Clearing Services for Global Markets A Framework for the Future Development of the Clearing Industry_12 pdf

385 Checking theory against reality – case studies of network strategies CAN SINGLE EUROPEAN CCP (2.) CAN’T BY INTERVIEWEE GROUP BY INTERVIEWEE LOCATION 10 LON 3 EU 4 LON 1 CH 1 ME FOR – CAN’T 2 CM FOR – CAN 3 CM 5 ME 2 EX 2 NCM 9 CAN 2 LON 3 EU CONFLICTED – CAN 6 CM 1 CH 1 EX 1 NCM 1 CH 1 US 4 US BENEFITS … BE ACHIEVED DIFFERENTLY 14 4 35 AGAINST FOR 2 0 13 CONFLICTED 20 CONFLICTED – CANFOR – CANFOR – CAN’T 1 REG Figure 8.29 Assessment of how many interviewees who were for or conflicted about the creation of a single European CCP believed that the potential benefits of the initiative can/cannot be achieved differently 291 Source: Author’s own. utility-like entities that should preferably be user-owned and/or user- governed, the empirical study indicates that this strong sentiment is slowly fading, at least in the derivatives arena. Finally, the US marketplace has also wit nessed the development of both horizontal (securities and options) and vertical (futures) structures, w ith varying degrees of user ownership and/or user governance. The fact that most US-based respondents had a futures background explains their reluctance to support Single CCP structures (and indicates that they are content with the less centralised structure of the Amer- ican futures clearing industry). Whereas Figure 8.28 suggests that the majority of interviewees opposed the creation of a single European CCP, a significant number nonethe- less advocated the initiative or felt conflicted about it. The next figure (Figure 8.29) therefore assesses how many of the interviewees who were either 291 Interviewee groups: CM – clearing member; NCM – non-clearing member; ME – market expert; EX – exchange; CH – clearing house; and REG – regulator. Interviewee locations: US – United States; EU – Continental Europe; and LON – London. 386 Clearing Services for Global Markets for or conflicted about the creation of a single European CCP believed that the initiative’s potential benefits can or cannot be achieved by different means. Figure 8.29 illustrates that of the twenty interviewees advocating a single European CCP, the vast majority (fourteen out of twenty) believed that the benefits of a Single CCP can generally be achieved via other means. Most of these individuals thought that a Single CCP is theoretically the best solution, but that it is simply not feasible to implement this kind of structure in Europe. Four of these interviewees suggested a clearing link initiative as an alternative, and three argued i n support of a more harmonised environment without further specification. Only four of the twenty interviewees advocating a single European CCP were of the opinion that the benefits of a single European CCP cannot be achieved by different means. 292 Finally, of the thirteen interviewees who were conflicted, the majority (nine out of thirteen) believed that the benefits of a Single CCP can generally also be achieved through a different initiative. 8.3.3 Summary of findings – impact of a single CCP on efficiency Now, the honest truth is that the small guys do not benefit from major levels of consolidation. And all attempts to bring cross-border differences down generally hurt niche players that are geographically constrained. 293 The purpose of this case study was to challenge the findings of Chapter 7 regarding the impact of a Single CCP on the efficiency of European clearing. The findings obtained from this study underscore and clarify the prelim- inary conclusions. This allows drawing final conclusions. The findings are summarised in the following. 8.3.3.1 Scale Impact Matrix – supply-side scale effects r The implementation of a Single CCP involves a very high degree of value chain, technical and legal harmonisation and integration efforts. The imple- mentation of such a network strategy is thus very complex and time- consuming, and likely to involve very high long-term investments. r Whereas the creation of a Single CCP offers high potential for increases in scale and scope, the extremely complex and thus costly integration process can be assumed to involve significant investments. The ultimate magnitude 292 Two respondents did not make clear whether or not they believed that the benefits of a Single CCP structure can or cannot be achieved differently. 293 Statement made by interviewed clearing member representative. 387 Checking theory against reality – case studies of network strategies of economies of scale and scope is therefore diminished by these counter- acting forces. r Additional complexities (including regulatory and political hurdles) related to integration and coordination, together with possible duplicated efforts, increased communication costs and slow response times can translate into further costs, possibly even to diseconomies of scale. 8.3.3.2 Scale Impact Matrix – demand-side scale effects r A Sing le CCP positively impacts the size of the CCP level network; the oppo- site is true for the GCM level network. The full integration of the partnering clearing houses makes it attractive for a number of market participants to disintermediate their clearer(s). r Whereas a single European CCP (when fully integrated) eliminates the opportunity for any of the involved clearing houses to establish a lead in Europe through their installed base, it cannot be assumed that the creation of a Single CCP would inhibit the emergence of new, competing clearing houses within Europe. The consolidated infrastructure could thus face competition from new market entrants. r This similarly suggests that the growth potential of a Single CCP network is likely to be limited. The appeal for other clearing houses to join such a CCP network is limited, because potential partners usually do not have the leeway to benefit from and further leverage their installed base. r Single CCP initiatives (as a particular form of M&A initiatives) have the drawback that the majority of resources must be committed to the inte- gration of the partnering clearing houses; this type of network initiative is thus unlikely to leave sufficient resources for additional projects or to spur innovation. The drain on resources also hampers the potential for the internalisation of GCM level network effects (and consequently diminishes the attractiveness for counterparties to disintermediate their clearer(s)). 