC derivatives contracts should be traded on exchanges and centrally cleared through CCPs. The objective is to make the OTC derivative markets more transparent, to mitigate systemic risk and prevent market abuse. Significant progress in regulations has been made in all major financial markets, not only to implement centralised clearing of OTC derivatives, but also to make CCPs safer.
Safety is now top of the policy agenda
The global reforms are beneficial to CCPs in the cash equities market as well, even if their use is not mandatory and they do not face the same challenges as CCPs clearing OTC derivatives. The OTC derivatives reforms mandating central clearing mean that CCPs have to be subject to more regulations not only to ensure that their risk management is sound but that they also have an effective recovery and resolution process ready to be activated if they ever get into serious trouble.
Equities CCPs are likewise subject to the regulations that set minimum safety standards and recovery arrangements. This can only be good news to all parties who want to grow their business in a safe environment, be they clearing service providers or users.
Clearing generates growth and improves efficiency
In the equities market, CCP clearing has already made very significant contributions to market growth by enabling business models that otherwise would have been too costly to implement. Through novation of trades to a CCP, multilateral netting becomes easy—a firm’s trades in the same security on the same day can be netted into one settlement obligation to deliver or receive securities from the CCP. An equities CCP typically can net down 99 percent of trades into single settlement obligations per security per client. CCPs make markets safer places to trade, all-in cost of trading lower, and post-trade operations more efficient.
These benefits can be amplified by getting more transactions through CCPs. There remain only about 10 percent of trades executed on stock exchanges and multilateral trading facilities (MTFs) in Europe that are not cleared by a CCP. Initiatives to get bilaterally transacted equity trades into central clearing have also started.
The first challenge
It would be unfair to say that the wide adoption of clearing in the equities market also created unanticipated and substantive problems, so let’s say that new challenges emerged from this success. Because the same stock can be traded on multiple platforms, when platforms use different CCPs, the firms that trade the same stock on multiple platforms need to settle with multiple CCPs and incur multiple settlement costs.
These firms were successful in convincing some platforms to open up and give access to multiple CCPs, ie, giving access to the firms’ CCP of choice to clear trades, in addition to the CCP originally chosen by the platform. This arrangement, called interoperability, brings significant savings in settlement fees whenever firms trade the same securities on multiple platforms and can use the same CCP. Three equities CCPs—EuroCCP, LCH.Clearnet and SIX x-clear—are interoperable on most of the MTFs, which means that firms have a choice among three CCPs for over 40 percent of all trades executed in Europe.
Interoperability is not a new concept: anyone who uses a mobile phone is a beneficiary of interoperability. It does not matter which carrier the party you call is using because the carriers all interoperate, and you can choose the carrier that suits you best among a variety of offerings.
The most difficult aspect of implementing interoperability in equities clearing is to ensure that the CCPs can adequately manage their exposure to each other, so that the safety of the system is not compromised if one or more of the interoperating CCPs failed. It took more than a year to work out inter-CCP risk management to the satisfaction of the five regulators that supervise the three interoperating CCPs. Multiple CCPs clearing concurrently for the same platforms has been working satisfactorily since early 2012. The inter-CCP risk management and operational arrangements in place now work equally well for any equities trade coming from any platform, and have been designed to be scalable for additional CCPs joining the cluster and additional platforms giving access to the CCPs.
The next challenge
An additional 24 percent of trades executed in Europe could become available in this three-CCP interoperating arrangement if all the platforms that are cleared by at least one of the interoperating CCPs were to give equal access to all of them. What remains is to convince trading platforms that there are valid commercial benefits to open up to multiple-CCP clearing so that all firms trading on these platforms have a choice of all three CCPs to choose from. Then the trading firms can minimise settlement costs and effective competition can deliver its usual benefits.
While there are still barriers to remove, the optimal clearing arrangement for CCPs and trading platforms to deliver the most value to market participants is plainly in sight.
But what about the impact on incumbent CCPs, who can lose their market share if there was competition? What about firms that do not benefit from settlement cost reduction because they only trade on one platform? What about businesses whose revenue from settling transactions will suffer if there were fewer settlements? What about CCPs in other asset classes who do not want interoperability to succeed because it could then extend beyond equities into their territory? What about national stock exchanges who fear losing business if their trades are cleared by an interoperating CCP that also clears for the MTFs?
These are not questions that we will attempt to answer because we will be answering for others. However, we do often ask clients how many equities CCPs they consider to be the optimal number for Europe. One client cited an interesting example of mobile phone operators in his country—consumers did not actually reap substantive benefits from competition until the third operator entered the market.
