Clearing Services for Global Markets A Framework for the Future Development of the Clearing Industry_9 docx

271 What theory reveals – framework for analysis of network strategies Efficiency Gains Profit Increase LOW HIGH LOW HIGH 1 2 3 4 Efficiency Losses Profit Decrease CM PR-G /CM AR-G 1 2 3 4 Cross-Margining Agreements Clearing Links Mergers & Acquisitions Single CCP Focus Area Figure 7.14 Business Model Impact Matrix for regionally-to-globally active clearing members Source: Author’s own. Cross-margining agreements lead to low efficiency gains and result in a proportional profit increase. 42 In contrast, clearing links, M&A and Single CCP initiatives translate into a disproportionately higher profit increase. This increase results from the positive revenue impact brought about by these network strategies, which, in addition to reducing costs, increase profits. From a prop. perspective, reg ionally-to-globally focused clearers benefit from the increased scale and scope of services available at a lower cost as well as from positive network effects. Disintermediation and enhanced internal efficiency now increase the attractiveness of self-clearing additional prod- ucts and markets in-house, which in turn enables the clearer to le verage its infrastructure – thus increasing the theoretical ‘revenues’ resulting from self- clearing. Similar considerations apply toregionally-to-globally active clearers with an agency focus. In this case, the disproportionately higher profit increase results from the clearer’s enhanced internal efficiency, which positively impacts its profit margin. Additionally, the clearer is able to offer its clients an increased scale and scope of services at lower cost. Finally, clearing links and Single 42 Cross-margining agreements are assumed to have little or no impact on revenues, because a significant increase in revenues would require an increase in the number of cleared contracts spurred by this type of network initiative. Whereas this could occur in reality, such a scenario is not included in this analysis. 272 Clearing Services for Global Markets CCP initiatives, which enable the CCP to internalise GCM level network effects, further strengthen and enhance the value proposition of regionally- to-globally active clearers. Their revenues are thus increased thanks to a greater profit margin and increased customer traffic. 43 7.3.3 BMIM for globally active clearing members Finally, Figure 7.15 illustrates the Business Model Impact Matrix for globally active clearing members. In contrast to the previously outlined matrices, the impact of network strategies on the business model of g lobally active clearers with a prop. or an agency focus is strikingly different. For clearers with a prop. focus, the efficiency gains generated by a cer- tain network strategy translate into a proportional profit increase. Network strategies are not assumed to impact revenues, because the scale and scope of services are not broadened. However, clearing services for different products and markets become accessible throug h a more consolidated infrastructure. 44 This allows clearers to leverage their infrastructure and reduce costs, but in contrast to regionally-to-globally active clearers, globally active clearing mem- bers have to overcome additional internal hurdles to realise these internal efficiency gains. Globally active clearers usually employ different legal entities within their company structure to become members of regional CCPs. This set-up can give rise to additional internal and external complexities as well as potential areas of conflict with regard to consolidating the clearing house interfaces. 43 Note that by definition, regionally-to-g lobally active clearing members and their NCMs and/or cus- tomers have an interest in being active in all of the partnering clearing houses’ markets and products. It could be argued that due to internal economies of scale, a globally active clearing member can offer the same products and markets at a lower price, so NCMs and/or customers of regionally-to-globally active clearers should in theory consider becoming a member of the higher volume (i.e. globally active) clearer. If the NCMs and/or customers base their decision purely on the basis of commissions charged by the clearers, network strategies do not result in NCMs and/or customers conducting more of their business through their re gionally-to-globally active clearer. Instead, these NCMs and/or customers can be expected to switch to a globally active clearer. However, globally active clearers already had a compet- itive advantage in terms of greater internal economies of scale prior to the network initiative; it would thus have already been attractive for NCMs and/or customers to choose the globally active clearer, had their sole decision criterion been commissions. It is therefore assumed that NCMs and/or customers of regionally-to-globally active clearing members do not base their decision strictly on commission levels, but also take additional factors into account, such as regional proximity, services tailored to the home market, long-term business relationship, etc. 44 Revenues would only increase to the extent that the enhanced internal efficiency spurs business growth. This scenario, which would lead to a disproportionately higher profit increase, is not covered by this analysis, however. 