Clearing Services for Global Markets A Framework for the Future Development of the Clearing Industry_9 docx

or an agency focus suffer from a negative impact on their business model when M&A and Single CCP initiatives are in force.Globally active clearers with an agency focus do not fare well u

Efficiency Gains Profit Increase

Figure 7.14 Business Model Impact Matrix for regionally-to-globally active clearing members

Source: Author’s own.

Cross-margining agreements lead to low efficiency gains and result in aproportional profit increase.42 In contrast, clearing links, M&A and SingleCCP initiatives translate into a disproportionately higher profit increase Thisincrease results from the positive revenue impact brought about by thesenetwork strategies, which, in addition to reducing costs, increase profits.From a prop perspective, regionally-to-globally focused clearers benefit fromthe increased scale and scope of services available at a lower cost as well

as from positive network effects Disintermediation and enhanced internalefficiency now increase the attractiveness of self-clearing additional prod-ucts and markets in-house, which in turn enables the clearer to leverage itsinfrastructure – thus increasing the theoretical ‘revenues’ resulting from self-clearing

Similar considerations apply to regionally-to-globally active clearers with anagency focus In this case, the disproportionately higher profit increase resultsfrom the clearer’s enhanced internal efficiency, which positively impacts itsprofit margin Additionally, the clearer is able to offer its clients an increasedscale and scope of services at lower cost Finally, clearing links and Single

42 Cross-margining agreements are assumed to have little or no impact on revenues, because a significant increase in revenues would require an increase in the number of cleared contracts spurred by this type

of network initiative Whereas this could occur in reality, such a scenario is not included in this analysis.

CCP initiatives, which enable the CCP to internalise GCM level networkeffects, further strengthen and enhance the value proposition of regionally-to-globally active clearers Their revenues are thus increased thanks to a greaterprofit margin and increased customer traffic.43

7.3.3 BMIM for globally active clearing members

Finally,Figure 7.15illustrates the Business Model Impact Matrix for globallyactive clearing members In contrast to the previously outlined matrices, theimpact of network strategies on the business model of globally active clearerswith a prop or an agency focus is strikingly different

For clearers with a prop focus, the efficiency gains generated by a tain network strategy translate into a proportional profit increase Networkstrategies are not assumed to impact revenues, because the scale and scope ofservices are not broadened However, clearing services for different products

This allows clearers to leverage their infrastructure and reduce costs, but incontrast to regionally-to-globally active clearers, globally active clearing mem-bers have to overcome additional internal hurdles to realise these internalefficiency gains Globally active clearers usually employ different legal entitieswithin their company structure to become members of regional CCPs Thisset-up can give rise to additional internal and external complexities as well

as potential areas of conflict with regard to consolidating the clearing houseinterfaces

43 Note that by definition, regionally-to-globally active clearing members and their NCMs and/or tomers have an interest in being active in all of the partnering clearing houses’ markets and products.

cus-It could be argued that due to internal economies of scale, a globally active clearing member can offer the same products and markets at a lower price, so NCMs and/or customers of regionally-to-globally active clearers should in theory consider becoming a member of the higher volume (i.e globally active) clearer If the NCMs and/or customers base their decision purely on the basis of commissions charged

by the clearers, network strategies do not result in NCMs and/or customers conducting more of their business through their regionally-to-globally active clearer Instead, these NCMs and/or customers can

be expected to switch to a globally active clearer However, globally active clearers already had a itive advantage in terms of greater internal economies of scale prior to the network initiative; it would thus have already been attractive for NCMs and/or customers to choose the globally active clearer, had their sole decision criterion been commissions It is therefore assumed that NCMs and/or customers of regionally-to-globally active clearing members do not base their decision strictly on commission levels, but also take additional factors into account, such as regional proximity, services tailored to the home market, long-term business relationship, etc.

compet-44 Revenues would only increase to the extent that the enhanced internal efficiency spurs business growth This scenario, which would lead to a disproportionately higher profit increase, is not covered by this analysis, however.

Efficiency Gains Profit Increase

Figure 7.15 Business Model Impact Matrix for globally active clearing members

Source: Author’s own.

