Could the introduction of central clearing for OTC derivatives break down the vertically-integrated exchange model in Europe?
It could, under amendments recently drafted by the presidency of the council of the European Union and members of European Parliament (MEPs).
On 15 September 2010, the European Commission (EC) proposed a new European market infrastructure regulation (EMIR) that would provide a framework for central clearing and risk mitigation of over-the-counter (OTC) derivatives; requirements for central counterparties (CCPs); post-trade interoperability; reporting obligations and requirements for trade repositories.
It suggested that central clearing be made mandatory for OTC derivatives as a core part of the EC's response to Group of 20 demands to reduce systemic risk in the derivatives market. The regulation is currently under consideration by the European Parliament and the Council of the European Union, Europe's two key decision-making bodies.
As part of this process, MEP Sharon Bowles, the chair of the Economic and Monetary Affairs Committee (ECON), and the current Hungarian presidency of the Council have both suggested expanding access to CCPs to exchange-traded derivatives, not only OTC derivatives. Bowles suggested removing ”OTC' from the description of the regulation, and from Article 3 that defines the clearing obligation on the basis that it “should not be compromised by definitions of, or restrictions to, OTC trading of derivatives contracts.”
Article 5 of the original proposal said, “A CCP that has been authorised to clear eligible OTC derivative contracts shall accept clearing such contracts on a non-discriminatory basis, regardless of the venue of execution,” which the Hungarian presidency has amended to “eligible (…) derivative contracts”. Although the proposals have not been accepted in any formal sense, they could threaten siloed business models, under which a single entity owns both a trading venue and the post-trade processing functions – i.e. a clearing house and settlement infrastructure – giving the firm a broader revenue base than it would receive through trading alone.
Why would that affect the silo model?
Vertically-integrated exchanges would no longer be able to prevent new players from offering competing services. such as by restricting access or levying extra fees.
Competing venues would be have to be given access to the CCP owned by a vertically-structure, enabling it to offer a choice of clearers, thereby giving market participants netting efficiencies. The clearing proposals could also mean that vertically-siloed exchanges would have to make their trade feeds available to rival CCPs, so that they can offer competing clearing services.
The Hungarian amendments specify that trading venues must be granted access to CCPs unless access would threaten the “smooth and orderly functioning of markets” giving access into the silo from the outside.
Bowles has expressed concern about preferential pricing, which biases against firms trading into a silo from an alternative venue. As a result she says that common ownership of trading platforms and CCPs can be anti-competitive and therefore such silos may have to be broken down through interoperability. “I don’t have any problem with ownership of post-trade infrastructure as long as you are not giving preferential treatment to your own exchange, you haven’t got any special deals and you are not behaving in an anti-competitive way,” she told theTRADEnews.com recently.
Under EMIR proposals, interoperability arrangements would be allowed between CCPs for cash instruments and, following a review by the European Securities and Market Authority in 2014, this could be extended to include ”other financial instruments'. If it were to happen it would mean that customers of a trading venue could trade out of its silo, effectively breaking it open.
Who would this hit hardest?
Deutsche Börse operates a siloed model in that it has an ownership stake in Eurex, its derivatives joint venture with Swiss market operator SIX Group, and Eurex Clearing. NYSE Euronext, which Deutsche Börse proposed to merge with on 14 February 2011, operates the NYSE Liffe derivatives market and offers clearing, by a third-party CCP, LCH.Clearnet. Some of the merger's value is predicated on the efficiencies that the combined derivatives market and post-trade services would bring. A total of 37% of the combined group's revenues was predicted to come from derivatives trading and clearing. If the silo was opened up, revenues would be reduced.
However in addition to EMIR, the EC has to consider the potential anti-competitive effects of the merger, not only in the actual derivatives trading business but in the post-trade market architecture. On 22 March 2011, at a hearing for ECON, Joaquin Almunia, European commissioner for competition, and vice president of the EC, said that he prefers models that are not in a vertical silo, and that interoperability should be encouraged. Newcomers to the derivatives trading business might encounter barriers to entry because of restricted access to post-trade services by rival trading venues, either forcing them to pay higher prices to use the services or to set up their own. The merger may force interoperability to be established sooner to prevent such a situation.
So is the silo doomed?
Possibly – Werner Langen MEP, the rapporteur for ECON's paper on EMIR, has said that the regulation should only apply to OTC derivatives. ECON is due to vote on the proposals from the MEPs on 20 April, with a plenary vote for the whole of parliament expected in May and Council is due to vote on 17 May.
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