8.3.3.3 Transaction Cost Impact Matrix r For regionally active clearing members (CM PR /CM AR ), indirect transaction costs are likely to increase if their home clearing house engages in M&A initiatives leading towards the creation of a Single CCP. The nature of these initiatives gives clearers no choice of participation; participation is obligatory. The magnitude of the increase of indirect costs depends on the structure of the initiative and the char acteristics of the clearing member. 294 294 One of the most crucial issues in this context is which clearing system will ‘survive’. 388 Clearing Services for Global Markets Clearers must thus potentially bear investments that will not be outweighed by cost savings or increased revenues. r Reg ionally-to-globally active clearing members (CM PR-G /CM AR-G )benefit significantly from the opportunity to clear many markets through their home clearing house, thus disintermediating their away market(s) clearer(s). The magnitude of such a cost reduction depends on the structure of the initiative and the characteristics of the clearing member. Cost reductions can b e counteracted by investments resulting from the need to implement and adapt to a new system, acquire knowledge, etc. r For globally active clearers with an agency focus (CM AG ), the main benefit of a Single CCP rests in the ability to centralise their various clearing relation- ships into a single relationship with one clearing house, which significantly reduces their indirect costs. For these clearers, cost reductions are unlikely to be counteracted by investments resulting from the need to implement and adapt to a new system, because they are already members of all European CCPs. r Globally active clearing members with a prop. focus (CM PG ), on the other hand, strive to benefit from reductions in clearing house fees as a result of a Single CCP. 8.3.3.4 Efficiency Impact Matrix r A single European CCP does not tr anslate into efficiency gains for all clearing member types. Regionally active clearers (CM PR /CM AR )infactsufferfrom efficiency losses as a result of a Single CCP. 8.3.3.5 Business Model Impact Matrix r Whereas a single European CCP benefits globally active clearing members with a prop. focus (CM PG ) or an agency focus (CM AG ) in terms of efficiency gains, clearers with an agency focus are likely to suffer from revenuedecreases due to disintermediation. It is thus doubtful that g lobally active clearing members with an agency focus would support the creation of a Single CCP, unless they were somehow able to retain a significant stake in the CCPs’ governance and/or ownership. r User governance and/or user ownership is the only means for clearers with an agency focus (CM AG ) to exercise control over the rules of European clearing and restrict access to the CCP network – and thus the only way to circumvent disintermediation and the associated revenue losses. 389 Checking theory against reality – case studies of network strategies 8.4 Final assessment – impact of network strategies on efficiency The purpose of Chapter 8 is to challenge the conclusions of Chapter 7 with case study findings and insights from the empirical study. For this purpose, three case studies were performed analysing clearing links, mergers and acquisitions, and a Single CCP initiative. The results of the analyses support the preliminary findings: the network strategy best suitedto enhance the efficiency of European derivatives clearing is a clearing link set-up, because it is the only network strategy that facilitates efficiency gains for all clearing member types. Besides supporting the findings of Chapter 7, the case studies also serve to provide more detailed insights into the complexities inherent to the imple- mentation of different network strategies in Europe. 8.4.1 Clearing links r Many interviewees found it difficult to assess the suitability of a clearing link solution for European clear ing. One of the obstacles to judging clearing links is that no link set-up actually exists that could serve as an adequate role model for Europe. Clearing links have so far been implemented with the primary objective of serving trading purposes – a fact that was also found to apply to the case study of the link between Eurex Clearing and The Clearing Corporation. r The GCL (Phase I) is a prime example of a clear ing link initiative whose dedicated purpose was not necessarily to enhance the efficiency of the clear- ing industry, and it thus consequently failed to deliver significant benefits and to overcome the starting problem. It showed that whereas such a clear- ing link can serve to increase slightly the efficiency of clearing for some market participants, there remains a huge unrealised potential for efficiency gains. 