Streetwise Professor

March 7, 2016

Clear the Way: LSE (and LCH!) on the Block

The biggest news from the exchange world in a long time is the proposed merger between LSE and Eurex. Both entities operate stock exchanges, but that’s a commoditized business these days, and it’s not the real driver of the merger. Instead, LSE’s LCH.Clearnet, and in particular LCH’s SwapClear, are the prizes. LSE and Eurex also both have valuable index businesses, but its hard to see how their value is enhanced through a combination: synergies, if they exist, are modest.

There are potentially large synergies on the clearing side. In particular, the ability to portfolio margin across interest rate products (notably various German government securities futures traded and cleared on Eurex, and Euro-denominated swaps cleared through LCH) would provide cost savings for customers that the merged entities could capture through higher fees. (Which is one reason why some market users are less than thrilled at the merger.)

A potential competitor to buy LSE, ICE, could also exploit these synergies. Indeed, its Euro- and Sterling-denominated short term interest rate futures contracts are arguably a better offset against Euro- and Sterling-denominated swaps than are Bunds or BOBLs.

The CME’s experience suggests that these synergies are not necessarily decisive competitively. The CME clears USD government security and STIRs, as well as USD interest rate swaps, and therefore has the greatest clearing synergies in the largest segment of the world interest rate complex. But LCH has a substantial lead in USD swap clearing.

It is likely that ICE will make a bid for LSE. If it wins, it will have a very strong clearing offering spanning exchange traded contracts, CDS, and IRS. Even if it loses, it can make Eurex pay up, thereby hobbling it as a competitor going forward: even at the current price, the LSE acquisition will strain Eurex’s balance sheet.

CME might also make a bid. Success would give it a veritable monopoly in USD interest rate clearing.

And that’s CME’s biggest obstacle. I doubt European anti-trust authorities would accept the creation of a clearing monopoly, especially since the monopolist would be American. (Just ask Google, Microsoft, etc., about that.) US antitrust authorities are likely to raise objections as well.

From a traditional antitrust perspective, an ICE acquisition would not present many challenges. But don’t put it past the Europeans to engage in protectionism via antitrust, and gin up objections to an ICE purchase.

Interestingly, the prospect of the merger between two huge clearinghouses is making people nervous about the systemic risk implications. CCPs are the new Too Big to Fail, and all that.

Welcome to the party, people. But it’s a little late to start worrying. As I pointed out going back to the 1990s, there are strong economies of scale and scope in clearing, meaning that consolidation is nearly inevitable. With swaps clearing mandates, the scale of clearing has been increased so much, and new scope economies have been created, that the consolidated entities will inevitably be huge, and systemically important.

If I had to handicap, I would put decent odds on the eventual success of a Eurex-LSE combination, but I think ICE has a decent opportunity of prevailing as well.

The most interesting thing about this is what it says about the new dynamics of exchange combinations. In the 2000s, yes, clearing was part of the story, but synergies in execution were important too. Now it’s all about clearing, and OTC clearing in particular. Which means that systemic risk concerns, which were largely overlooked in the pre-crisis exchange mergers, will move front and center.

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  1. How do you see single counterparty credit limits and legal lending limits being affected by the merger? with regulatory rules pushing to cleared products, a decrease in the number of clearinghouses would push market participants toward their limits more quickly (i suppose the question is how close are they to the limits now and how much more cleared transaction they will do once margin rules are in effect …)

    Comment by in the margins — March 8, 2016 @ 5:08 am

  2. Craig,

    If antitrust regulatory action were not an issue, would a CME acquisition of the LSE create most value? Would there be any other benefits over what would accrue to CME and LSE shareholders?

    Comment by John L. McCormack — March 8, 2016 @ 7:30 am

  3. @John-Not an easy question to answer. It could arguably create the most value for shareholders, by reducing competition in the OTC clearing space–which is why the antitrust authorities will likely look askance at any such combination. It could also lead to some cost savings as redundant systems could be combined, and through portfolio netting across swaps, and across USD futures and USD swaps currently cleared at LCH. The shareholders would capture some of this, but some would accrue to customers.

    I also have some questions about the jurisdictional issues that could limit the netting benefits. I would imagine that European authorities would insist that financial institutions in their jurisdiction clear through a CCP that is also in their jurisdiction.

    Then there is the systemic risk issue, which is not easy to unpack.

    The ProfessorComment by The Professor — March 8, 2016 @ 3:58 pm

  4. Welcome back prof. I was wondering when you would break your silence.

    @ in the margins – do you know how banks set their clearing limits to a CCP? They tend to look at their current exposures and then double them to get a limit. Once they get close they just up it again. Is any bank going to stop trading Euro Dollars or OTC swaps cos they are at their CCP (too big to fail and will be bailed out) limits?

    No-one is talking about the main customers i.e. the dealer banks who account for the majority of the volumes in the key contracts/products which can give rise to the margin efficiencies. They will have a key say in this deal either directly as shareholders of LCH (remember LSE is approx 55% owner and the banks own the rest) or they club together as clients and take their business to somewhere else. This would be painful but possible if they really don’t like the outcome. I suspect they would prefer everyone just went back to owning their existing patches. They want some competition to keep the others honest and trading / clearing prices down. I suspect the main buy-side players will share a similar view regarding competition.

    If any takeover of LSE happens the ‘losers’ might not be too bothered since ‘winner’ will have probably overpaid and they will be the official opposition and could well pick up business as the participants look ensure genuine competition remains.

    Comment by Greenwichmeanttiger — March 8, 2016 @ 5:50 pm

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