Risk 25 firms of the future: LCH.Clearnet

Ian Axe, LCH.Clearnet

Many in the industry suspect there will eventually be consolidation in the over-the-counter clearing space, but few predicted that trend would begin before mandatory clearing regulations even came into effect. If LCH.Clearnet’s acquisition of International Derivatives Clearing Group (IDCG) goes ahead, though – and many believe an announcement is imminent – it will open a new chapter for the fast-evolving sector.

It’s a development that may reassure dealers, increasingly alarmed at the queue of clearing houses and exchanges waiting to enter the OTC market. This proliferation has been encouraged by national regulators, in Japan and elsewhere, that want to see certain local-currency transactions cleared through domestic central counterparties (CCPs). The problem, dealers say, is that this fragments liquidity and netting sets, and could end up replicating the tangled web of exposures policy-makers had been hoping to eliminate (Risk April 2011, pages 38–41 and www.risk.net/2161673).

Those concerns are shared by Ian Axe, London-based chief executive of LCH.Clearnet Group. “How many clearers do you have before you turn around and say ‘Wow, we have a bifurcated, fragmented clearing market’? That is a serious question the regulators need to think about. We think it is immensely healthy to have competition, but there is definitely a question as to how many clearing houses there should be,” he says.

The acquisition of IDCG by LCH.Clearnet would narrow the field. The firms announced they were talking about a deal on April 24, which would see the UK-based clearer become sole owner of New York-based IDCG. Nasdaq OMX – currently the majority owner of IDCG – would become a shareholder in LCH.Clearnet. The deal may not fly, but many in the market think an agreement could be reached within weeks.

Axe is clear about the benefits – it would give the CCP a domestic clearing presence to complement its existing multinational SwapClear platform. While LCH.Clearnet has pushed hard to develop its US business, launching a service for futures commission merchants in March 2011, IDCG has run a Commodity Futures Trading Commission (CFTC)-licensed derivatives clearing organisation in the US since December 2008, and an acquisition would help capture a wider universe of domestic clients, says Axe.

The strategy is not to cannibalise what is a very successful and important clearing vehicle in the US, but we feel we can complement it with a domestic service offering – Ian Axe, LCH.Clearnet

“We are an international clearing house, but the market is opening up to much more than international firms. The multinational model for international firms is very viable, but I may also want a domestic model with a domestic licence in the US, which would allow us to service other clients that don’t want a cross-border clearing platform. The strategy is not to cannibalise what is a very successful and important clearing vehicle in the US, but we feel we can complement it with a domestic service offering,” he explains.

This might just be the start – the clearer was in discussions with Tokyo-based Japan Securities Clearing Corporation last year over a possible joint venture, for instance. That initiative didn’t work out, mainly because of a decision by Japan’s Financial Services Agency to limit a mandatory clearing requirement to domestic dealers in the first phase from November 2012, which meant the economics of the deal didn’t stack up (Risk December 2011, page 8). However, Axe doesn’t rule out further tie-ups.

“We are open to green-field developments, joint ventures and acquisitions – we are very open to that,” he says. “However, you have to prioritise and ensure that, when you are running a risk management firm, you actually deliver and quality is assured. I can’t afford to be expanding the firm in multiple jurisdictions in parallel if one doesn’t get the full attention and quality risk management that is required.”

Risk management comes up again and again. Axe expresses concern about rival clearers potentially slashing margin levels to win business. “We would be opposed to a race to the bottom on risk management,” he says. He also warns against firms more familiar with listed products underestimating the risk management and liquidity challenges associated with OTC clearing.

“A lot of CCPs are evolving at the moment, and several are moving from highly liquid, cash equity clearing services. With those aspirations comes a lot of responsibility around risk management and understanding the importance of initial margin and the liquidity of the default fund, which is far more complex for OTC products than highly liquid products.”