295 r The case study thus illustrates that if a link interconnects too few clearing networks, does not compensate for the lost intermediary (GCM) level by providing most of these services themselves (thereby successfully internalis- ing GCM level network effects) and neglects to offer a full choice of clearing location (including all products), it will ultimately fail to gain t raction. Consequently, if the partnering clearing houses do not adequately attempt 295 The unrealised potential for efficiency gains is a direct result of the limitations of the GCL initiative, which have been identified in the context of the section 8.1.2.6. 390 Clearing Services for Global Markets to overcome the link-inherent starting problem, a significant amount of potential for efficiency gains will go unrealised. Such a link initiative is not designed to increase significantly the efficiency of the European clearing industry. r Additionally,the failure of relevant clearing members to recognise the poten- tial value proposition of a clearing link set-up, low internal prioritisation of implementing the link, mandatory open interest transfers, regulatory and political issues can create further uncertainty about the future development of a clearing link initiative and inhibit clearing members from expecting positive future network effects and thus aggravate the starting problem. r The case study also suggested that not all stakeholders have a comprehensive grasp of the concept and value proposition of clearing links in general. Surprisingly, clearing houses in particular proved to know little about the Global Clearing Link. Although the GCL was never a concept intended to invite other CCPs to participate, for a European clearing link initiative to be successful, it is important that all European CCPs understand the value of interconnecting. A link initiative can only flourish if clearing houses truly understand the value of leveraging their installed base, internalising the GCM level network effects and using the initiative to strengthen their unique CCP level network effects. 8.4.2 Mergers and acquisitions r The case study of the merger between the London Clearing House and Clearnet revealed that the complexities of successfully implementing M&A initiatives between European clearing houses are even greater than assumed in Chapter 7. In reality, the counteracting forces, such as necessary long- term investments as well as additional regulatory and political hurdles, significantly impede mergers. Within Europe, the full integration of the part nering CCPs, which is necessary to achieve the maximum efficiency gains, has proved to be next to impossible. r The very high complexity of integration inherent to M&A initiatives also decelerates the CCPs’ ability to innovate and increases costs. If M&A strate- gies are employed to increase the efficiency of European clearing, it is thus likely that many potential efficiency gains will remain unrealised. r Additionally, the insights generated by the case study underscored the finding that M&A initiatives do not benefit all clearing members, as they potentially have a detr imental impact on low volume clearers with a regional business focus. 391 Checking theory against reality – case studies of network strategies r The LCH.Clearnet merger is a prime example of an M&A initiative between CCPs that has so far failed to deliver on precisely those issues critical for realising high efficiency gains for medium and high volume clearers. r The case study also suggests that M&A initiatives between two major Euro- pean CCPs by no means necessarily spur the further harmonisation or integration of the European clearing industry. 8.4.3 Single CCP r The insights from the empirical study and the M&A and Single CCP case studies supported the preliminary findings of Chapter 7 regarding the com- plexities of combining European clearing houses with different historical backgrounds, profiles and legal environments as well as the near impossi- bility of consolidating European CCPs into a single group. r Additionally, the case study insights underlined the findings regarding the unequal distribution of benefits and costs inherent to this type of network strateg y. A single European CCP initiative does not benefit all clearing members; it can in fact exert a detrimental impact on low volume clearers with a regional business focus. r High volume clearers with an agency focus prefer the establishment of a Single CCP over clearing links, because clearing links can have a significantly negative impact on their business model and it is generally easier to succeed in lobbying for user ownership/governance (thus controlling the rules of clearing) of one single entity than it is for various entities. High volume clearers with an agency focus are therefore likely to oppose a Single CCP unless they have a substantial say in the governance of the clearing house and can influence the rules of clearing. This is the only way for them to circumvent the risk of disintermediation and the associated revenue losses. r The analysis also supported the finding that globally active clearers with a prop. focus are likely to benefit most, in terms of efficiency gains, from the implementation of a Single CCP. Nonetheless, this group of clearers will only support a Single CCP if it can secure the means to control the rules of clearing, i.e. make sure that clearing fees (i.e. their core cost driver) are sufficiently reduced and that the consolidated infrastructure does not abuse its dominant position. Whether or not such fee reductions truly reflect an increase in internal efficiency of the merged entity or merely represent a quick fix to appease the clearing members that exert control over the Sing le CCP would require further research. 