Clearing Services for Global Markets A Framework for the Future Development of the Clearing Industry_7 pptx

233 Exploring theoretical basics – scale effects in clearing are not being exploited (and can thus be le veraged) must be considered, as well as to what extent the enlargement of scope requires additional investments into production factors. When economies of scope are realised through geographical diversifica- tion, the possible cost implications are similar to those of a scale enlargement through the connection of new marketplaces, meaning that the associated costs highly depend on the level of automation and the use of standard interfaces. On the other hand, the integration of new marketplaces that are located in a different regulatory environment can entail additional upgrades or changes to the core architecture of the clearing system. The associated costs of enlarging scope through diversification attheprod- uct level (e.g. derivatives on commodities, foreign exchange derivatives, credit derivatives, etc.) are highly contingent upon the complexity and unique sys- tem requirements of these products. If new technology solutions, upgrades or changes to the core architecture of the clearing system are required, substantial investments may be necessary. When a clearing house decides to enlarge the scope of its clearing services by integrating new asset classes, sizable investments can be required for various reasons. First, new asset classes often have different regulatory reporting and market functioning particularities, which might well entail extensive and costly system changes, or even the development of a completely new clearing system. Secondly, some asset classes require greater manual processing and intervention than others, which can translate into increased personnel costs. Finally, if a clearing house boosts the scope of its services by increasing the number of complementary clearing services it offers, major costs may be involved. The further away the service is from the CCP’s core clearing services and the more additional knowledge and system solutions the clearing house needs to incorpor ate, the higher personnel and IT costs are likely to be. Finally, enlargements in the scale and scope of a clearing house can increase the number of clearing members, the average open interest held by the CCP and the value of transactions cleared. When the numberofconnectedclearing members balloons, costs can arise from the technological changes required to accommodate them (i.e. if the clearing system was configured to admit a predefined and restricted number of clearing members and this number is surmounted). More clearing members can also result in increased personnel costs if transactions require a large amount of manual processing 138 or if a 138 This depends onthetype of assetclass cleared; whereas theclearing of commodity derivatives commonly involves a relatively high amount of manual labour – due to its often relative low degree of electronic processing – the clearing of exchange-traded financial derivatives is largely automated today. 234 Clearing Services for Global Markets significantly increased error rate necessitates the hiring of additional personnel. 139 Furthermore, the more clearing members are connected, the more complex the administration of the clearing system’s account structures becomes, which in turn results in an increased system load – potentially requiring capacity enhancements. Increases in scale or scope are also likely to result in a rise of av erage open interest held by the CCP. Whether or not such an increase has any cost implications for the clearing house depends on the associated number of clearing members. The more clearing members hold the open interest, the higher the monitoring effor t for the CCP will be. A significant open interest increase could require an increase in system capacity, depending on the age and architecture of the clearing system. An increase in scale boosts the valueoftransactionscleared so long as the scale increase is not achieved via the minimisation of the contract sizes of existing products. Additionally, a scope enlargement through diversifi- cation at the product level also leads to an increased value of transactions cleared. Whether or not this increased value has any cost impact depends on the amount of transactions netted and their correlation with other pro- cessed positions. An increased value of cleared transactions only results in an increased risk management effort for the clearing house if few positions are netted and correlated. 140 Generally, increases in a clearing house’s scale and scope can both eventually require an increase in system capacity or an enhancement of the system’s processing power in terms of speed. The older the clearing system, the lower its capacity and processing power is likely to be. Whether or not new technology solutions, upgrades or changes to the core architecture of the clearing system are required also depends on additional factors, such as the complexity of clearing services, products and markets. 6.2.5 Preliminary conclusions The demand for services offered by a clearing house is subject to high vari- ability in comparison to other industries. This fluctuation results from the direct interdependence of the demand for clearing services and the demand for derivatives products in general. Traded volumes in derivatives markets 139 The more clearing members are involved, the more risk management the CCP may have to perform, and the greater the likelihood of errors in judgements. 