Clearers need to start with a mindset that there will be a default, and set the risk management framework accordingly, he adds. “In insurance terms, it’s like saying someone will crash their car and someone will lose their watch. It’s a different philosophy of risk management, where you are setting yourself up under the expectation that an event will happen,” he explains.

As such, the strength of the clearing members is crucial. Many market participants criticised a decision by the CFTC last October to prevent CCPs setting membership criteria in excess of $50 million in capital, and claim attempts to broaden access will weaken clearing houses’ ability to withstand a default. Axe has a more nuanced take. “People always quote the one line from the CFTC, which is an aspiration of open access – we have been consistently supportive of that. But what we have always stated is that with membership comes responsibility, and the proportionality of risk-taking is imperative. That means you have to be able to handle the risk management of default,” he says.

But risk management isn’t the only important consideration for a clearing house – being able to provide collateral efficiency will also be a determining factor when clients come to choose a CCP, Axe says. Clients don’t have a never-ending supply of collateral, and clearing houses can set themselves apart by easing the burden for users (see pages 16-19).

In part, this can be achieved through further consolidation of clearing houses, but some CCPs are opting for a different route. In LCH.Clearnet’s case, it announced in March that it would work with New York Portfolio Clearing (NYPC), the Depository Trust & Clearing Corporation (DTCC) and NYSE Euronext to explore a cross-margining arrangement in the US.

The so-called one-pot approach would combine the interest rate futures contracts traded on NYSE Liffe US and cleared by NYPC, fixed-income cash and repo trades cleared by the DTCC’s Fixed Income Clearing Corporation and interest rate swaps cleared by SwapClear into a single portfolio for the purposes of margin netting. The system already exists – SwapClear would be a new addition. But critics claim throwing OTC contracts into the mix will make the initiative far more complex, and question how the approach will work in the event of a default. Where will the capital reside, and will it be enough to cover losses at each venue, for instance?

Axe says the details are still being ironed out, but believes it is do-able. “The market needs organisations to work together to look at the client need, and the client does not have an endless stream of high-quality collateral. So clearing houses need to be very effective on how they optimise and cross-margin. It is really important to stress that the risk management must never be compromised, so efficiency must be gained at the right tolerance of risk management,” he says.

While there may be signs of consolidation in the OTC clearing space, LCH.Clearnet has itself recently been acquired by London Stock Exchange (LSE) Group. The deal closed in April, with LSE Group now holding 60% of the shares in the clearing firm. At first glance, it looks like a radical departure for LCH.Clearnet. Several clearers, including CME Group and Eurex, have been built off the back of an exchange business. Both of these entities employ a vertical business model – in other words, the exchange dictates that its listed contracts can only be cleared through its clearing house, and the clearer exclusively accepts contracts from that exchange. In contrast, LCH.Clearnet has always prided itself on its horizontal model – it can work with multiple exchanges, dealers and brokers. Axe says this will not change.

“We have a majority-owner partner that accepts the horizontal model is important. But it also presents an opportunity for us to work with them to expand some of the exchange clearing services that will benefit from scale and from a larger infrastructure,” he says.

There will be broader changes to the business, though. Regulators in the US and Europe are finalising rules that will require a much wider array of derivatives contracts to clear through CCPs. In the past year alone, LCH.Clearnet has launched a clearing service for non-deliverable forwards through ForexClear, and expanded its existing credit default swap (CDS) platform globally via CDSClear, initially covering credit indexes. New additions are on the way – the firm is working on foreign exchange options, although regulatory requirements on settlement have slowed that particular initiative. Single-name CDS contracts are likely to be added to CDSClear by the end of this year, and SwapClear is working to introduce swaptions.

Ultimately, regulators may be expecting too much, too soon. The Group of 20 nations agreed in September 2009 that all standardised derivatives must be cleared on a CCP by the end of 2012. This is unlikely, acknowledges Axe. “It is good to have a timeline, and I think parts of it can be met. But the full implementation of the rules will easily roll into 2013,” he says.