Internal complexities can emerge by virtue of the different legal ties working under different local budgets and local management Salaries,bonuses and hierarchies may depend on these budgets, which can makethe consolidation of clearing house interfaces a difficult and complex inter-nal undertaking External difficulties related to consolidating clearing houseinterfaces can result from NCMs and other customers objecting to such aninitiative, i.e for reasons of demanding local contacts, etc

enti-For globally active clearers with a prop focus, all network strategiespositively impact their business model The same is not true for globallyactive clearers with an agency focus, however On the one hand, this type

of clearing member benefits from high efficiency gains, as outlined in theEfficiency Impact Matrix, but at the same time, they are at risk of being

net-work effects increases the attractiveness of disintermediation.46

45 Although it is unlikely that a globally active clearer would be put out of business completely, it is also unlikely that the remaining NCMs would do more business (thus making up for the lost NCM business), unless lower internal costs were to be translated into reduced commissions, which would in turn translate into an increase of the number of cleared contracts.

46 Regionally-to-globally active clearers could, of course, also run the risk of being disintermediated by NCMs that now consider it cost-efficient to self-clear their business This scenario is not scrutinised here,

Figure 7.7 showed that clearing links have a high to very high potential

strategies possess a high and medium potential for internalising GCM levelnetwork effects, respectively It is consequently assumed that in the context

of M&A initiatives, efficiency gains are counteracted by a medium strongrisk of disintermediation, which results in lost revenues The overall effect isconsequently assumed to be a very low profit increase

Because clearing link and Single CCP initiatives significantly increase theattractiveness of disintermediation, it is assumed that revenue losses ultimatelyoutweigh the efficiency gains The only way for globally active clearers with anagency focus to circumvent the risk of disintermediation is to restrict access

to the CCP level network.48

Influencing the level of access to the CCP network is assumed to be

illustrates the potential efficiency gains for globally active clearers with an

agency focus that succeed in restricting access to the CCP network; doing

so enables them to circumvent disintermediation and the associated enue losses These clearers stand to gain from restricting access to the CCPlevel network under clearing links, M&A and Single CCP initiatives However,regionally-to-globally active clearers suffer from restricted access, because theylose their disintermediation benefits and are prevented from leveraging theirinternal infrastructure A scenario of restricted access would thus serve to rein-force the structural particularities of the European Value Provision Network

rev-by sustaining the competitive advantage held rev-by high volume clearers overlower volume clearers Globally active clearers would consequently maintaintheir dominant position within the European VPN, i.e a very high percentage

of the European market share in derivatives clearing would continue to beconcentrated in the hands of a few very high volume clearers

as this analysis is concerned with the disintermediation of globally active GCMs by regionally-to-globally active clearers.

47 Note that the risk of disintermediation through clearing links is minimal, unless the CCPs are able to convince clearing members to expect positive future network effects – i.e by persuading them that the clearing link will be extended in scope, and that the clearing houses will make up for the lost intermediary level by providing these services themselves, thus successfully internalising GCM level network effects Only then can the utility derived from the network outweigh the costs of alternation in the long run, and the starting problem will be overcome For the purpose of this analysis, it is assumed that clearing link initiatives overcome the starting problem If, in reality, the link initiative fails to convince clearing members to expect positive future network effects, then a Single CCP initiative has by far the greatest potential for successful disintermediation.

48 Restricted access in this case refers to scenarios in which only globally active clearers are granted full access to a CCP level network resulting from a clearing link, M&A or Single CCP initiative.

Efficiency Gains Profit Increase

CMAGcan implement restricted access

CM AG

CMPG

1 2 3 4

Figure 7.16 Business Model Impact Matrix for globally active clearers that succeed in implementing restricted

access to the CCP level network

Source: Author’s own.

To summarise, although some network strategies are cost efficient, they arenot necessarily profit-maximising for all clearing member types Regionallyactive clearers with a prop or an agency focus suffer from a negative impact

on their business model when M&A and Single CCP initiatives are in force.Globally active clearers with an agency focus do not fare well under SingleCCP initiatives and clearing links (when these replicate the size of the SingleCCP network) that allow unrestricted access to the CCP level network

7.4 Preliminary findings – impact of network strategies on efficiency

frame-work for analysing the impact of netframe-work strategies on the efficiency of pean clearing Four matrices were used to assess the impact of cross-marginingagreements, clearing links, M&A and Single CCP initiatives and allowed pre-liminary conclusions to be drawn about the impact of these network strategies