140 Also note that a clearing house employs several risk protection measures related to the value of cleared transactions, such as higher margin requirements, contributions to the default fund, etc. 235 Exploring theoretical basics – scale effects in clearing are erratic; 141 the volume of contracts available for clearing is therefore also erratic. The capacity of the clearing house infrastructure has to be configured to accommodate the greatest expected trading volume available for clearing. This is due to the service character of clearing house offerings. Neither supply nor demand for clearing is storable. On average, the actual utilisation of capac- ities is therefore relatively low compared to the highest available capacity. 142 The high proportion of non-utilised capacity results in high fixed costs. The main cause of economies of scale in clearing services therefore lies in the indivisibility of production factors, i.e. the clearing infrastructure. The operation of a clearing house requires a complex infrastructure whose most important component is the clearing system. The related IT costs are to a large degree independent of the number of contracts cleared. The higher the number of contracts cleared through the system, the lower the average costs. An enlargement of the clearing house’s scale results in positive effects on the average costs. This implies disadvantages for smaller clearing houses. It is therefore assumed that a minimum optimal clearing house size exists. Nonetheless, it is important to understand that whether or not any of the outlined costs actually arise when a clearing house increases its scale and/or scope depends on the specific characteristics of the CCP and the initiative pur- sued. The true potential for supply-side scale economies in network strategies is further analysed in Chapter 7. 6.3 Summary of findings The purpose of Chapter 6 was to classify and explore possible demand- and supply-side scale effects in clearing. The chapter yielded some crucial insights, which are summarised in the following. 6.3.1 Demand-side scale effects r The Value Provision Network constitutes a two-layered (product layer and system layer) and two-level (CCP level and GCM level) network structure and exhibits a number of positive and negative network effects. 141 As an example: Book (2001) cites that the peak system load at Eurex on a given trading day was up to 75 per cent higher than the average daily system load in 1999. Cf. Book (2001), p. 191. Variation in demand for derivative products is not only manifest on a day-to-day basis, but intra-day volumes also vary significantly. 142 The capacity of the Eurex system is, for example, designed to provide headroom of approximately 70 p er cent above the peak system load. Cf. Eurex (ed.) (2007a), p. 10. 236 Clearing Services for Global Markets r Many of the network effects on the CCP and GCM levels are similar in nature and can impact one another. r An important aspect of the interrelation between the CCP level and GCM level networks is that, strictly speaking, the size of the CCP level network is not determined by the number of clearing members, but rather by the number of counterparties (i.e. clear ing members, non-clearing members and other customers). In the extreme, this means that positive and negative network effects on the CCP level can arise despite a downturn in the number of clearing members. r The size of the CCP level network is consequently closely interrelated to the size of the GCM level network – which is not true the opposite way round. r Theoretically, all GCM level network effects can be replicated on the CCP level, but not all CCP level network effects can be replicated on the GCM level. r There exist some unique network effects on the CCP level (netting, cross- margining, open interest and information effects) that do not occur (or are more limited in scope) on the GCM level and could only be replicated by the GCM if it became the central counterparty itself. r Nonetheless, the value-added function and the network effects on the GCM level are significant in the context of the current structure of the Euro- pean VPN, because most clearers offer single access to many platforms and markets; the same is not true for CCPs. Therefore, the size, interface and collateral management effects are significantly greater on the GCM level than they are on the CCP level. r The fungibility effect constitutes another network effect that increases the value of the clearing services provided by GCMs. The complementary offer- ing effect is also greater on the GCM level network than on the CCP level network – again because most clearers offer a wider range of complementary clearing services. r Additionally, CCP and GCM level network effects exhibit spill-over effects on to other par ts of the transaction value chain. Despite the currently high value-added function of the GCM level, the most significant positive spill- over effects on to the trading and settlement layer result from the CCP level network effects. Additionally, the CCP level generates unique positive network effects that support the stability of mar kets and that are not easily replicable by the GCM level. r CCPs can internalise the strong and important positive network effects on the GCM level by engaging in network strategies and enlarging the range of the complementary products and services offered. 