273 What theory reveals – framework for analysis of network strategies Efficiency Gains Profit Increase LOW HIGH LOWHIGH 1 3 2 4 Efficiency Losses Profit Decrease CM PG /CM AG 1 2 3 4 CM AG CM PG 1 2 3 4 Cross-Margining Agreements Clearing Links Mergers & Acquisitions Single CCP Focus Area Figure 7.15 Business Model Impact Matrix for globally active clearing members Source: Author’s own. Internal complexities can emerge by virtue of the different legal enti- ties working under different local budgets and local management. Salaries, bonuses and hierarchies may depend on these budgets, which can make the consolidation of clearing house interfaces a difficult and complex inter- nal undertaking. External difficulties related to consolidating clearing house interfaces can result from NCMs and other customers objecting to such an initiative, i.e. for reasons of demanding local contacts, etc. For globally active clearers with a prop. focus, all network st rategies positively impact their business model. The same is not true for globally active clearers with an agency focus, however. On the one hand, this type of clearing member benefits from high efficiency gains, as outlined in the Efficiency Impact Matrix, but at the same time, they are at risk of being disintermediated. 45 As outlined above, the internalisation of GCM level net- work effects increases the attractiveness of disintermediation. 46 45 Although it is unlikely that a globally active clearer would be put out of business completely, it is also unlike ly that the remaining NCMs would do more business (thus making up for the lost NCM business), unless lower internal costs were to be translated into reduced commissions, which would in turn translate into an increase of the number of cleared contracts. 46 Regionally-to-globally active clearers could, of course, also run the risk of being disintermediated by NCMs that now consider it cost-efficient to self-clear their business. This scenario is not scrutinised here, 274 Clearing Services for Global Markets Figure 7.7 showed that clearing links have a high to very high potential to internalise GCM level network effects, 47 whereas Single CCP and M&A strategies possess a high and medium potential for internalising GCM level network effects, respectively. It is consequently assumed that in the context of M&A initiatives, efficiency gains are counteracted by a medium strong risk of disintermediation, which results in lost revenues. The overall effect is consequently assumed to be a very low profit increase. Because clearing link and Single CCP initiatives significantly increase the attractiveness of disintermediation, it is assumed that revenue losses ultimately outweigh the efficiency gains. The only way for globally active clearers with an agency focus to circumvent the risk of disintermediation is to restrict access to the CCP level networ k. 48 Influencing the level of access to the CCP network is assumed to be possi- ble when clearing houses are user-owned and/or user-governed. Figure 7.16 illustrates the potential efficiency gains for globally active clearers with an agency focus that succeed in restricting access to the CCP network; doing so enables them to circumvent disintermediation and the associated rev- enue losses. These clearers stand to gain from restricting access to the CCP level network under clearing links, M&A and Single CCP initiatives. However, regionally-to-globally active clearers suffer from restricted access, because they lose their disintermediation benefits and are prevented from leveraging their internal infrastructure. A scenario of restr icted access would thus serve to rein- force the structural particularities of the European Value Provision Network by sustaining the competitive advantage held by high volume clearers over lower volume clearers. Globally active clearers would consequently maintain their dominant position within the European VPN, i.e. a very high percentage of the European market share in derivatives clearing would continue to be concentrated in the hands of a few very high volume clearers. as this analysis is concerned with the disintermediation of globally active GCMsby regionally-to-globally active clearers. 