Euro-on the efficiency of clearing The preliminary cEuro-onclusiEuro-ons drawn from these

matrices will be compared to real-world case studies inChapter 8, which areanalysed according to the above-mentioned framework The findings of thematrices are briefly summarised below, compared to findings of the EuropeanCentral Bank, and used to further clarify the insights provided by the so-called

‘McP Curve’ and to evaluate the claim that the clearing industry exhibits

‘natural monopoly’ characteristics

7.4.1 Scale Impact Matrix

demand- and supply-side scale effects related to a particular network egy

the potential for the greatest ‘net’ scale economies Whereas M&A strategieshave higher supply-side and lower demand-side scale effects than the SingleCCP scenario, the relative magnitude of their respective net scale effects iscomparable

7.4.2 Transaction Cost Impact Matrix

demand-and supply-side scale effects of each network strategy translate into a tional or disproportional impact on transaction costs for different clearingmember types

(regionally active clearers with a prop or an agency focus), CMPR-G/CMAR-G

(regionally-to-globally active clearers with a prop or an agency focus) and

CMPG/CMAG(globally active clearers with a prop or an agency focus)

r For regionally active clearers with a prop or an agency focus, indirect costsare the core cost driver Cross-margining agreements have no cost impact forthis type of clearer, while M&A and Single CCP initiatives actually increaseindirect costs Clearing links, on the other hand, do not imply additionalindirect costs, and could potentially lead to cost reductions Nonetheless,clearing links are not suited to reduce significantly these clearers’ indirectcosts

r For regionally-to-globally active clearers with a prop or an agency focus,indirect costs are also the core cost driver These clearers benefit fromnetwork strategies enabling them to clear many markets through theirdomestic home clearing house, thus disintermediating the clearer(s) they

employ as intermediary (ies) to other markets Cross-margining ments serve slightly to lower indirect costs, but do not enable disinterme-diation While clearing links, M&A and Single CCP initiatives are all suited

agree-to reduce significantly these clearers’ indirect costs, clearing links (followed

by Single CCP and M&A initiatives) turn out to have the greatest positiveimpact

r For globally active clearers with a prop focus, direct costs are the core costdriver These clearers’ main benefit from network strategies comes from thepotential to reduce clearing house charges Cross-margining agreementsserve slightly to lower costs, but have no potential significantly to reducedirect costs Clearing links, M&A and Single CCP initiatives, on the otherhand, are all suited to impact significantly these clearers’ core cost driver.For globally active clearers with a prop focus, the Single CCP initiativepossesses the strongest cost-reduction potential, followed by clearing linksand M&A initiatives

r For globally active clearers with an agency focus, indirect costs are the corecost driver These clearers’ main benefit from network strategies comes frombeing able to consolidate their various clearing relationships, i.e centralisethese into a single relationship Cross-margining agreements serve slightly

to lower costs, but do not enable such a consolidation Clearing links, M&Aand Single CCP initiatives are all suited to impact significantly these clearers’core cost driver For globally active clearers with an agency focus, clearinglinks (followed by Single CCP and M&A initiatives) turn out to have thegreatest positive impact

7.4.3 Efficiency Impact Matrix

Cost Impact Matrices and allowed for conclusions on the overall efficiencyimpact of the various network strategies to be drawn

agree-ments, which generally have little or no impact on efficiency, clearing linksare the only network strategy that results in efficiency gains for all clearingmember types

r Regionally active clearers potentially suffer from efficiency losses as a result

of M&A and Single CCP initiatives

r Nonetheless, while clearing links are suited to reduce significantly the corecost driver of globally active clearers with a prop focus, these clearers enjoythe greatest efficiency gains from a Single CCP initiative

