Pre-crisis around 90% of derivatives contracts were traded over the counter; new regulations focussed on centralised clearing are now driving changes to the landscape of the exchange and clearing industry. For example in Europe, EMIR is making it mandatory for all OTC derivatives to be centrally cleared by the end of 2012. But what does this actually mean for exchanges?
In preparation for new regulation, many exchanges are looking at strategic targets for mergers and acquisitions (e.g. LCH.Clearnet and the LSE1) which can add clearing capabilities to the services they offer and off-set the current erosion of their traditional revenue streams. In addition, exchanges are implementing changes to deal with new requirements around transparency and reporting, whilst at the opposite end of the spectrum we are also seeing clearing houses enhance products and capabilities to attract OTC customers in competition to the traditional exchanges.
If regulation is forcing exchanges to look at their M&A strategy, it is also driving interoperability between exchanges and a consequent reduction in research and development costs, whilst encouraging innovation, product enhancement and the creation of new revenue streams. A good example of this dynamic is the agreement reached by ICE and CME for CME to provide ICE Link (its straight through processing software) to CME to help facilitate the clearing of credit default swaps2.
Exchanges also have to react to differences in regulatory approach between regions, for example, the divergent approach that the US and EU regulators are taking to competition in the clearing market. US regulators are encouraging competition in clearing instruments used by clearing houses for OTC traded derivatives, but not listed traded derivatives, leaving some clearing houses to maintain their dominant position as more derivative customers move onto traded exchanges. In contrast, the EC-driven MIFID II directive has stated that clearing houses would have to accept clearing instruments used by clearing houses “on a non-discriminatory and transparent basis, regardless of the trading venue on which the transaction is executed”3 . These regulatory differences could have major implications for development of new innovative clearing tools, and may stifle investment and growth in clearing products in certain regions.
For any exchange attempting to enhance their clearing capabilities, clearing tool innovation is imperative. Examples of new innovative tools being developed include collateral transformation facilities, which enable clients to post non-eligible instruments with dealers, who then switch these instruments for cash in the repo market, and offering credit lines for intra-day margin calls which are settled at end of day. Such innovations can represent risky strategies for exchanges and clearing houses; they allow participants to work around aspects of the regulation4 and provide opportunities for new revenue streams, but only whilst the regulators allows the practices to continue.
Other changes are emerging. To deal with regulatory demand for increased transparency, the DTCC has created a database holding approximately 98 percent of all credit derivative transactions5 which allows regulators portal access to transaction data in various report formats. Given the increase in volatility seen recently, exchanges are also becoming stricter in margin requirements; examples include ICE and CME, who have raised margin requirements on some future contracts.
In conclusion, it is evident that the exchange and clearing industry is going through an exciting period of change at the moment; it is unlikely that this pace will slow anytime soon. As Dodd-Frank, MIFID II and EMIR start to take shape, more investment (and probably more M&A activity) will be seen amongst exchanges. We are starting to see more and more derivative participants trading through exchanges, and as this trend continues it will be up to the market leaders to maintain investment to enhance products and services to keep ahead of the competition.
References:
1. LSE in £900m bid talks with LCH.Clearnet – telegraph.co.uk, Philip Aldrick, 2nd September 2011.
2. ICE links to CME – futuresmag.com, Michael J. McFarlin, 1st June 2011.
4. Now you see it now you don’t – collateral transformation – ft.com, Tracy Alloway, 04 July 2011.