47 Note that the risk of disintermediation through clearing links is minimal, unless the CCPs are able to convince clearing members to expect positive future network effects – i.e. by persuading them that the clearing link will be extended inscope, and that the clearing houses will make up for the lost intermediary level by providing these services themselves, thus successfully internalising GCM level network effects. Only then can the utility derived from the network outweig h the costs of alternation in the long run, and the starting problem will be overcome. For the purpose of this analysis, it is assumed that clearing link initiatives overcome the starting problem. If, in reality, the link initiative fails to convince clearing members to expect positive future network effects, then a Single CCP initiative has by far the greatest potential for successful disintermediation. 48 Restricted access in this case refers to scenarios in which only globally active clearers are granted full access to a CCP level network resulting from a clearing link, M&A or Single CCP initiative. 275 What theory reveals – framework for analysis of network strategies Efficiency Gains Profit Increase LOW HIGH LOWHIGH 1 3 2 4 Efficiency Losses Profit Decrease CM PG /CM AG 1 2 3 4 Only achievable if CM AG can implement restricted access CM AG CM PG 1 2 3 4 Cross-Margining Agreements Clearing Links Mergers & Acquisitions Single CCP Focus Area Figure 7.16 Business Model Impact Matrix for globally active clearers that succeed in implementing restricted access to the CCP level network Source: Author’s own. To summarise, although some network strategies are cost efficient, they are not necessarily profit-maximising for all clearing member types. Regionally active clearers with a prop. or an agency focus suffer from a negative impact on their business model when M&A and Single CCP initiatives are in force. Globally active clearers with an agency focus do not fare we ll under Single CCP initiatives and clearing links (when these replicate the size of the Single CCP network) that allow unrestricted access to the CCP level network. 7.4 Preliminary findings – impact of network strategies on efficiency Building on the findings of Chapters 5 and 6, Chapter 7 establishes a frame- work for analysing the impact of network st rategies on the efficiency of Euro- pean clearing. Four mat rices were used to assess the impact of cross-margining agreements, clearing links, M&A and Single CCP initiatives and allowed pre- liminary conclusions to be drawn about the impact of these network strategies on the efficiency of clearing. The preliminary conclusions drawn from these 276 Clearing Services for Global Markets matrices w ill be compared to real-world case studies in Chapter 8 , which are analysed according to the above-mentioned framework. The findings of the matrices are br iefly summarised below, compared to findings of the European Central Bank, and used to further clarify the insights provided by the so-called ‘McP Curve’ and to evaluate the claim that the clearing industry exhibits ‘natural monopoly’ characteristics. 7.4.1 Scale Impact Matrix r The Scale Impact Matrix serves to classify the magnitude of p otential demand- and supply-side scale effects related to a particular network strat- egy. r The findings from the Scale Impact Matrix suggest that clearing links hold the potential for the greatest ‘net’ scale economies. Whereas M&A strateg ies have higher supply-side and lower demand-side scale effects than the Single CCP scenario, the relative magnitude of their respective net scale effects is comparable. 7.4.2 Transaction Cost Impact Matrix r The Transaction Cost Impact Matrix analysed whether or not the demand- and supply-side scale effects of each network strategy translate into a propor- tional or disproportional impact on transaction costs for different clearing member types. r The analysis differentiated the following customer groups: CM PR /CM AR (regionally active clearers with a prop. or an agency focus), CM PR-G /CM AR-G (regionally-to-globally active clearers with a prop. or an agency focus) and CM PG /CM AG (globally active clearers with a prop. or an agency focus). r For regionally active clearers with a prop. or an agency focus, indirect costs are the core cost driver. Cross-margining agreements have no cost impact for this ty pe of clearer, while M&A and Sing le CCP initiatives actually increase indirect costs. Clearing links, on the other hand, do not imply additional indirect costs, and could potentially lead to cost reductions. Nonetheless, clearing links are not suited to reduce significantly these clearers’ indirect costs. r For regionally-to-globally active clearers with a prop. or an agency focus, indirect costs are also the core cost driver. These clearers benefit from network strategies enabling them to clear many markets through their domestic home clearing house, thus disintermediating the clearer(s) they 277 What theory reveals – framework for analysis of network strategies employ as intermediary (ies) to other markets. Cross-margining agree- ments serve slightly to lower indirect costs, but do not enable disinterme- diation. While clearing links, M&A and Single CCP initiatives are all suited to reduce significantly these clearers’ indirect costs, clearing links (followed by Single CCP and M&A initiatives) turn