392 Clearing Services for Global Markets r When Single CCP initiatives fail to translate into indirect cost savings and merely accommodate clearing members by offering fee cuts, globally active clearers with a prop. focus benefit significantly, whilst all other clearing member types remain unable to reduce their core cost driver (i.e. indirect costs). r Regarding the issue of governance, the M&A and the Single CCP case studies revealed that ceding partial control over a clearing house in the context of a merger as a trade-off for efficiency gains makes sense from the perspective of high volume clearers with an agency perspective, as long as the resulting structure is not a monopoly. If the CCP is a monopoly, the risk of disintermediation is likely to exceed the potential benefits for these clearers. Finally, the case studies also lent support to the preliminary finding that European derivatives clearing does not constitute a natural monopoly. Despite the widespread belief that clearing generally qualifies as a natural monopoly, no evidence of this was found in multinational markets, such as the European clearing industry, in which ‘[n]ew clearing arr angements are emerging all the time’. 296 To summarise, whereas different network st rategies have varying potential to increase the efficiency of the European clearing industry, clearing links were found to be the only initiative that generates efficiency gains for all clearing members. Particular attention must also be given to the impact of harmonisation and integration initiatives on smaller regional or niche markets and on clearing members with less negotiating and lobbying power than Europe’s high volume clearers. Although a clearing link strategy is best suited to benefit all clearers, the implementation of such an initiative will also be cumbersome and demand a lot from the different stakeholders. Furthermore, there are many kinds of clearing link initiative, and not all of them can serve to increase the efficiency of European clearing. Therefore, the parameters and prerequisites identified in this study as necessary for enhancing the efficiency of the European clearing industry through a link set-up will be summarised and further detailed in Chapter 10. Prior to that and based on the findings of Chapters 7 and 8, Chapter 9 provides a quantitative assessment of the efficiency impact of European network strategies. 296 Moskow (2006). 9 Quantifying the efficiency impact – European network strategies Analysing the impact of network strategies on the efficiency of European clearing consists of a three-step approach: the findings derived in Chapters 7 and 8 (step 1 and 2) serve as the basis for a quantification of the efficiency impact of European network strategies, which is presented in this chapter (step 3). First, the quantified efficiency impacts of a European clearing link set- up and a single European CCP are presented in terms of total costs borne by European clearing members (section 9.1). The next section (section 9.2) breaks these costs down into the members’ average direct and indirect costs. The calculation of the respective efficiency impact is based on the findings of sections 5.2.3 and 5.2.4, as well as the conclusions derived in Chapters 7 and 8. Finally, a summary of the insights derived in this chapter is provided (section 9.3). 9.1 Total European industry costs Whereas section 5.2.3 introduced an estimate of the total European clearing industry costs in 2005, this section presents the recalculated estimate under the assumption of implemented European clearing links (section 9.1.1) and a single European CCP (section 9.1.2), i.e. quantifies the potential efficiency impact of each network strategy. As the calculation of costs is based on the results presented in section 5.2.3, the same caveats apply to the figures pre- sented in the following. 1 For details on the quantitative analysis and the underlying assumptions, refer to Appendix 8. 1 An additional caveat applies to the estimated efficiency impact: the implementation of European clearing links or a single European CCP is likely to impact the composition of all-in clearing costs for different clearing member types (see Figure 5.5). When a certain network strategy enables a disproportionately higher/lower reduction of indirect costs as compared to direct costs (or vice versa) for certain clearing member types, then this affects the ratio of direct to indirect costs. This kind of de velopment is not 394 Clearing Services for Global Markets QUANTIFYING THE EFFICIENCY IMPACT – EUROPEAN NETWORK STRATEGIES Total European Industry Costs 9.1 9 Quantifies efficiency impact of a European clearing link set-up and the creation of a single European CCP. Quantifies the impact of European clearing links and a single European CCP on total European derivatives clearing costs. Quantifies the impact of European clearing links and a single European CCP on clearing members’ average direct and indirect costs. European Clearing Members’ Average Costs9.2 PURPOSECHAPTER Summary 9.3 Figure 9.1 Structure of Chapter 9 9.1.1 Efficiency impact of clearing links This section furnishes a recalculation of the 2005 total costs borne by European clearing members according to the assumption of implemented clearing links between Eurex Clearing, LCH.Clearnet, OMX Clearing, MEFF and CC&G. Figure 9.2 outlines the quantitative results of the analysis. 