The bid by London Stock Exchange for LCH.Clearnet, the London-headquartered clearing house, is indicative of the winds of change blowing through the European derivatives industry as exchange consolidation reinforces the vertical silo clearing model.

LCH.Clearnet and the London Stock Exchange have been the biggest losers from the expansion of the exchange-owned vertical silo clearing model. Successful horizontal clearing requires the backing of the herd and when Liffe announced it was to sever ties with LCH and build its own clearing house, this put pressure on the London Metal Exchange to follow suit, which it duly did, announcing it was exploring its options in June.

At the same time, LCH has experienced significant pressure on its cash equities clearing business. A vicious price war between LCH, Euro CCP and EMCF has resulted in clearing fees for cash equities falling. Fees from clearing cash equities fell by 21% in 2010.

For the London Stock Exchange, the trend towards vertical silo clearing is a commercial disadvantage. Owning a clearing house enables an exchange to earn profits from post trade services while being able to get products to market quicker without the lengthy process of approval by a clearing house outside the control of the exchange.

It is clear that the exchange faces two main challenges: building up its derivatives markets and establishing a sustainable clearing clearing house. Should its deal for LCH be successful it will be a significant step forward in both respects.

The unpolished jewel

While revenues in its traditional businesses fall, LCH has established itself as a market leader in interest rate swap clearing and whoever wins the race to acquire LCH will take control of SwapClear, the unpolished jewel in LCH’s crown. Last year, SwapClear volumes rose by 25% and it cleared a total of $248tr of swaps in 2010 from its 36 members.

However, it earned just €21.2m in revenues from its OTC derivatives clearing operations. This represented an increase of 26% in line with the increase in volumes but the amount was dwarfed by the €74.5m earned from ETD clearing. To profit from its dominance in OTC clearing would require a commercialisation of the product that may be unacceptable for its members, many of which are currently shareholders in LCH and have the power to make an LSE takeover difficult.

In 2010, total revenue at LCH fell by almost 40% to €553.6m. Much of this was due to the one off termination fee of €260.4m paid by NYSE Euronext upon the notice of termination of its contract and the impact of low interest rates on its earnings from member’s collateral, however it experienced an 8.1% decline in revenue from clearing fees.

Rival bids

LSE will face stiff competition from Markit. The post trade services company, which is backed by a consortium of banks, has reportedly made a bid of €15 a share for the clearer. The bid is short of the reported €21 a share bid by LSE but has a number of advantages: it is a smaller operation and can therefore be more responsive during the bidding process and many of its shareholders are also shareholders in LCH.

What it plans for the clearer are is uncertain although it may shut down the cash equities clearing side of the business and focus on ETD and OTC derivative clearing. That will depend what appetite it has to fight the price war and lead the expected consolidation in the cash equities space. With four clearing houses competing in that space, losers are inevitable.

RIP horizontal clearing?

A successful bid by LSE for LCH could result in the death of horizontal clearing in European derivatives markets. It would be a deep irony as LSE has been arguing the anti-competitive nature of vertical clearing in its opposition to the Deutsche Börse NYSE Euronext merger.

However, Ruben Lee, CEO of Oxford Finance Group and author of Running the World’s Markets: The Governance of Financial Infrastructure, said that it was too early to sound the death knell for horizontal clearing.

“The argument against vertical clearing has sufficient legs both politically and commercially to suggest that this would not be the end of horizontal clearing in European derivatives markets. Many regulators and market participants feel that vertically integrated clearing could enable exchanges to prevent competition from other exchanges.”

Regulatory pressure may well provide a boost for horizontal clearing. Last month, the Financial Times reported that regulators in Brussels had circulated a new addition to Mifid that would require clearing houses in Europe to accept for clearing instruments “on a non-discriminatory and transparent basis, regardless of the trading venue on which the transaction is executed”.

This comes as the European Commission continues its investigation in the merger between NYSE Euronext and Deutsche Börse with some analysts predicting that a mandated opening of clearing services could be a caveat for the deal to progress.

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