out to have the greatest positive impact. r For globally active clearers with a prop. focus, direct costs are the core cost driver. These clearers’ main benefit from network strategies comes from the potential to reduce clearing house charges. Cross-margining agreements serve slightly to lower costs, but have no potential significantly to reduce direct costs. Clearing links, M&A and Single CCP initiatives, on the other hand, are all suited to impact significantly these clearers’ core cost driver. For globally active clearers with a prop. focus, the Single CCP initiative possesses the strongest cost-reduction potential, followed by clearing links and M&A initiatives. r For globally active clearers with an agency focus, indirect costs are the core cost driver. These clearers’ main benefit from network strategies comes from being able to consolidate their various clearing relationships, i.e. centralise these into a single relationship. Cross-margining agreements serve slightly to lower costs, but do not enable such a consolidation. Clearing links, M&A and Single CCP initiatives are all suited to impact significantly these clearers’ core cost driver. For globally active clearers with an agency focus, clearing links (followed by Single CCP and M&A initiatives) turn out to have the greatest positive impact. 7.4.3 Efficiency Impact Matrix r The Efficiency Impact Matrix consolidated the results of the Transaction Cost Impact Matrices and allowed for conclusions on the overall efficiency impact of the various network strategies to be drawn. r The Efficiency Impact Matrix shows that besides cross-margining agree- ments, which generally have little or no impact on efficiency, clearing links are the only network strategy that results in efficiency gains for all clearing member types. r Regionally active clearers potentially suffer from efficiency losses as a result of M&A and Single CCP initiatives. r Nonetheless, while clearing links are suited to reduce significantly the core cost driver of globally active clearers with a prop. focus, these clearers enjoy the greatest efficiency gains from a Single CCP initiative. 278 Clearing Services for Global Markets 7.4.4 Business Model Impact Matrix r The Business Model Impact Matrix illustrated whether the efficiency increase (decrease) corresponding to the different network strategies trans- lates into a propor tional or disproportional profit increase or decrease for different clearing member types. r It illustrated that the efficiency increase (decrease) resulting from different network strategies translates into a proportional profit impact for regionally active clearers; clearing link, M&A and Single CCP initiatives lead to a disproportionately higher profit increase for regionally-to-globally active clearing members. r For globally active clearers with a prop. focus, the efficiency gains of network strategies translate into a proportional profit increase, whereas for globally active clearers with an agency focus, Single CCP and clearing link initiatives can lead to a disproportional decrease in profits. r The analysis shows that although some network strategies are cost efficient, they are not necessarily profit-maximising for all clearing member types. r Regionally focused clearers with a prop. or an agency perspective suffer from efficiency losses and a negative impact on their business model when M&A and Single CCP initiatives are undertaken. r Although globally active clearers with an agency focus benefit from efficiency gains, they simultaneously suffer from a negative impact on their business model if Single CCP or clearing link initiatives (which replicate the size of the Single CCP network) are set up. r It was outlined above that particularly large investment banks are active in both proprietary and agency business. The Business Model Impact Matrix illustrated the internal conflict that arises when these firms have to decide whether or not to support a certain network strategy: the only network strategy that has a positive impact on the business model of both the prop. and the agency side relates to M&A initiatives between CCPs. These clearers are thus likely to support M&A initiatives, but unlikely to support a clearing link set-up. For globally active clearers with a prop. focus, a Single CCP ini- tiative is preferable over clearing links, as it has the greatest positive potential impact. For globally active clearers with an agency focus, clearing links actu- ally have a significantly negative impact on their business model, which is why they have an interest in circumventing such a scenario. Whether or not large investment banks support the creation of a Single CCP will prob- ably depend on whether the bank places greater emphasis on proprietary 279 What theory reveals – framework for analysis of network strategies or agency business. From a prop. perspective, they should absolutely be in favour of a Single CCP; from an agency perspective, however, the y can be