Streetwise Professor

September 6, 2011

Splitting the Baby

Filed under: Clearing,Derivatives,Exchanges,Regulation — The Professor @ 9:03 pm

Back in June, at a nice lunch with several LCH.Clearnet executives in The City, I was asked my opinion on the company’s future.  Recent news, notably the offers for the company by Markit and LSE, have brought that conversation to mind.

My answer was that I thought that the trend towards vertical integration by exchanges was inexorable, and that there were good economic reasons for this (which I have discussed for years here on SWP).  As a result, I didn’t/don’t consider the model of an independent firm clearing for multiple execution venues/exchanges to be viable.  Especially with Frank-n-Dodd and Emir, but likely even without that impetus, there definitely will be increasing opportunities for clearing OTC derivatives.  (Although I cautioned that if the ambitions of regulators and legislators to make OTC trading exchange-like were successful, the same kind of dynamic now playing out in listed derivatives could occur in swaps.)  So SwapClear is clearly a viable business (similarly, RepoClear).  But major dealer firms would demand considerable influence over, and perhaps control over, the clearing entity.  Any such entity would either be, or closely resemble, a member cooperative.

My prediction was that (a) the exchange clearing business of LCH.Clearnet would either go away, or be absorbed into an exchange or exchanges, and (b) the swap clearing business would be largely in the orbit of the big dealer banks, although how that would be achieved organizationally remains to be seen.

The LSE offer is clearly intended to obtain the in-house clearing capability that LSE has lacked for decades (in part due to its own missteps in the 1970s and 1980s).  But LSE has no comparative advantage in operating the OTC clearing business, and the dealer banks have no interest in having LSE control it.

In contrast, the OTC derivatives business is a much closer fit with Markit, given the overlap between the membership of OTCDerivNet (which governs SwapClear) and the ownership of Markit, and the synergy between Markit’s OTC valuation, processing, and data business and OTC clearing.  But Markit really has no need for LCH.Clearnet’s listed clearing business.

So the sensible outcome would be to split the baby, with LSE taking over its own clearing by acquiring part of LCH.Clearnet, and Markit taking the OTC-related business.  That end state seems much more sensible than either LSE or Markit swallowing all of the big London-Paris clearer.  How that end state is reached–how the baby actually gets split–will be quite interesting to watch.  I am sure there will be much drama in the coming months.

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1 Comment »

  1. LCH Clearnet is poorly capitalised. A large portion of its regulatory capital is a subordinated bond. It lacks sufficient tangible equity capital. S&P recently downgraded LCH Clearnet. It is important that a company of such systemic importance should strengthen its capital base and the recent takeover approach is the ideal opportunity to strengthen LCH Clearnet’s tangible equity base. Either the subordinated debt should be replaced with equity or there should be a parent with strong capital base. On this front I believe LSE may be a better parent. Markit is a private company owned by banks. Its solidity is unknown. Are the banks, given their other issues, willing to inject new capital? FSA which are the regulator, should make sure that LCH Clearnet will have a much stronger tangible equity base in future.

    Comment by O.Kamshad — September 7, 2011 @ 9:20 am

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