At the beginning of the crisis, it was quickly recognised that the “marketisation” of finance would make resolution more complex. Regulators weren’t just dealing with soured bank loans but a crisis of confidence in the market for securitised credit risk, including the $30 trillion credit-default-swap market. It is striking therefore that the focus of regulatory attention today is on improving competition for banks and insufficient attention is being paid to the competition-sapping vertical integration of private financial institutions involved in the exchange, clearing, and settlement of securities.
This is far less arcane and distant than it appears. The heated bidding between $500 million to $1 billion by the world’s largest exchanges for LCH Clearnet and the reported $150 million of increased profits that is likely to be derived by the combination of Deutsche Borse with NYSE Euronext will come from the vertical integration of exchange, clearing, and settlement. These profits will come under pressure if European competition authorities follow through on their commitments to maintain competitiveness in securities trading by requiring clearers not to restrict clearing to transactions on exchanges owned by the same commercial grouping.
We are at an historic turning point for market structure
Dividing up the clearing of securities transactions into vertical silos would pose systemic risks and weaken efficiency for users. So the stakes are high, but so far the debate has been tepid. Issues of financial stability and competition are getting lost in a jingoistic tussle.
- Germany is trying to protect its nationally reared champion from any intervention by competition authorities.
- Others worry that giving the New York Stock Exchange (NYSE) and other US-based firms a route into the European clearing markets will not be reciprocated in the US.
A more critical issue should be whether regulators are once more awarding a regulatory license for private profit under public guarantee, with systemically dangerous implications. Recall that after the 1997-1999 Thailand-to-LTCM crisis, regulators tried to outsource systemic risk management to credit-rating agencies. They are doing it again by mandating clearing through central clearers. Back then, as potentially today, they created profit opportunities for private companies that led to new, systemically dangerous behaviour.
Settlement is the delivery of a security for payment of cash. Clearing is the matching of a buyer for every seller and a seller for every buyer in a securities transaction, reducing counterparty risk. To function well, markets require this kind of plumbing to be leak-proof. When markets lost faith in the credit ratings of structured products in 2007, the uncertainty over who held what and what was it worth led to a sharp rise in counterparty risk, jamming up the money markets and contributing to the failure of institutions that had grown dependent on markets rather than depositors – like Northern Rock. This is why regulators have rightly moved to require derivative contracts to be centrally cleared and reported.
But this creates a windfall for incumbents in the clearing-and-settlement business and has prompted attempts at industry consolidation and a capture of supernatural profits through vertical integration by clearers only clearing trades carried out on their in-house exchanges. Is this loss of competitiveness in trading venue justified by increased stability?
Risks to the wider financial system from clearing and settlement of transactions are reduced by counterparty exposures that can be netted across the full range of financial instruments. Vertically integrated clearing houses dedicated to a single instrument, like credit derivatives used as a hedge against other instruments, will multiply and concentrate risks in a crisis, not reduce them. This is especially the case where a financial instrument traded on one trading platform is used as a hedge against an equity position traded on another. I owe this insight to Duffie and Zhu (2011) and, separately, to Robert Reoch.
There is therefore an argument, from the perspective of systemic stability, for a single regulated utility company that clears and settles all security transactions. But clearing requires substantial investment in technology innovation and the experience of equity trading platforms is that the biggest technological strides were spurred on by competition from new players.
The authorities can boost both competition and financial stability by ensuring the interoperability of clearing houses where counterparties choose where they clear their transactions independently of where they trade them and clearers grant fair access to third party trading venues. This would deliver more financial stability by maximising the netting across a wide range of related instruments irrespective of where the best place to trade those instruments are at any one time – horizontal integration versus vertical integration. Forcing trading venues and clearers to fight separately for business will also deliver better services and lower costs to users.
Duffie, Darrell and Haoxiang Zhu (2010), “Does a Central Clearing Counterparty Reduce Counterparty Risk?”, Graduate School of Business Stanford University.