expected to oppose the implementation of a Single CCP. 7.4.5 Summary of impact To summarise on the impact that network strategies have on the efficiency of European clearing, the preliminary findings suggest that a clearing link set-up appears to be the most attractive network strategy because it enables all clearing member types to benefit from efficiency gains. As outlined above, the services provided as well as the products and markets processed by different European clearing houses are not identical, and due to their installed bases, they are not necessarily interchangeable. Enlarging the size of a CCP network through clearing links benefits European clearing houses because it enables them to leverage their significant installed base and helps them to sustain their unique services in cases where these services and processes have been tailored to the specific demands of regional market particularities and different regulatory environments. Additionally, it enables clearing houses to internalise the GCM level network effects and to strengthen their unique CCP level network effects. Clearers can additionally benefit from the high growth potential afforded by links; they may entice other clearing houses outside of the defined European markets to join the network. Links are also not prone to give rise to negative network effects. The European Central Bank (ECB) finds that ‘[i]t is clear that, in the short-term, a single infrastructure would maximise network externalities and economies of scale. However, these short-term advantages have to be balanced against the inefficiencies that may be caused in the long run by the absence of competition (e.g. a lack of dynamism and innovation).’ 49 In accordance with the doubts expressed by the ECB, the analysis suggests that consolidating the European clearing industry through mergers and acquisitions to form a single monopoly CCP runs the risk of depriving mar ket participants of the competitive forces inherent to a link solution and denies them the benefit of utilising clearing services that have been tailored to best fit regional market particularities. Findings from the Scale Impact Matrix additionally suggest that even in the short term, a single infrast ructure created through a Single CCP initiative does not serve to maximise network externalities or economies 49 European Central Bank (ed.) (2001c), p. 3. 280 Clearing Services for Global Markets of scale. Rather, clearing links incorporate greater potential for economies of scale and scope as well as network effects. The Efficiency Impact Matrix further illustrated that while a Single CCP could potentially lead to efficiency gains for regionally-to-globally and globally active clearers, regionally active clearers suffer efficiency losses. This analysis thus indicated that, even in the short term, a Single CCP is not suited to enhance the efficiency for all European clearing members. However, clearing members benefit from a link solution, because it does not oblige participation and entails lower invest ments. The link strategy thus translates into efficiency gains for all European clearing members. Nonetheless, the benefits of a link set-up can only be achieved if the clearing houses endeavour to overcome the link-inherent starting problem. 50 The starting problem will only be overcome and the utility derived from the CCP level network can only offset the individual clearer’s costs of alternation in the long run when the partnering CCPs: r convince their clearers to expect positive future network effects – implying that the clearing link will be extended in its scope; r compensate for the lost intermediary (GCM) level by providing most of these services themselves – thereby successfully internalising GCM level network effects; and r make up for the lost participation in other CCP networks by providing a similar service level and processing all products and markets. Additionally, the benefits of a link set-up can only fully flourish when the partnering clearing houses provide a choice of clearing location. If no choice of clearing location is offered, network participants are locked into a partic- ular clearing network. 51 However, again, this situation does not represent an instance of strong lock-in: it is not a coordination failure among users that prevents clearers from actually switching to the superior network, but the legal restrictions established by the exchanges or clearing houses that prohibit the choice of clearing location. T herefore, to era dicate non-network-effect- related coordination problems on the CCP level, the provision of choice of clearing location helps to prevent this particular scenario. Consequently, pro- vided that opportunities for choice of clearing location exist through clearing links, it appears unlikely that CCP level network effects lead to strong forms of lock-in. If strong lock-in effects do not exist on the GCM and CCP levels, first-mover-wins and winner-takes-all conditions are also unlikely to emerge. 