7.4.4 Business Model Impact Matrix

increase (decrease) corresponding to the different network strategies lates into a proportional or disproportional profit increase or decrease fordifferent clearing member types

trans-r It illustrated that the efficiency increase (decrease) resulting from differentnetwork strategies translates into a proportional profit impact for regionallyactive clearers; clearing link, M&A and Single CCP initiatives lead to adisproportionately higher profit increase for regionally-to-globally activeclearing members

r For globally active clearers with a prop focus, the efficiency gains of networkstrategies translate into a proportional profit increase, whereas for globallyactive clearers with an agency focus, Single CCP and clearing link initiativescan lead to a disproportional decrease in profits

r The analysis shows that although some network strategies are cost efficient,they are not necessarily profit-maximising for all clearing member types

r Regionally focused clearers with a prop or an agency perspective suffer fromefficiency losses and a negative impact on their business model when M&Aand Single CCP initiatives are undertaken

r Although globally active clearers with an agency focus benefit from efficiencygains, they simultaneously suffer from a negative impact on their businessmodel if Single CCP or clearing link initiatives (which replicate the size ofthe Single CCP network) are set up

r It was outlined above that particularly large investment banks are active inboth proprietary and agency business The Business Model Impact Matrixillustrated the internal conflict that arises when these firms have to decidewhether or not to support a certain network strategy: the only networkstrategy that has a positive impact on the business model of both the prop.and the agency side relates to M&A initiatives between CCPs These clearersare thus likely to support M&A initiatives, but unlikely to support a clearinglink set-up For globally active clearers with a prop focus, a Single CCP ini-tiative is preferable over clearing links, as it has the greatest positive potentialimpact For globally active clearers with an agency focus, clearing links actu-ally have a significantly negative impact on their business model, which iswhy they have an interest in circumventing such a scenario Whether ornot large investment banks support the creation of a Single CCP will prob-ably depend on whether the bank places greater emphasis on proprietary

or agency business From a prop perspective, they should absolutely be infavour of a Single CCP; from an agency perspective, however, they can beexpected to oppose the implementation of a Single CCP.

7.4.5 Summary of impact

To summarise on the impact that network strategies have on the efficiency

of European clearing, the preliminary findings suggest that a clearing linkset-up appears to be the most attractive network strategy because it enablesall clearing member types to benefit from efficiency gains

As outlined above, the services provided as well as the products and marketsprocessed by different European clearing houses are not identical, and due

to their installed bases, they are not necessarily interchangeable Enlargingthe size of a CCP network through clearing links benefits European clearinghouses because it enables them to leverage their significant installed baseand helps them to sustain their unique services in cases where these servicesand processes have been tailored to the specific demands of regional marketparticularities and different regulatory environments Additionally, it enablesclearing houses to internalise the GCM level network effects and to strengthentheir unique CCP level network effects Clearers can additionally benefit fromthe high growth potential afforded by links; they may entice other clearinghouses outside of the defined European markets to join the network Linksare also not prone to give rise to negative network effects

The European Central Bank (ECB) finds that ‘[i]t is clear that, in theshort-term, a single infrastructure would maximise network externalities andeconomies of scale However, these short-term advantages have to be balancedagainst the inefficiencies that may be caused in the long run by the absence

with the doubts expressed by the ECB, the analysis suggests that consolidatingthe European clearing industry through mergers and acquisitions to form asingle monopoly CCP runs the risk of depriving market participants of thecompetitive forces inherent to a link solution and denies them the benefit ofutilising clearing services that have been tailored to best fit regional marketparticularities Findings from the Scale Impact Matrix additionally suggestthat even in the short term, a single infrastructure created through a SingleCCP initiative does not serve to maximise network externalities or economies

49 European Central Bank (ed.) (2001c), p 3.

of scale Rather, clearing links incorporate greater potential for economies

of scale and scope as well as network effects The Efficiency Impact Matrixfurther illustrated that while a Single CCP could potentially lead to efficiencygains for regionally-to-globally and globally active clearers, regionally activeclearers suffer efficiency losses This analysis thus indicated that, even in theshort term, a Single CCP is not suited to enhance the efficiency for all Europeanclearing members However, clearing members benefit from a link solution,because it does not oblige participation and entails lower investments Thelink strategy thus translates into efficiency gains for all European clearingmembers

