CCP in Focus - Fragmentation vs. Consolidation in the CCP World

CCPs are widely recognised as a critical element in capital market post-trade infrastructure and as such you might expect the central clearing segment to be relatively static: no frequent mergers and acquisitions, or emergence of new players. Infrastructure, almost by definition, does not move much. Surprisingly, this is not the case for CCPs, most notably in the recent past. As a result of the increasingly attractive clearing profits and the global OTC derivatives market reforms, the CCP world has entered a period of dramatic change.

In August 2012, LCH.Clearnet bought the International Derivatives Clearing Group (IDCG) and turned it into a U.S-domiciled swap clearing service. In November 2012, Brazil announced its plan to consolidate its four clearing houses into one. About four months later, Japan Securities Clearing Corporation (JSCC) and Japan Government Bond Clearing Corporation (JGBCC) began their merger process, with JSCC becoming the surviving entity and assuming all JGBCC’s business. Earlier this month, the European Multilateral Clearing Facility (EMCF) and EuroCCP completed their merger. Around the same time, ICE and DTCC agreed to wind down their joint venture, New York Portfolio Clearing (NYPC) and integrate the interest rate products into the London-based CCP, ICE Clear Europe.

While consolidation is creating more powerful multi-asset class CCPs in some parts of the world, other markets are going in the opposite direction – fragmentation. With the global regulatory mandate set by G20 to bring OTC derivatives into central clearing, some countries are building new CCPs instead of using their existing derivatives CCPs. For example, in November 2013 Hong Kong saw the launch of a new CCP, OTC Clear, for interest rate swaps and currency swaps, even though the market was already served by one cash CCP and two other derivatives CCPs. In mainland China, Shanghai Clearing House is expected to become the CCP for OTC derivatives, the sixth CCP in China. The clearing industry in some other Asian markets such as India and Taiwan are in a fragmented state as well, sometimes by asset class and sometimes not.

So, consolidation vs. fragmentation, why have some markets chosen the former whilst others favoured the latter?

As you may have noticed in the examples above, consolidation of CCPs mainly happens in the supposedly developed, free markets. Mergers and acquisitions are driven by stiff competition among CCPs. Clearing profit is volume dependent – the higher the volume, the higher the fee revenue and the lower the cost per transaction for the CCP. A CCP with relatively low volume could either combine with another small CCP to achieve the economies of scale (such as EMCF and EuroCCP), or be acquired by a larger CCP which seeks strategic expansion (such as IDCG and LCH.Clearnet). Another important advantage of a consolidated CCP is that it is more likely to conduct portfolio margining between different products, providing clearing members with considerable margin reduction – in the case of Japan, margin offsets between Japanese government bonds and futures & options on these bonds are now possible given that the two product groups have been integrated into one single CCP, i.e. JSCC.

However, the fragmentation option has its own merits. In mainland China, Taiwan and India, the clearing landscape is largely shaped by the trading landscape: every exchange has its own clearing department (in-house CCP) or clearing house. Without competition among the local CCPs and with barriers to entry for foreign players, these CCPs may lack the motivation to self-improve and lose the opportunity to attract clearing members by offering a wider range of margin offsets. Nonetheless, fragmentation offers ring-fencing between different markets – an event of default at one exchange and one CCP will not impact participants of other exchanges and CCPs.

For instance, if Firm A defaulted on the cotton contract of Zhengzhou Commodity Exchange, Firm B clearing copper at Shanghai Futures Exchange would not be affected at all; but if China had one single CCP for all the commodities exchanges, Firm B might see its default fund contribution used to compensate the losses caused by Firm A. With fragmentation, counterparty risk is diversified; hence there is lower probability that one single CCP can pose significant systemic risk to the entire market. This is probably why ‘too big to fail’, which has been a real headache for the Western world for years, is less of an issue in these fragmented markets where asset classes are traded and processed in entirely different institutional structures.

In a nutshell, consolidation can establish big multi-asset-class CCPs, the fittest that have survived, whilst fragmentation lays out a conservative path by putting fewer eggs in more baskets. One could view it as efficiency gains vs. safety through ring-fencing, even though it is more likely that fragmentation is preferred in order to protect vested interests as opposed to protect clearing members. Both models have their benefits and drawbacks and authorities in different jurisdictions made different choices when sketching the new landscape. It will be interesting to see how CCPs moving in the two directions evolve in the future and whether or not they will converge at some point. It wouldn’t come as a surprise to see a bit of pushing and shoving, in the meantime, between the two opposing business solutions, amongst market participants and the authorities overseeing them.

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