237 Exploring theoretical basics – scale effects in clearing r A CCP’s engagement in network strategies should thus theoretically be driven by two objectives: firstly, to internalise the GCM level network effects; and, secondly, to make their unique CCP level network effects stronger, thus increasing network participants’ willingness to pay for these services. r Internalising the strong and important positive GCM level network effects on the CCP level is beneficial, because doing so may significantly reduce clearing-related transaction costs and thereby increase the efficiency of the industry. First level transaction costs can thus be reduced through greater CCP level network effects. Second level transaction costs can possibly be reduced through a disintermediation of the GCM level. r The internalisation of GCM level network effects by a CCP through network strategies is further analysed in Chapter 7. r The economic implications resulting from the network characteristics are articulated in potential barriers to market entry, due to the proprietary character of clearing networks and their general incompatibility. New entrants can only succeed in establishing a network if they achieve a critical size. r Chapter 7 will also analyse how strong the installed base, starting problem and lock-in effects on the system and product layer can possibly be and how innovative ability and compatibility are affected in the context of different network strategies. 6.3.2 Supply-side scale effects r A clearing house is regarded as a producing enterprise that generates a certain output through the use of different input factors. To determine the existence of economies of scale and scope in clearing, the number of contracts cleared is used as an output variable. r Economies of scale in clearing originate from an increase in the number of contracts cleared, which can result from different scenarios: existing clearing members clear more existing products (market growth), existing clearing members clear new products (possibly new marketplaces), new clearing members clear existing products or new clearing members clear new products. r Economies of scope can result from product level or geographical diver- sification, the integration of asset classes or an increase in the number of complementary clearing services offered by the CCP. r Evidence suggests that economies of scale exist in clearing. There are dif- ferent scenarios for increasing the scale and scope of a clearing house, each 238 Clearing Services for Global Markets of which has different implications for the respective clearing house’s cost structures. r The analysis of clearing houses’ cost str uctures shows that a high percentage of costs are fixed. Whether or not an increase in scale and scope translates into positive economies is highly dependent on the type of network initiative pursued as well as on the characteristics and cost structure of the involved CCPs. r The true potential for supply-side scale economies in network strategies is further analysed in Chapter 7. It is the purpose of this study to determine the efficiency impact of various network strategies. Chapter 6, together with Chapter 5,providesthebasisfor this analysis. The following Chapter 7 establishes an original framework to finally analyse the impact of network strategies on the efficiency of clearing. 7 What theory reveals – framework for efficiency analysis of network strategies Interconnection [between competing networks] upsets thenormal competitive model inseveralways Butinterconnectionalsoallowscompetitorstobecomeasourceof customers for oneanother when one provider originates traffic and another eventually delivers it. 1 The ultimate research objective of this study is to determine the efficiency impact of various network strategies within the European clearing industry. An assessment of this impact serves to identify the most preferable future clearing industry structure. To this end, Chapter 7 establishes an original framework to explore the impact of network strategies on the efficiency of clearing. The framework builds on the findings of the previous chapters and consists of four matrices that serve to gauge the efficiency impact of the various network strategies. The matrices illustrate the complex relationships between demand- and supply- side scale effects in clearing as well as the impact of these effects on transaction costs and industry efficiency. Additionally, the matrices take other industry- impacting dynamics into account, ultimately revealing that although some scenarios are cost efficient, they are not necessarily profit-maximising for all participants of the Value Provision Network. The analysis conducted in this chapter delivers preliminary findings that are then compared with case study findings in Chapter 8; this allows final conclusions to be drawn regarding the efficiency impact of various network strategies within the European clearing industry. In the following, four different network strategies are analysed accord- ing to the framework introduced in Figure 7.2: cross-margining agreements, clearing links, mergers and acquisitions (M&A) and the creation of a single European CCP. In a first step (section 7.1), the Scale Impact Matrix analyses 1 Coyne/Dye (1998), pp. 100–01. 