Nonetheless, the benefits of a link set-up can only be achieved if the clearing

starting problem will only be overcome and the utility derived from the CCPlevel network can only offset the individual clearer’s costs of alternation in thelong run when the partnering CCPs:

r convince their clearers to expect positive future network effects – implyingthat the clearing link will be extended in its scope;

these services themselves – thereby successfully internalising GCM levelnetwork effects; and

similar service level and processing all products and markets

Additionally, the benefits of a link set-up can only fully flourish when thepartnering clearing houses provide a choice of clearing location If no choice

of clearing location is offered, network participants are locked into a ular clearing network.51However, again, this situation does not represent aninstance of strong lock-in: it is not a coordination failure among users thatprevents clearers from actually switching to the superior network, but thelegal restrictions established by the exchanges or clearing houses that prohibitthe choice of clearing location Therefore, to eradicate non-network-effect-related coordination problems on the CCP level, the provision of choice ofclearing location helps to prevent this particular scenario Consequently, pro-vided that opportunities for choice of clearing location exist through clearinglinks, it appears unlikely that CCP level network effects lead to strong forms

partic-of lock-in If strong lock-in effects do not exist on the GCM and CCP levels,first-mover-wins and winner-takes-all conditions are also unlikely to emerge

50 Refer to section 7.1.2.2.2 for an explanation of the starting problem.

51 Note that clearing houses alone cannot offer choice of clearing location Rather in a first instance, the respective exchanges must give allowance to the use of various clearing houses.

Market participants then benefit from the competitive forces between clearinghouses in the context of a clearing link set-up.

The analysis reveals that it is crucial for the success of clearing link initiativesthat the partnering CCPs endeavour to compensate for the lost intermediary(GCM) level services by providing most of these services themselves However,

it also showed that it is very difficult for clearing houses to internalise the entirerange of GCM level network effects It can thus be assumed that there willcontinue to be a justification for the value-added function of the GCM level,despite the attractiveness of disintermediation spurred by such a link initiative.For some counterparties, it will simply remain more cost efficient to retain

an intermediary relationship with their GCM(s) Even so, it should be notedthat globally active clearers with an agency perspective can still be expected

to oppose the implementation of such a clearing link scenario, because theirbusiness model is likely to suffer significantly from disintermediation.52The only way for globally active clearers with an agency focus to circum-vent the risk of disintermediation is to restrict access to the newly createdCCP level network – thus circumventing disintermediation and the associ-ated revenue losses Influencing the level of access to the CCP network isassumed to be possible only in the case of user ownership or user governance.Despite the finding that a clearing link set-up offers greater efficiency gains forthese clearing member types, globally active clearers with an agency focus arelikely to prefer the establishment of a Single CCP over the implementation ofclearing links The reason for this is that it is presumably easier to succeed inimplementing user ownership or user governance (thus controlling the rules

of clearing) for one entity than it is to control the rules of clearing of variousentities

The analysis also revealed that globally active clearers with a prop focusbenefit most, in terms of efficiency gains, from the implementation of aSingle CCP Nonetheless, these clearers will presumably only adopt a SingleCCP approach if they have the means to control the rules of clearing, i.e toensure that clearing fees are sufficiently reduced and that the consolidatedinfrastructure does not abuse its monopoly position Nonetheless, the risk of

a user ownership/user governance structure that is dominated by high volumeclearers is that these clearing members will succeed in further strengtheningtheir already preferential position within the European VPN and that low andmedium clearers will consequently become further disadvantaged

52 Note that in spite of this negative impact on the business model, the overall efficiency of the industry can still be increased, because disintermediation reduces transaction costs.

These conclusions are in accord with and serve to clarify further the insights

CCPs, which is indicated on the horizontal axis and decreases from right

to left

The upper line illustrates the financial benefits derived by clearing pants given the number of CCPs The lower line represents the public benefitsassociated with the number of Central Counterparties From right to left, itcan be seen that it is in everyone’s best interest – including the public interest –

partici-to have fewer and fewer CCPs; this was at least the case until approximately

2002 McPartland observes that up to roughly this point in time, there wereincreasing private financial benefits for clearing participants as well as con-current public benefits associated with having fewer clearing houses After

2002, however, the remaining benefits are private; the public benefits begin tobecome negative at some future point in time He argues that the real benefit ofdecreasing the number of clearing houses is that the high volume clearers cangreatly simplify their internal operations and achieve significant internal cost

53 Cf McPartland ( 2002 ), pp 105–6.

54 Magnitude is represented on the vertical axis It is primarily a measure of financial magnitude when applicable to private benefits (top line), and intrinsic magnitude when applicable to public benefits (lower line) Many, but not all, public benefits are financial in nature Nonetheless, the relevant public benefits, given the number of CCPs, are expressed on the vertical axis as though it were a financial measure (relative to the level of private benefits) Cf McPartland ( 2002 ), p 105.

