European clearing house LCH.Clearnet and multilateral trading facility (MTF) Chi-X Europe have joined forces to offer a clearing service for equity contracts for difference (CFD) trades.
The firms expect to launch the service in Q3 2010, subject to regulatory approval. It will initially be available for UK blue-chip equities and will be extended to further European markets shortly after launch.
The service will combine new initiatives from both firms: ChiClear CFD from Chi-X and EquityClear CFD from LCH.Clearnet. The firms claim that the service will improve the efficiency of the existing CFD trading process and bring central counterparty clearing to an over-the-counter market, thereby reducing counterparty risk.
While CFDs are typically used by hedge funds to gain exposure to an equity’s price movements without the need to hold the underlying security, Emlyn Scott, business development, equities at LCH.Clearnet, said the central clearing element of the service could make CFDs more accessible to traditional long-only asset managers.
“Some sections of the buy-side have limited access to CFDs today as regulation can restrict the amount of OTC trading they can do,” Scott told theTRADEnews.com. “If you make it centrally cleared, a lot of those barriers go away.”
Equity CFDs pay the holder the difference between the price of the underlying equity at the start of the contract term and the price at the end. Hedge funds typically like to use them to gain equity exposure because they are exempt from stamp duty, allow them to take long and short positions and allow them to take leveraged positions without needing to hold large amounts of capital themselves. The UK Financial Services Authority estimated that CFDs made up 30% of all UK equity transactions in 2007.
Under the existing trading model, a hedge fund’s executing broker will execute an equity hedge in the underlying equity to offset the position that will be incurred by issuing the CFD to the hedge fund. The equity trade will be cleared, settled and confirmed to the broker, which will then ‘give up’ the equity to the prime broker, which in turn will issue the CFD to the client.
“It is a relatively efficient process with the exception of the give-up between the executing broker and the prime broker,” said Scott. “That is inefficient, often conducted manually via email or Bloomberg messages, prone to error and introduces a time-lag between the prime broker and executing broker.”
The new model enabled by the LCH/Chi-X clearing solution would shift the give-up process to the clearing realm. Instead of giving up the equity to the prime broker after trade conformation of the equity hedge, the executing broker puts a balanced CFD-versus-equity cross into Chi-X Europe’s service, which Chi-X validates and sends to LCH.Clearnet for clearing.
Unlike previous attempts to move standardise CFD trading, such as the London Stock Exchange’s ill-fated combined CFD and equity order book, which the exchange abandoned in April last year, the LCH/Chi-X initiative does not attempt to replace the OTC trading element of the process, leaving the broker free to hunt for the best price on any market for the equity hedge.
“What we are doing here synergises with the way the market works today as opposed to creating an alternative marketplace,” said Scott. “The market can get best execution and run its existing processes, but we are removing the problematic part – the executing broker’s give-up to the prime broker.”
He added that the service will represent the first time a trading venue and clearing house have accepted ‘mismatched’ trades – instead of the trade being made up of a buy and sell in the same instrument, one side of the trade will be an equity and the other a CFD. “This has effectively never been done before,” he said.
LCH will divide the trades into their respective CFD and equity components, and will require financing from nominated firms, comprising tier-one banks, to tackle the CFD portion.
While LCH could have interacted directly with clients, it chose to work with Chi-X as it had existing technology and relationships. “We thought it was better to work with a partner that has all the right relationships and is tried and trusted in the market to perform that role rather than trying to do it ourselves,” said Scott.