A proposal by a consortium of major derivatives dealers to acquire London-based clearing house LCH.Clearnet has led to suggestions that banks becoming intimately involved in the clearing process could present a conflict of interest.
BNP Paribas, Société Générale, UBS, JP Morgan, HSBC, Royal Bank of Scotland and Deutsche Bank - also acting as adviser on the acquisition - along with interdealer broker Icap, make up the bidding group. Sources say the final composition could change, with other institutions, including the London Stock Exchange, expressing an interest.
But the dealers will have to act fast - LCH.Clearnet signed a non-binding merger agreement on October 22, 2008, with US clearing giant The Depository Trust & Clearing Corporation (DTCC). The two firms have until March 15 to thrash out terms, which could see DTCC acquire LCH.Clearnet for €739 million.
And the prospect of a dealer-owned clearing house has raised concerns about a conflict of interest in the clearing business. With regulatory pressure propelling clearing services into the spotlight - particularly in the credit derivatives arena - some observers believe the bid for LCH.Clearnet would be a means for dealers to exert greater influence.
"Dealers may be obliged by regulators to move more of their business on to CCPs and believe they have insufficient control of central counterparties (CCPs) in Europe. Eurex isn't really dealer-controlled, and while LCH.Clearnet has dealers in its ownership, the main credit default swap (CDS) players don't have any specific control there," said a senior clearing official at a European exchange. LCH.Clearnet has 109 member firms, but if the consortium's bid is accepted, a far smaller number would be able to decide its governance and clearing criteria. "Dealers can control who plays at the table, what games are played, and the level to which the smaller players can compete with them," he continued.
The prospect of a dealer-owned CCP has led others to question whether the structure of a theoretically market-neutral institution could be modified to be advantageous to its owners; allowing them, for example, to set favourable collateral or margining requirements.
"There are no minimum risk standards in the CCP industry in Europe because there is no regulator that supervises CCPs across all jurisdictions. But this could be in danger now the European Commission wants CCPs to compete," said Diana Chan, the chief executive of Euro CCP, a European subsidiary of DTCC. "One likely area of competition will be margin."
Other market participants question whether regulators will approve a dealer-run CCP. "The best thing would be to implement incentive-neutral structures in the market: this is essential to good risk management. It is not without reason that within banks, compliance and risk management are typically independent from trading," notes a vice-president of a European CCP.
Alberto Pravettoni, head of corporate strategy at LCH.Clearnet, said he understood these concerns. "It is important to question how representative a group of banks can be of the market - if three banks took ownership of LCH.Clearnet that would not be an appropriate market structure," he said, but declined to comment whether the size of the bidding dealer group would be similarly inappropriate.
Julien Kasparian, head of market infrastructure solutions at consortium member BNP Paribas Securities Services, pointed out: "There is a conflict of interest if we have brokers governing a central counterparty that is supposed to be market-neutral and needs to manage the risk between the members. A broker that owns his own clearing business is a danger."
But, he added, even if the consortium succeeds, a conflict of interest is not inevitable: strict regulation of the dealers involved, and the banks' agreement with the European Commission on February 19 to use a regional-domiciled CCP for CDS contracts, minimises the risk of dealers acting in their own interest.
Pravettoni agreed with that view. "LCH.Clearnet is subject to intense regulatory scrutiny. If we were to present a model that called for small margin payments because that is the desire of the owner banks, regulators simply wouldn't accept it," he remarks. "It is not in the commercial interest of banks to cut corners. If you take away the inherent integrity of the clearing house you will undermine its purpose and the markets it serves. In such circumstances, everyone would be a loser."
Meanwhile, if the rival DTCC bid is successful, LCH.Clearnet will move to an at-cost governance model, with any excess revenue returned to users proportionate to their usage. Chan predicted that this approach could have tangible risk management benefits.
"With at-cost governance, loss sharing serves as an inbuilt defence against moral hazard: if the margin collected is insufficient to cover a defaulting member, the surviving participants have to bear the consequences," she said. "A for-profit CCP is run like a business and there is a trade-off between risk and reward."
By contrast, a banker involved with the dealer consortium says the group is motivated by a desire to retain control over the derivatives business and to benefit financially. "The CCP will need to make a profit to create new products and protect participants by spreading the risk. Having a totally not-for-profit CCP may end up being unproductive," he said.
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