savings McPartland (2002) concludes that the greatest cost savings beyondthis particular point are consequently private financial benefits, which accrue

to the largest clearing members as a result of their significantly streamlinedoperating efficiencies

The findings of the analysis inChapter 7reinforce the insights provided bythe McP Curve, but they also serve to clarify them further They show thatthe above conclusions are only true for a reduction in the number of clearinghouse networks resulting from a Single CCP initiative or a clearing link set-up

in which high volume clearing members succeed in restricting access to theCCP level network (and thus in impeding disintermediation) However, if theconsolidation of the CCP networks is achieved through a clearing link set-up

in which the partnering clearing houses engage to overcome the link-inherentstarting problem, choice of clearing location is provided and access to thenetwork is unrestricted, the findings of the McP Curve are unlikely to hold

It is thus only when a Single CCP solution or link set-up that restricts access

to the CCP network is employed that the number of clearing house networksbecomes reduced beyond the point where high volume clearers (especiallyclearing members with a prop focus) benefit most, and public benefits begin

Finally, when strong network effects and economies of scale exist in an

industry, it is often argued that the industry constitutes a natural monopoly.55

Nonetheless, it is disputed whether clearing qualifies as a natural monopoly.56The literature both supports and refutes the assertion; some sources advo-cate classifying the securities clearing and settlement industry as a natural

55 ‘A natural monopoly exists if a single supplier can serve the market in question more cost-efficiently than several suppliers, meaning that the cost function in the relevant area of demand is subadditive Reviews of the cost side of networks focus primarily on the bundling advantages achieved through economies of scale and economies of scope in service provision These bundling advantages can imply that a single network operator may be able to serve a given market at a lower cost than a number of competing suppliers.’ Knieps ( 2006 ), p 49 Also refer to Baumol ( 1977 ); and Baumol/Panzar/Willig (1982).

56 Cf European Central Bank (ed.) (2001b), p 84.

monopoly,57whereas others oppose this view.58Most of these contributions,however, tend to refer to the clearing services provided by CSDs/ICSDs ratherthan by CCPs.

The preliminary findings of this study provide no evidence supporting thenatural monopoly assumption of the European derivatives clearing industry.First of all, the services provided by the different European clearing housesare not necessarily interchangeable Second, provided that opportunities forchoice of clearing location exist through clearing links, it appears unlikelythat CCP level network effects lead to strong forms of lock-in If strong lock-

in effects do not exist on the GCM and CCP levels, first-mover-wins andwinner-takes-all conditions are consequently also unlikely to exist Third,despite strong economies of scale and network effects, consolidation in theform of a monopolistic Single CCP was shown potentially to induce highlycounteractive forces in the form of necessary investments, costs related to thecomplexity of integration (possibly giving rise to diseconomies of scale) andnegative network effects Finally, provided that choice of clearing location isguaranteed by clearing houses through links, the European clearing industrycan be assumed to be contestable

The second step of the analysis of the impact of network strategies on

findings of this chapter with conclusions from three case studies This allowsfinal conclusions to be drawn

57 See Competition Commission South Africa ( 2001 ); Cruickshank ( 2001 ), p 325; European Securities Forum (ed.) (2002), p 6; Lee ( 2002 ), p 12; Russo ( 2002 ), p 237; European Financial Services Round Table (ed.) (2003), p 2; Heckinger/Lee/McPartland (2003), p 15; Singapore Exchange (ed.) (2004), p 8; CONSOB (ed.) (2004), p 24; Office of Fair Trading (ed.) (2004), pp 43–4; Branch/Griffiths (2005),

pp 4–5; Rochet ( 2005 ), p 9; Bliss/Papathanassiou (2006), p 36; LIBA (ed.) (2006), p 6; and Direction G´en´erale du Tr´esor et de la Politique ´Economique (ed.) (2006), p 5.

