Safety first, consolidation later?

Shares in the London Stock Exchange Group (LSEG) fell 8% on Friday after the market operator acknowledged the likely impact on its post-trade operations of new regulatory guidelines, which provided an indication of the cost of building safer, more transparent financial markets.

Last Thursday, the European Securities and Markets Authority (ESMA) revealed its proposed technical standards for the operation of central counterparties (CCPs) under the European market infrastructure regulation, which establishes a new framework for trading, central clearing and reporting of OTC derivatives in Europe. The standards will be final once approved by the European Commission in three months’ time, coinciding with the Group of 20 deadline for reforms to reduce systemic risk in the OTC derivatives markets. 

Noting the new capital requirements from 2013, multi-asset CCP LCH.Clearnet predicted it would need to increase its regulatory capital by €300-375 million in the first half of 2013. The clearer, which has diversified its revenues beyond core cash equity and listed derivatives clearing significantly in recent years, reported unaudited total revenues of €247 million to the end of June, a 28% rise on the comparable 2011 figure. The LSEG, which expects to complete its acquisition of a majority stake in LCH.Clearnet in Q4 2012, said it was in discussions with the clearer about the financial implications of the proposed rules on capital, including measures “to ensure it can continue to deliver an acceptable return on capital employed”. RBC Capital Markets says equity raising is unlikely, suggesting a renegotiation of the purchase price and an increase in LSEG debt facilities may both on the cards.

LSEG’s existing Italian clearer, CC&G, will also have to adapt the new regulatory environment. While LSEG expects the higher capital requirements will be met from CC&G’s existing resources, ESMA’s new rules cast a long shadow. RBC Capital Markets, having already factored in a 22% decline in CC&G’s net interest income (NII) in the 2014 financial year, says now “a larger decline … is likely”. CC&G currently accounts for around 15% of LSEG revenue.

With around half of its £1.39 billion committed facilities unused, RBC reckons LSEG can stump up its share of LCH.Clearnet’s increased regulatory capital requirement through debt arrangements already in place, but doing so would leave leverage and NII outside the firm’s comfort zone, requiring additional action.

Fears have been voiced in a number of quarters about whether CCPs that have traditionally cleared exchange-traded instruments can handle the more complex exposures that arise when acting as a central counterparty to OTC derivative transactions. LCH.Clearnet has been at the forefront of efforts by CCPs to diversify into other asset classes. The ESMA technical guidelines for clearing OTC derivatives offer CCPs latitude on the range of instruments they clear and the opportunity to compete on margin as well as fees. But the cost of this flexibility appears to lie in the clearing licence fee demanded by the regulator. The optimum number of European clearers is often put at around three or four (which also sounds the right number for a cartel). As such, one can’t help but wonder whether ESMA has calibrated its proposed rules to offer a level of competition that does not compromise the underlying objective of market stability and which very quickly eliminates the minor and under-resourced players.