Competition and consolidation in the CCP space – LSEG and Deutsche Borse

The proposed takeover of London Stock Exchange Group by Deutsche Borse is posing a number of questions for regulators and governments in deciding whether or not such a deal is healthy for financial markets. The stock exchanges would merge, but so too, would their central counterparty clearinghouses, LCH.Clearnet and Eurex Clearing.

Central clearing, the pillar of the regulatory response to the financial crises, is big business now. CCPs are money makers for those that run them. In 2015, SwapClear, one of LCH’s clearing platforms, cleared US$533 trillion in notional interest rate derivatives, part of the clearing house generating an income of EUR€496 million for LSEG. Eurex generated even bigger income in 2015 at €1.025 billion.

It stands to reason that the more margin that CCPs hold, the more robust they will be, but the competitive nature of the clearing landscape requires careful consideration at this juncture.  Gathering collateral is becoming an expensive business as there are guidelines as to what qualifies as acceptable collateral at CCPs; clearing members cannot just post anything, and there are haircuts to be applied. Market participants with a clearing obligation (the vast majority) will be attracted by lower margin requirements to fulfil their trades. Clients will also be attracted by CCPs with a more diverse range of acceptable collateral, i.e. CCPs that will take lower grade collateral. There have been fears of a race to the bottom (Collateral for clearing – a race to the bottom?).

In the eyes of clients, the posting of initial margin is pointless; if another clearing member at their chosen CCP goes into default then that client’s margin is not touched (unless in the unlikely event of recovery and resolution) and if the client’s clearing member goes into default it can port its positions away to another clearing member, taking its margin with it. The most client business will be won by those CCPs that can keep initial margin requirements to a minimum.

Given that CCPs are commercial entities the incentives for encouraging clearing through themselves are obvious. To further reduce margin requirements, the notion of portfolio margining has been introduced at CCPs, whereby one position in a portfolio can be offset against another, thereby reducing margin requirements.

We covered this topic last year (The pros and cons of portfolio margining) and two diverging opinions from within the European clearing community emerged. EACH (the European Association of Clearing Houses) released a paper stating that; “CCPs have an interest to incentivise well diversified portfolios.” They do not. They have no incentive to do anything other than act as a CCP.

On the other side, LCH released a paper at around the same time stating that, “the level of margin reduction allowed should be limited so as to not overstate the extent to which these portfolio effects are reliable under stressed conditions, actionable during the default management process and in line with the need to avoid pro-cyclicality.”

EACH was chaired by Eurex at the time of its report; LCH is now part of LSEG. So, if Deutsche Borse completes the proposed takeover of LSEG, which attitude will be prevalent? LCH has previously been accused of setting its swap margin requirements too low. So LCH is not competing on portfolio margining, but may well be competing on initial margin.

The two clearinghouses currently hold $170 billion in margin. If they were to become joined in anyway, then there would be portfolio margining options to be passed on to clearing members of the two CCPs, which will reduce the amount of margin held, as has been publicly discussed by those involved in the takeover talks. The advantage of being able to offer portfolio margining advantages across two major CCPs clearing futures and swaps will encourage clearing at the venues.

The consequences of this will be less margin (less than the $170 billion currently held across the two CCPs) to cover the same risk. The justification is netting the risk, seemingly against LCH’s better judgement, to reduce the margin calls. In a negative interest rate environment, CCPs do not make much income on the margins that they collect (where and how they hold margin is tightly regulated) but on the clearing fees that they charge.  

If the prevalent attitude to emerge was the more cavalier portfolio margining attitude proffered by Eurex, combined with the more cavalier margin requirements that LCH have been accused of, then that would make the CCP landscape a riskier place than it is now, with two of the largest CCPs in Europe collecting less margin.

At the smaller end of the scale, LCH is not LSEG’s only clearing arm, as CC&G, the Italian CCP, is also under the group’s umbrella. In 2015, CC&G cleared 120.1 million contracts and held €12.3 billion in initial margin.  Along with Monte Titoli, the Italian Central Securities Depository, it provided income of £119.1 million to LSEG in 2015. What will come of these Italian infrastructures in any Deutsche Borse takeover of LSEG? All of the focus has been on Eurex and LCH.Clearnet, but there are other post-trade infrastructures to be considered in any deal between Deutsche Borse and LSEG.

CCPs are already too big to fail; the creation of a monolithic European CCP also concentrates more risk into one venue. The regulators and governments involved in any proposed deal need to carefully consider and monitor any changes that will be affected in the CCP landscape.

Consolidation in the European CCP space is inevitable as it is the regulatory end goal, but is this right path to take? Consolidation is being forced in the CSD space in Europe through T2S and CSDR and this does not look to necessarily be the right path to take and nor will it be in the CCP space. Consolidation, as we are seeing here, will result in lower initial margin collections to cover the same amount of risk. Is this policy the right one to pursue?

Tags: LSEDeutsche BorseCCPRegulation