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For the past year or so, the one thing you didn’t do at the London Stock Exchange was mention the c-word.
I mean, of course, clearing. For most of this time the LSE’s clearing strategy has been, at best, opaque.
Shortly after he was hired in January 2010, the exchange’s head of post-trade, Kevin Milne, spent a lot of time talking with the LSE’s biggest customers – the banks – about the LSE’s clearing arrangements.
With exchanges verticalising around it, the idea was to figure out what this meant for the LSE, which lacks an in-house clearer for its main UK market (even as it has a clearer in Italy for the Milan market).
Plus there was a crescendo building around the broader issue of clearing thanks to the upcoming European Market Infrastructure Regulation (Emir).
Then things started to get interesting. Xavier Rolet, chief executive, signalled in May last year that relations between the LSE and LCH.Clearnet, its third party clearing provider, had all but broken down.
He sent a shot across LCH.Clearnet’s bow by suggesting for the first time that the LSE might be looking for an alternative provider of clearing services.
Lack of “in-house capabilities” in the post-trade business at the LSE and “dependency on certain not-always-ideal external suppliers” – a none-too subtle reference to LCH.Clearnet – had prevented the London bourse from “innovating successfully”, he said.
The comments were taken as a sign that the LSE will build its own clearing house in London.
Two months later, Mr Rolet quit the board of LCH.Clearnet. Around that time, he also hired Patrick Birley, a former head of LCH.Clearnet’s UK operations, as a consultant to advise on clearing strategy.
By December it became public that Mr Birley and the LSE had parted ways, amid disagreement over what clearing strategy to pursue and how to go about it: whether to build its own clearer or take a majority stake in LCH.Clearnet – or do nothing.
The “do nothing” option is what happened. In a way this was understandable. With so much in flux in market structures in Brussels – especially concerning clearing – a “wait and see” approach probably made sense. Who could say which way Emir would go in terms of the so-called “scope” issue?... Would the UK and others succeed in their efforts to have Emir’s scope expanded beyond OTC derivatives to listed derivatives, with all that implied for instilling competition in listed derivatives and between clearing houses in Europe?
Then there was the uncertainty over “interoperability” in cash equities clearing in Europe. And in September last year Mr Rolet had started discussing a possible merger with his counterpart at TMX Group, operator of Canada’s main exchanges.
Before the summer break wait-and-see no longer seemed viable, would be my guess. It became clear that the UK had probably been out-gunned on the scope issue (we will know for sure this week or next).
With the failure of its Canadian adventure, it made sense for the LSE to move from “wait and see” to doing something.
So does LCH.Clearnet make sense for the LSE? Yes. It gives the LSE a clearer in London, finally. Any exchange that hopes to enter new markets and innovate on product is handicapped without having its own clearing. That is especially relevant in derivatives, where the LSE is just out of the starting blocks with its Turquoise FTSE futures initiative.
An acquisition of LCH.Clearnet also would also be immediately accretive to earnings, given the clearer’s large treasury business – the bread-and-butter of any clearing house. LCH.Clearnet earns 29 per cent of its revenues from lending out the collateral posted to it by market participants. Only 14 per cent comes from cash equities clearing (a rapidly commoditising business, in any case).
Mr Rolet has shown that he can run a clearing house more efficiently in Italy. In May the LSE revealed a 30 per cent jump in income at the LSE group’s post-trade services business, mostly from its Italian clearing house. That was as a result of widening the group of local banks that Cassa uses to deposit margin funds in overnight, allowing it to negotiate more favourable euribor rates.
But what about SwapClear, the over-the-counter (OTC) interest rate swaps clearing service under LCH.Clearnet?
While LCH.Clearnet books OTC derivatives revenues on its accounts from the SwapClear service, this does not tell the full story on where SwapClear profits go. Some go to the OTC derivatives dealer-banks that form a curious governance mechanism for SwapClear, known as OTCDerivNet. The amount of profit that goes to these banks is dictated by a sliding scale of thresholds set out in an arrangement between LCH.Clearnet and the banks, revised last year.
It is a glass bead game that few even in the industry understand, but the bottom line is that any LSE deal with LCH.Clearnet would probably have to allow SwapClear to be ring-fenced somehow to allow the banks to carry on. I can’t see the SwapClear banks represented on the LCH.Clearnet board being enthusiastic, either, about exchange control of LCH.Clearnet (which is what you’d get if the LSE wants 51 per cent).
This is one hurdle that Markit, the LSE’s rival bidder, does not face. Perhaps that is why the LSE has offered a knock-out €21 a share price for LCH.Clearnet, above Markit’s €15 offered for 100 per cent of LCH.Clearnet.
The LSE can just about afford it. Barclays Capital calculates the LSE has £650-£700m of firepower. Depending on what LCH.Clearnet stake LSE acquires, it might need to issue “minimal new equity” to fund it.
But even as I can make a case for the LSE’s interest in LCH.Clearnet, there is a more compelling overlap with Markit. Many of Markit’s shareholders are the same banks in OTCDerivNet; their interests are aligned. And Markit is at least a player in the OTC derivatives “plumbing” business that fits well with SwapClear. It also has a joint venture with the Depository Trust & Clearing Corporation – DerivSERV – which is at the heart of OTC derivatives processing already. Not to speak of a strong US presence, which is where SwapClear is in the midst of trying to gain traction with “buyside” clearing.
We’ve been here before with the LSE, of course. The exchange was briefly a non-committal member of the “Lily” consortium, which included 14 banks and the inter-dealer broker Icap, and which bid for LCH.Clearnet in 2009.
It seems this time things are serious. But for Mr Rolet’s sake, this big ticket deal had better work, since shareholders and the board may be less forgiving if, post-TMX, this venture fails as well.
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