Clearing the Way

Futures exchanges around the world have operated their own clearing houses for decades, but this longstanding business model is facing a new debate in the United States and Europe.

When it comes to clearing, futures and equity exchanges have taken separate paths. One clearing model isn't superior to another because each is designed for the unique business needs of the markets it serves.

For more than 100 years, the futures industry has benefited from a central counterparty clearing (CCP) model in which exchanges own their own clearing houses. This "vertical" model has allowed exchanges to invest confidently in developing innovative new products and services that have helped markets grow. It also has encouraged the development of risk management tools, such as the Standard Portfolio Analysis of Risk (SPAN) system, which has become the industry standard for portfolio risk assessment and is now used by more than 50 exchanges worldwide.

In contrast, the securities and options world, where exchanges list stocks and options issued by third-party corporations, uses a "horizontal" or utility model, with one participant-owned clearing house for all the exchanges' products. For stocks, it is the Depository Trust & Clearing Corporation and for options, the Options Clearing Corporation. This model works because stocks are issued by a third party, whereas futures are proprietary products, created by the exchanges on which they trade.

As consolidation and globalization reshape the industry, a tug of war has developed between established futures exchanges and the large investment banks and hedge funds that are some of their biggest users. For example, several of the big banks plan to start electronic exchanges to compete with CME Group in the United States and Liffe in Europe. One of the newest startups, Electronic Liquidity Exchange (ELX), is backed by investment banks, such as JPMorgan and Merrill Lynch, and financial services firms, such as Citadel Investment Group and Peak6. And in Europe, brokers including Goldman Sachs and UBS are in talks to start a rival exchange to Liffe, called Project Rainbow.

These firms contend that the ownership of clearing services that futures exchanges like CME Group have makes it harder for new exchanges to enter the market and build liquidity. Other market participants have added their opinions to the conversation, suggesting that it may be time to mandate a horizontal model rather than continuing to let the market determine which model best meets its needs. The Futures Industry Association (FIA), whose board is weighted toward many of the large investment banks, also favors instituting a horizontal clearing model.

Proponents of vertical clearing counter that this clearing model has been the industry standard for decades, with astonishing success. The CCP model has protected exchange-traded markets against many of the issues around transparency, liquidity, and valuations that periodically crop up in over-the-counter (OTC) markets. CME Clearing has operated without a single default in the 100-plus years it has existed.

Basically, they say, "If it ain't broke, don't fix it."

In a speech to the Managed Funds Association earlier this year, CME Group Chief Executive Officer Craig Donohue pointed out that, "Despite [CME Group's] significant growth, we have improved market efficiencies, reducing capital, margining and financing costs, as well as exchange trading fees, by hundred of millions of dollars over the last decade."

Donohue also contended that central counterparty clearing systems guarantee three essential benefits to the customer: transparency of valuation, because CCPs show daily mark-to-market prices to all participants; independence; and neutrality, because they are not dominated by a few large interested parties. Over the years, exchange-owned clearing houses have demonstrated their ability to enhance transparency and reduce systemic credit risk. By contrast, the intermediaries that own a utility clearing house have the potential to limit clearing services to selected products and markets in the pursuit of proprietary trading profits or prime brokerage revenue streams. In turn, this may limit transparency and exacerbate risk in the swap and credit markets. Opponents of the vertical model contend that, by making it harder for new exchanges to compete, the current model discourages innovation and perpetuates higher prices. But the current vertical model is the one that truly encourages innovation, say its proponents. Exchanges that depend upon clearing as a profit center have an incentive to improve their products and innovate in the clearing arena.

"The clearing house structure in the industry has been very innovative over the last 25 years," says Tom Kloet, former senior executive vice president and chief operating officer of NewEdge Financial, a clearing member of CME Group. "Regulators should ask the question, 'Would a single, horizontal model bring developments like SPAN?'"

He acknowledges that it would be difficult for newcomer exchanges to duplicate CME Group's operational excellence and product innovation. "A 'me too' effort won't create a competitive model," he says. "But there is room to create something better."

The issue of global competition
Competition in futures is now global, and the global trend is toward increased vertical clearing, Donohue pointed out. Some 70 percent of all futures and options contracts traded globally are cleared through exchange-owned or controlled clearing facilities. However, looking at derivatives volumes worldwide, only about 17 percent of derivatives trading is transacted on an exchange, a percentage dwarfed by the 83 percent of trading done in the OTC derivatives market.