240 Clearing Services for Global Markets WHAT THEORY REVEALS – FRAMEWORK FOR EFFICIENCY ANALYSIS OF NETWORK STRATEGIES Scale Impact Matrix 7.1 7 Establishes a framework to analyse the impact of network strategies on the efficiency of clearing. The Scale Impact Matrix analyses the magnitude of demand- and supply-side scale effects related to a particular network strategy. The Transaction Cost Impact and Efficiency Impact Matrix analyse whether the scale effects translate into proportional efficiency gains or losses. The Business Model Impact Matrix illustrates whether the efficiency increase (decrease) translates into a proportional or disproportional profit increase or decrease. 7.2 Transaction Cost Impact Matrix and Efficiency Impact Matrix Business Model Impact Matrix 7.3 Preliminary Findings – Impact of Network Strategies on Efficiency 7.4 PURPOSECHAPTER Figure 7.1 Structure of Chapter 7 SCALE IMPACT MATRIX 1 XIRTAM TCAPMI ELACSSTCEFFE ELACS EDIS-YLPPUS FO SISYLANA Typified assessment of potential for economies of scale and scope in different network strategies Deriving network strategies net supply-side scale effects BUSINESS MODEL IMPACT MATRICES: LOW, MEDIUM AND HIGH VOLUME CLEARERS A ANALYSIS OF DEMAND-SIDE SCALE EFFECTS Typified assessment of potential for positive and negative network effects Deriving network strategies net demand-side scale effects B C TRANSACTION COST IMPACT MATRIX AND EFFICIENCY IMPACT MATRIX EFFICIENCY IMPACT MATRIX 2 SCALE EFFECTS’ IMPACT ON COSTS TRANSACTION COST IMPACT MATRICES: LOW, MEDIUM AND HIGH VOLUME CLEARERS A B C = = + = BUSINESS MODEL IMPACT MATRIX 3 CM PR /CM AR CM PR-G /CM AR-G + + CM PR /CM AR CM PR-G /CM AR-G CM PG /CM AG CM PG /CM AG Figure 7.2 Framework for efficiency analysis of network strategies Source: Author’s own. 241 What theory reveals – framework for analysis of network strategies the magnitude of demand- and supply-side scale effects related to a par- ticular network strateg y. The Transaction Cost Impact Matrix and the Effi- ciency Impact Matrix analyse whether or not these demand- and supply-side scale effects translate into proportional or disproportional efficiency gains or losses for different clearing member types (section 7.2). The Business Model Impact Matrix illustrates whether the efficiency increase (decrease) corre- sponding to different network strategies translates into a proportional or dis- proportional profit increase or decrease for different clearing member types (section 7.3). Finally (section 7.4), the preliminary findings obtained from the matrices regarding the efficiency impact of the different network strategies are summarised. Note that this theoretical assessment of the scale, transaction cost, efficiency and business model impacts is based on archetypes of the various network strategies. Utilising such a simplified and abstract theoretical setting makes it possible to obtain preliminary conclusions on the efficiency impact of these four network strategies. In reality, of course, the network strategies are often more complicated than the archetypes due to the particularities of the indi- vidual clearing houses and their members. As outlined in section 3.3,network strategies between clearing houses commonly combine the characteristics of several different archetypical set-ups. The efficiency impact of any real-world network strategy is thus influenced by additional factors that are beyond the scope of this chapter’s analysis. 2 To reflect the complexities associated with each network strategy as accu- rately as possible, the following analysis utilises the most complex struc- tural set-up of each network strateg y as defined in section 3.3.1. More con- cretely, the cross-margining analysis refers to the one-pot cross-margining approach, and the clearing link analysis assumes the Recognised CCP Model, 3 replicating the size of the Single CCP network. The mergers and acqui- sitions scenario assumes the full integration of the involved clearing sys- tems, and the Single CCP scenario is modelled by assuming the merger of LCH.Clearnet, Eurex Clearing, CC&G and the clearing houses of OMX and MEFF. 2 Chapter 8 complements the preliminary conclusions presented in this chapter with an assessment of the efficiency impact of different real-world network initiatives. 3 Although the most complex functional link set-up is the Fully Integrated Systems link, this sce- nario is not analysed because it is thought to be subsumed by the mergers and acquisitions str at- egy. McPartland refers to the idea of interlinking various CCPs while each clearing house maintains a reciprocal clearing member status with the others as ‘Open Architecture Clearing’. Cf. McPartland (2003a). 