50 Refer to section 7.1.2.2.2 for an explanation of the starting problem. 51 Note that clearing houses alone cannot offer choice of clearing location. Rather in a first instance, the respective exchanges must give allowance to the use of various clearing houses. [...]... access to the away market: Many of the Asian brokerage firms tend to be smaller; they don’t have the capital of a Morgan Stanley or a Goldman Sachs, so the Asian clearing houses can play a role in representing the financial standing and credit standing of their smaller brokerage firms Just to give you an example, the Eurex clearing house would not take a lot of Asian-based brokers as their clearing members,... furnishes a variety of clearing services for other exchanges and marketplaces Market participants can apply to become an Individual Clearing Member or a Clearing Member The difference between these clearing memberships is that whereas ICMs are only allowed to clear their own transactions, Clearing Members can clear their own transactions, their clients’ transactions and those of affiliated exchange participants... provide a fairly substantial period for analysis On the other hand, the GCL is recent enough to constitute an adequate concept for the analysis of current and future clearing links Finally, it also allows European clearing to be analysed in a global context, as the link extends across different time zones The main drawback of this case study is the limited publicly available data on both clearing houses The. .. transactions as well as those of exchange participants that do not hold a clearing licence (NCMs), while DCMs can clear their own transactions, their clients’ transactions and the transactions of their 100 per cent company-affiliated NCMs Clearing members must comply with the minimum capital requirements of ECAG,46 contribute to the clearing fund47 and maintain appropriate clearing and settlement accounts... known as the Global Clearing Link (GCL), established in 2003 between the German-Swiss clearing house Eurex Clearing AG (ECAG) and the US-American clearing house The Clearing Corporation (CCorp) Although only one of the partnering CCPs is based in Europe, this network initiative still qualifies as a valuable case study analysis for various reasons: first and foremost, the link involves one of Europe’s largest... What theory reveals – framework for analysis of network strategies Market participants then benefit from the competitive forces between clearing houses in the context of a clearing link set-up The analysis reveals that it is crucial for the success of clearing link initiatives that the partnering CCPs endeavour to compensate for the lost intermediary (GCM) level services by providing most of these services. .. threat of disintermediation I don’t think clearing links add much value I really do believe that there is a limited amount of value that a clearing link is able to bring to the table I think that the value a clearing link brings is largely geared to local players in the market and it essentially 20 Interview with Gary Alan DeWaal 21 Interview with Fred Grede 294 Clearing Services for Global Markets. .. clearing houses On the one hand, clearing links benefit the partnering clearing houses by enabling them to provide clearing services for a broader range of products and markets At the same time, clearing houses might be worried that the implementation of a particular clearing link could limit their business development responsiveness by requiring all of the partnering clearing houses to develop clearing. .. refer to www.clearingcorp.com Cf Eurex /The Clearing Corporation (eds.) (27.05.2003) The described dynamics largely pertain to the competitive situation of the involved exchanges, rather than those of the partnering clearing houses Nonetheless, these dynamics ultimately shaped the benefits and drawbacks of the clearing link; they thus play a crucial role for the analysis of the network initiative Refer... Clearing Services for Global Markets and settlement accounts, and satisfy CCorp’s requirements on operational capabilities and efficiencies.56 8.1.2.2 Background and objectives of the initiative In May 2003, CCorp and Eurex announced that they would enter into a long-term agreement to create a global clearing solution; the initiative was referred to as the Global Clearing Link (GCL).57 One-and -a- half years . that choice of clearing location is guaranteed by clearing houses through links, the European clearing industry can be assumed to be contestable. The second step of the analysis of the impact of. in the market are covering the liabilities they have, then they will have to manage them more actively, banks themselves will have to manage them more actively. That means that yesterday 9 Refer. to the findings of section 5.1.4.2 for details on the interviewees’ assessments of the cost of capital. 290 Clearing Services for Global Markets they didn’t bother to move a position into a clearing