58 See, e.g Federation of European Securities Exchanges (ed.) (2004), p 5; and Knieps ( 2006 ), p 59 Milne ( 2002 ), pp 10–13, outlines that certain core functions provided by custodians have the characteristics

of a natural monopoly, whereas all other clearing and settlement-related services are competitive in their nature Also refer to the studies of Van Cayseele/Voor de Mededinging (2005); and Serifsoy/Weiß (2005).

studies of network strategies

The previous chapter delivers preliminary findings regarding the impact ofnetwork strategies on the efficiency of clearing; this chapter challenges theseconclusions with findings from the empirical study and real-world case stud-ies In the following, a case study analysis is performed for each of three types

mergers and acquisitions, and a Single CCP

As the centre of the analysis is on the European clearing industry, the selectedcase studies focus on network strategies that involve European clearing houses.The clearing link study (section 8.1) presents findings from the empirical studyconcerning cross-margining agreements and clearing links and analyses thelink established in 2003 between Eurex Clearing (a Frankfurt-based clearinghouse) and the Clearing Corporation (a Chicago-based clearing house) Themergers and acquisitions study (section 8.2) examines the merger between theLondon Clearing House (LCH) and Clearnet (a Paris-based clearing house)

in 2003, which produced LCH.Clearnet In contrast to the other two casestudies, the Single CCP study (section 8.3) deals with a hypothetical scenario:the creation of a single clearing house for Europe

Each case analysis mines the interviewees’ perceptions of the respectivenetwork strategy in terms of its overall benefits and constraints Additionally,the interviewees’ feedback regarding the suitability of clearing links or a SingleCCP to integrate European clearing is presented.2Whilst all three case studies

and detail of the respective studies varies: because the analysis conducted in

Chapter 7 identified clearing links as the most suitable network strategy to

1 Note that due to their very low efficiency impact, cross-margining agreements are not analysed separately, but rather as part of the clearing link study.

2 The suitability of mergers and acquisitions as a means to integrate the European industry is not analysed

in the merger study ( section 8.2 ), but in the Single CCP study ( section 8.3 ) The reason for this is that consolidating the European clearing industry through M&A initiatives results in the creation of a Single CCP.

CHECKING THEORY AGAINST REALITY –

CASE STUDIES OF NETWORK STRATEGIES

Clearing Link Study

8.1

impact of network strategies on the efficiency of clearing with insights from the empirical study and case study findings

Presents findings from the empirical study on cross-margining agreements and clearing links Case study: The clearing link established in 2003 between The Clearing Corporation and Eurex Clearing.

Case study: The merger between the London Clearing House and Clearnet in 2003.

Presents findings from the empirical study on a single CCP.

Case study: The creation of a single clearing house for Europe (a hypothetical scenario).

Figure 8.1 Structure of Chapter 8

increase the efficiency of the European clearing industry, the clearing linkstudy receives more weight in the subsequent analysis and is conducted ingreater detail Furthermore, due to the limited scope of this study and the lack

of detailed data available regarding the merger and Single CCP studies, thesetwo cases are presented in abbreviated form

In the final assessment (section 8.4), conclusions are drawn regarding theimpact of network strategies on the efficiency of European clearing; summaris-ing whether the insights from the case studies support or refute the findingsfromChapter 7 This process also reveals the shortcomings of a purely the-oretical assessment by outlining the difficulties associated with translatingtheoretical concepts into reality

8.1 The clearing link study

This chapter presents insights from the empirical study and a real-world case

First, findings from the empirical study regarding cross-margining agreements

analysis of a concrete case study, i.e the clearing link established between

Eurex Clearing and The Clearing Corporation, is furnished (section 8.1.2).The section concludes by summarising the findings regarding the impact ofclearing links on efficiency (section 8.1.3).

8.1.1 Findings from the empirical study

The empirical study furnished insights as to what role the different networkstrategies play in reality by soliciting feedback from various stakeholders

on two critical issues Interviewees were asked to critique cross-marginingagreements (section 8.1.1.1) and clearing links (section 8.1.1.2) in terms oftheir ability to provide value-added; the interviews produced valuable detailsabout the major benefits and constraints of these initiatives Furthermore, thestakeholders were asked to comment on the suitability of clearing links as ameans to integrate the European clearing industry (section 8.1.1.3)

8.1.1.1 Cross-margining agreements: general benefits and constraints

The industry has hugely benefited [from cross-margining agreements], because the cost of carrying offsetting positions is greatly diminished, and a lot more volume ensues 3