242 Clearing Services for Global Markets 1 2 3 4 Cross-Margining Agreements Clearing Links Mergers & Acquisitions Single CCP 1 LOW HIGH LOW HIGH 2 3 LOW MEDIUM MEDIUM HIGH MED. MED. HIGH 4 Demand-Side Scale Effects Supply-Side Scale Effects Figure 7.3 Scale Impact Matrix Source: Author’s own. 7.1 Scale Impact Matrix The first step in the efficiency assessment of network strategies, the Scale Impact Matrix (SIM), serves to classify the demand- and supply-side scale effects of cross-margining agreements, clearing links, mergers and acquisi- tions, and the single European CCP model (see Figure 7.3). The mat rix illus- trates the supply-side versus demand-side scale effects inherent to the different network strategies. The vertical axis shows the typified impact of supply-side scale effects; the horizontal axis shows the typified impact of demand-side scale effects. Identifying the potential magnitude of each networkstrategy’s demand- and supply-side scale effects is important because e conomies of scale and scope – together with network effects – can impact direct and indirect transaction costs. The higher a network strategy’s demand- and supply-side scale effects, the greater the potential to reduce clearing members’ transaction costs. The Scale Impact Matrix thus furnishes input for the subsequent analysis of these costs in section 7.2. The findings of the SIM suggest that clearing links can potentially exert the greatest scale effects. Whereas M&A strategies 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. Sections 7.1.1 [...]... links and then M &A initiatives 7.2.1.3 TCIM for globally active clearing members Finally, Figure 7.11 outlines the Transaction Cost Impact Matrix for globally active clearing members Globally active clearers are defined as being active in all major markets, with direct access to each of the many CCPs The globally active clearer holds a direct clearing membership with all of the major clearing 33 Also... Also note that the magnitude of these savings is greater for regionally-to-globally active clearing members than for regionally active clearers, due to the larger scope of their business – necessitating the involvement of a greater number of intermediaries 266 Clearing Services for Global Markets houses As these clearers are direct members of all of the partnering clearing houses, their main benefit... for the cost implications associated with integrating various market places and clearing systems Cf Katz/Shapiro (1985), pp 424–5 247 What theory reveals – framework for analysis of network strategies Apart from cross-margining agreements, the potential for an increase in the size of the CCP level network by means of clearing links, M &A and a Single CCP is theoretically equally great; but note that... domestic home clearing house, while acting as NCMs in other (foreign) markets Regionally-to-globally active clearers thus benefit from network strategies enabling them to clear many markets through their domestic home clearing house, because they can then disintermediate the clearer(s) they employ to access other markets The findings of Chapter 5 reveal that the greatest P&L impact for this type of clearing. .. not active in the away clearing house’s products and markets The link enables them to leverage their existing relationship with the home clearing house in terms of obtaining access to a broader range of products and markets. 12 Secondly, links offer opportunities for clearers that were previously members of all of the partnering CCPs Clearing links could theoretically enable these globally active clearers... choice of clearing location cannot be offered by M &A or Single CCP initiatives, as these ultimately fully integrate different clearing systems into a single system 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 253 What theory reveals – framework for analysis of network... regionally-to-globally active clearing members.37 The reason for this is that globally active clearers do not have 34 35 36 37 Refer to Chapter 5 for details The magnitude of these savings is greater for globally active, i.e high volume, clearing members, because due to the scale of their business, they require a greater number of communication lines than medium volume clearing members The magnitude of these savings... networks, all providers are part of a single network, and there is no way for a firm to establish a lead in terms of its installed base.11 Generally, however, the weaker the network strategy in terms of technical and legal harmonisation and integration, the more leeway exists for clearing houses to establish a lead through benefiting from their installed base Certain network strategies make all the products and... new clearing house initiative (in this case being the link infrastructure) than are clearing members with a proprietary focus 251 What theory reveals – framework for analysis of network strategies 7.1.2.2.3 Lock-in The installed base of a CCP or GCM can result in lock-in effects, which can adversely impact the dynamics of a network strategy and potentially stunt the future development of the clearing. .. not active in the away clearing house’s products and markets, the starting problem stems from the necessity of investing in the link infrastructure15 and the related dilemma of whether the utility derived from the link will outweigh the associated investments in the long run The starting problem also pertains to globally active clearing members that are direct members of all of the partnering clearing . Exploring theoretical basics – scale effects in clearing are erratic; 141 the volume of contracts available for clearing is therefore also erratic. The capacity of the clearing house infrastructure has. Services for Global Markets WHAT THEORY REVEALS – FRAMEWORK FOR EFFICIENCY ANALYSIS OF NETWORK STRATEGIES Scale Impact Matrix 7. 1 7 Establishes a framework to analyse the impact of network strategies. suggests that economies of scale exist in clearing. There are dif- ferent scenarios for increasing the scale and scope of a clearing house, each 238 Clearing Services for Global Markets of which has