In Europe, Liffe is renegotiating its contract with LCH.Clearnet in order to manage its own clearing house and compete on a more level playing field with CME Group and Eurex. In a letter to the Financial Times, Liffe's Chief Executive Hugh Freedberg said, "The vast majority of derivatives exchanges in the world also operate their own clearing services... If Liffe is not able freely to choose its clearing solution, it would not be able to compete on a level playing field and would be at a competitive disadvantage." At least two futures regulators share the view that the current structure does not need to be replaced. Walter Lukken, acting chairman of the Commodity Futures Trading Commission (CFTC), said the CFTC is "confident that the U.S. futures exchanges and clearing houses are functioning well, especially during these turbulent economic times." CFTC Commissioner Bart Chilton also released a statement questioning the Department of Justice's (DOJ) judgment and timing of its February 2008 letter to the U.S. Treasury, calling for a change in clearing structure. "The business model that the DOJ staff is now condemning received, only a few short months ago, the legal blessing of DOJ following its extensive, comprehensive, and exhaustive review of the CME/CBOT merger." The CFTC considers itself "market-neutral" regarding clearing structure.

Factbox
CME Clearing360
To bridge the gap between over-the-counter (OTC) markets and central counterparty clearing, CME Clearing offers a series of services called CME Clearing360, which extends the benefits of exchange-traded clearing to the OTC market in some "plain vanilla" products, and also provides other clearing services. Through CME Clearing360, firms such as hedge funds, proprietary trading firms and global and regional banks have access to the same performance guarantee that has traditionally been available only with exchange-traded products. CME Clearing360 provides these customers with greater capital and operational efficiencies, including risk offsets against related futures and options positions. It also delivers world-class risk management of the credit, operational, and legal risks related to OTC trading, as well as regulated market protections. CME Clearing360 includes transactions executed on FXMarketSpace, cleared interest rate swaps, block trades executed through Pivot, ethanol calendar swaps and substitutions. CME Group also serves OTC market participants in the credit derivatives markets through its subsidiary CMA. Some of these initiatives are CME Group "firsts": FXMarketSpace, a joint venture company of CME Group and Reuters, is the first centrally-cleared, global FX platform for the cash FX market. Later this year, CME Clearing360 will offer clearing services for a new product, CME Swaps on Swapstream, which will be the first interest rate swap product to offer all OTC market participants the full benefit of central counterparty clearing.

Kim Taylor, PRESIDENT, CME CLEARING Q: Which solution really benefits the end user of the markets: the "vertical" exchange-owned central counterparty clearing model (i.e., CME Clearing) or the "horizontal" utility model? A: A vertical model gives end users access to a pool of liquidity where they can trade at the best price. But it also provides them with access to innovation in products.

In the horizontal model, the clearing members own the clearing house. That model is aligned to benefit just that group, rather than all end users. In contrast, CME Group - and CME Clearing - is publicly owned by a wide variety of different investors. Vertical models focus on several areas: supporting innovation, bringing new products to market quickly, delivering cost efficiencies through low clearing fees and/or rebates for intermediaries, and enhancing operational efficiencies that allow clearing members to connect with the lowest cost. In contrast, horizontal models focus solely on the last two.

Some people define competition very narrowly as the ability of different trading vehicles offering the same products to compete solely on the fees they charge. We define competition much more broadly: there is competition among different service models and among clearing houses for the right to provide services to various markets. This type of competition benefits the end users of the market, rather than only benefiting the clearing members.

Q: What about the charge that CME Group has become so powerful that it now inhibits new exchanges from starting up?

A: Other exchanges are starting all the time, with no dearth of clearing services providers to choose from. The IntercontinentalExchange (ICE) is a very good example of a successful new entrant. ICE used an available clearing provider for a while and then decided to support its own product innovations with its own market model. They've already done it in the United States and are now seeking an exchange-owned clearing model in Europe. Another new exchange, ELX, hasn't announced a clearer yet, but they have a number of choices. There is no compelling evidence that clearing makes or breaks success in entering a market. What is important in attracting people to use a less liquid market is that you need to offer them some added benefit. People who have added electronic access to a historically non-electronic market have been successful in competing against established liquidity.

Q: Which clearing model is more consistent with the Commodity Futures Modernization Act of 2000?

A: The CFTC is pretty clear in the way it operates - it is open to competition in the markets it regulates. The U.S. futures industry is probably the easiest market to enter with either a new exchange vehicle or a new clearing vehicle. Any clearing structure can be efficient and provide appropriate risk management. But each clearing structure is optimized for a slightly different mix of participants.

Q: What are the potential dangers of a regulator imposing a clearing model on the industry?

A: A regulator-mandated structure could potentially create a system that is less responsive to changes in market conditions. Depending on its ownership, a utility model's only goal may be to keep transaction costs down. Transaction costs consist of the fees and the spread. So, if an exchange charges "lower" fees, but lacks liquidity so spreads are wide, the end users' overall transaction costs will actually go up.

We believe in a market-driven solution, which allows more than one type of clearing model, as opposed to a solution mandated by regulators.

Graphic captions:
HOW CLEARING MODELS MANAGE RISK
With a central counterparty model, the clearing house is the buyer to every seller and the seller to every buyer. So, if Trader A defaults, the default is contained between Trader A and the clearing house, protecting everyone in the green circles below.The over-the-counter market's bilateral model works differently. If Trader A defaults, neither Trader A, Trader B, nor the others they transact business with are protected from that default, leaving everyone in the orange circles at risk.

 

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