Euro Clearing Competition Debated
London has the combination of factors needed for a cutting edge in clearing euro-denominated derivatives according to a new report while Germany’s Eurex Clearing claimed an increase in market share last month.
The European Union has proposed that systematically important clearing houses that clear euro derivatives have to be located in the trading bloc. The majority of euro interest rate swaps are cleared by LCH, which is owned by the London Stock Exchange Group, and the UK is leaving the European Union next year.
The Brexit unit of The Institute of Economic Affairs said in a report, London’s Global Reach and the Half a Trillion Dollars Equity Prize, that three quarters of euro clearing takes place in London and one tenth in Paris. In addition, euro, sterling and yen derivatives are routinely cleared in the US.
Economist Dr Gerard Lyons said in the report: “Economic and commercial realities determine where the market goes, not regulators in Brussels. The media often gives the misleading impression the EU could decide if the market will move. It cannot.”
Lyons continued that if the EU forces relocation, this might be seen as protectionist as clearing of euro derivatives could not happen in North America or Asia, and the US could take retaliatory action.
“London is where the liquidity is, where multiple global currencies are cleared and where banks can make effective use of their capital,” he added. “In Paris, or Frankfurt, liquidity would be lower and bid-ask spreads subsequently higher.”
Eurex Clearing, part of Deutsche Börse Group, reported that the average daily volume cleared in over-the-counter interest rate swaps increased to €35bn last month, versus €5bn last year.
In October last year the clearer introduced a partnership program to share a significant part of the economics of its interest rate swap segment with the ten most active participants. Eurex said the program now has 25 market participants from the US, UK, Asia and Europe.
Erik Müller, chief executive of Eurex Clearing, said in a statement: “We observe an increasing number of banks now quoting the same spread for Eurex Clearing and LCH cleared swaps. This provides end clients such as investment funds, insurance firms and pension funds with real choice for the first time.”
However Amir Khwaja, chief executive at Clarus Financial, said in a blog that the derivatives analytics provider’s data does not support the view that Eurex gained market share in euro interest rate swap clearing last month.
— Clarus (@clarusft) February 7, 2018
“We see that Eurex’s monthly share in 2017 varies from a low of 1% to a high of 1.8%, with an average of 1.4%,” said Khwaja. “Against this the 1.3% share in Jan 2018 does not stand out at all.”
He said the seven times surge in Eurex volume was due to a rise in clearing of euro forward rate agreements from €5bn in the preceding 12 months to €325bn last month.
Clarus’ total Eurex volume last month was €405.5bn of single-sided notional, which is then doubled and divided by 23 business days to give the average daily volume of €35bn stated by Eurex.
“Mystery solved and the statement of an ADV of €35bn and seven times increase is factually correct,” added Khwaja. “However like many marketing statistics, there is devil in the detail, which may or may not be relevant depending on the question we are seeking to answer.”
Peter Rippon, chief executive of OpenGamma, which helps financial institutions reduce the cost of trading and clearing derivatives, said in an email: “One of the challenges resulting from liquidity spreading across multiple clearing houses would be banks losing the natural hedging offset that comes from having all risk concentrated within a single CCP. They will inevitably find it much harder to actively manage exposure across multiple clearing houses, and will have more work to do in order to understand, and therefore optimise, margin and capital.”
Rippon continued that critical mass of liquidity at more than one CCP gives end-clients choice and can spur innovation. “But to fully capitalise on this, firms need to be able to unlock and understand the factors which determine the best possible deal,” he added.
History of The World Part III – disruption v "me too" competitiont.co/dndWZH7Ubv
— Steve Grob (@SteveGFidessa) February 6, 2018
Steve Grob, director of group strategy at Fidessa, compared Eurex taking trading in Bund futures contract from London-based incumbent, LIFFE, in the 1990s to the German venue’s current attempt to take Euro denominated clearing from LCH.
“It did this by deploying screens across the London market which meant trading was simpler and, crucially, cheaper than the manual floor based alternative offered by LIFFE,” said Grob. “This story went on to become a marketing classic on eating your competitor’s lunch as no one had ever thought that liquidity could be moved in such a meaningful way.”
He continued that Eurex is now competing on fees while true disruption needs to operate at or offer a fundamental advantage.
“Open access would have created the ideal backdrop for this as trading would have been formally decoupled from clearing,” he added. “Meanwhile marketeers can see what distinguishes true disruption from simple “me-too” competition.”
MiFID II, the regulations that went live in the European Union last month, was meant to mandate open access so that clearing could be processed at a different venue from trading, but this has been delayed due to the Brexit negotiations.
Andrew Bailey, chief executive of the UK Financial Conduct Authority, said in a speech this week that fragmentation of financial markets is not in the interests of either the UK or the EU as diversification and transparency will fall, while risk will increase.
“Take clearing houses as a case in point; they reap benefits by being multi-currency,” added Bailey. “Segregating currencies reduces the depth of liquidity pools and increases costs.”
He continued that if the UK leaves the EU without mitigating action on both sides, this would require an abrupt close-out of positions, with attendant financial stability risks and costs to real economies.
Bailey said: “I would add that this risk is more acute for EU users because of the volume of activity conducted in UK CCPs.”
Equivalence process does not offer sufficient certainty after Brexit.
UK firms will lose EU authorisations in March 2019.
A well-defined Brexit transition period is needed by the end of March.
Rules can be better tailored, but there are concerns about access to talent and funding.
Equivalence will not be a reliable long-term framework for financial services.