2 Under the assumption of implemented European clearing links, total European costs of derivatives clearing would have amounted to roughly €1.503 billion in 2005, representing a reduction of 31 per cent when compared with the orig- inal estimate. Although this figure pertains to the first level of transaction costs, i.e. all of the direct and indirect costs borne by clearing members, any such cost reduction also benefits market participants with indirect access to the market infrastructure. NCMs and other customers, for example, benefit from cost reductions when the savings are redistributed within the VPN and are ultimately passed on (either directly or indirectly as part of commissions) by the clearers to their respective NCMs and/or other customers. Under a clearing link scenario, direct costs would have come to about €523 million, or been trimmed by roughly 28 per cent. Indirect costs would have weighed in at €980 million, representing a 32 per cent decrease compared to the original 2005 estimate. Figure 9.3 outlines the per cent stake the different clearing members would have held in the costs of European derivatives clearing in 2005 under the accounted for in this quantitative analysis. This is due to the lack of a basis for providing well-founded assumptions as to how different network strategies affect the composition of all-in clearing costs for the different clearing member types. 2 Figures are rounded to millions of euros; €100,000 to €499,000 are rounded down, whereas €500,000 to €999,000 are rounded up. [...]... for a full choice of clearing location r Make sure that they sufficiently educate market participants about the benefits of such a link set-up The failure of relevant clearing members to recognise the potential value proposition of a clearing link set-up and low internal prioritisation of implementing the link can potentially aggravate the starting problem r Engage to educate other clearing houses and... provides a basic framework designed to serve as a starting point for European CCP managers to shape their European clearing link strategy At this juncture, it must be emphasised that European clearing members cannot be assumed to value all potential clearing links equally; in other words, some clearing links are better suited than others to increase truly the efficiency of European clearing To assess the. .. necessary to regard the European clearing industry (including all European clearing houses) as one large network Today, information technology and mapping software can generally serve to identify how customers actually use networks as well as how they value each of a network’s links.24 For clearing house managers, the greatest problem actually lies in the current structure of the European clearing. .. decrease with an increase of the number of contracts cleared The figures also illustrate the findings from Chapters 7 and 8 with quantitative cost data: they show that medium and 7 A detailed interpretation of these results and their possible effect on the structure of the VPN are discussed in more detail in section 10.1 402 Clearing Services for Global Markets φ Unit Costs in EUR Market Share STATUS... 9.2.2) Again, this analysis does not claim to deliver results applicable to any particular clearing member, but instead provides an archetypical assessment of clearing costs The estimated costs enable a better understanding of the efficiency impact that European clearing links or a Single CCP can have on different clearing member types’ average costs and also serves to illuminate the possible effect that... a lane concentration pattern, clearing members heavily use or heavily value individual clearing links When a CCP’s clearing members show lane 26 Coyne/Dye (1998), p 100 420 Clearing Services for Global Markets concentration patterns, it makes strategic sense for managers to focus on these particular lanes Lane concentration can be beneficial for clearing houses in that it allows CCPs to concentrate... [Managers] first need to realize that different customers can use the same network in a variety of ways Individuals may be using a network in every conceivable way, but if managers look at usage in the aggregate, they will see patterns emerge And that’s important because for each major usage pattern that managers identify in their network, they need to develop a different strategy.22 The results of. .. European derivatives clearing Competition is important in achieving the overall objective of creating a safe, efficient and integrated EU clearing and settlement infrastructure The basic conditions for this goal are transparency and open access To avoid discrimination against classes of participants and competitive distortions, participation requirements should be fair and open within the scope of services. .. three-step approach to analyse the impact of network strategies on the efficiency of European clearing Based on the findings derived in Chapters 7 and 8, this chapter presents a quantification of the potential efficiency impact of a European clearing link set-up and a single European CCP, the results of which are briefly summarised in the following 9.3.1 Total European industry costs r Under the assumption of implemented... the mere implementation of a quasi ‘random’ clearing link set-up between European CCPs will not automatically increase the efficiency of the clearing industry It is vital to the success of a European clearing link initiative that its implementation be both economical for the partnering clearing houses and serve customer demand Only then can demand- and supply-side scale economies fully blossom and the . initiatives (as a particular form of M& ;A initiatives) have the drawback that the majority of resources must be committed to the inte- gration of the partnering clearing houses; this type of. of a European clearing link set-up and the creation of a single European CCP. Quantifies the impact of European clearing links and a single European CCP on total European derivatives clearing. stakeholders. Furthermore, there are many kinds of clearing link initiative, and not all of them can serve to increase the efficiency of European clearing. Therefore, the parameters and prerequisites