The economic benefit given was never sufficient to make it worthwhile I have more money in my pocket now than the industry has ever saved in cross-margining 4

Roughly 57 per cent (forty-five out of seventy-nine) of the interviewees issuedconcrete opinions on cross-margining agreements.5At first sight, their over-all assessment appears unambiguous: thirty-two interviewees felt that cross-margining agreements provide value-added and increase the efficiency ofclearing, ten respondents saw no value-added and three interviewees wereconflicted (seeFigure 8.2)

However, the picture becomes fuzzier upon closer analysis Although thegreat majority of the interviewed clearing house and exchange representatives,market experts and NCMs acknowledged the value-added provided by suchagreements, the clearing members’ responses were more divided Seven clear-ers asserted that such network strategies provide no value-added; four clearersmade the opposite claim On the other hand, three clearers saw general value

in cross-margining agreements, but felt that these initiatives could potentiallyharm their business model These clearers are thus classified as ‘conflicted’

3 Interview with William C Floersch 4 Statement made by interviewed market expert.

5 The remaining interviewees either said that they did not know, had no clear opinion, did not specify their opinion or declined to answer.

Value-7 CM

2 ME

1 CH

Added

Value-4 LON

3 EU

3 US

Added

Figure 8.2 Interviewees’ assessment of cross-margining agreements 6

Source: Author’s own.

The fact that the US-based interviewees provided the bulk of the crete assessments7is likely due to the significantly greater number of cross-

different views expressed with regard to the value-added of cross-marginingagreements, the following presents the general benefits and constraints of suchinitiatives as identified by the interviewees themselves

Interviewees claimed that in terms of benefits, cross-margining agreements

generally enable a more efficient use of capital by minimising the costs ofcarrying offsetting positions When cross-margining opportunities extend

6 Interviewee groups: CM – clearing member; NCM – non-clearing member; ME – market expert; EX – exchange; and CH – clearing house Interviewee locations: US – United States; EU – Continental Europe; and LON – London.

7 69 per cent of all US-based interviewees provided assessments, whereas only 52 and 41 per cent tively of all London- and Continental-Europe-based respondents gauged the relevance of this network strategy.

respec-8 Refer to section 3.3.2 for an overview of European and American cross-margining initiatives.

across different asset classes, clearing members can better leverage the sameamount of capital or financial resources, because they can assume a moreintegrated risk profile The higher the correlation between the products forwhich cross-margining is offered, the greater the potential benefits in terms ofreduced cost of capital and risk management, as the need for risk monitoringdecreases Reducing the aggregate level of margin that a clearing member isrequired to post to collateralise the positions held through the participatingclearing houses can ultimately lead to higher volumes This is especially truewhen counterparties are collateral poor – and thus highly sensitive to thecost of capital – because capital is thereby freed up that can then be allocatedfor additional trading opportunities The primary benefit of cross-marginingthus lies in its potential to reduce the cost of capital Consequently, whether ornot cross-margining agreements have appeal as stand-alone initiatives greatlydepends on individual clearing members’ sensitivity to the cost of capital.9

In addition to the benefits that cross-margining agreements can provide,the interviewees identified a variety of constraints inherent to the utilisationand implementation of this network strategy First of all, clearing memberswill generally consider the trade-off between the potential savings they expect

to realise and the back-office and IT development work that will be necessary

in order to be able to interact with the cross-margining schema As outlined insection 3.3.1.1, some initiatives require cumbersome processing Additionally,

as collateral-rich clearing members generally tend to be less interested in margining agreements, the issue of required system changes is not so muchabout costs, but rather the prioritisation of the multiple demands placed

cross-on their IT resources For globally active clearers with a prop focus, theimplementation of cross-margining agreements is contingent on the internaldemand If a clearer is able to pass on collateral savings to the individual traderlevel (i.e has an appropriate internal system in place for this purpose), traderswill clearly strive to benefit from such savings, which can affect their bottom-line The attractiveness of cross-margining agreements is consequently related

to whether the charge on capital is computed efficiently within firms.The enforcement or auditing of those capital charges is still pretty primitive and happens from time to time It doesn’t happen daily, the way I would have thought; it’s kind of monthly that people look at these things I think if regulators require a more regular audit or measurement of how banks or intermediaries in the market are covering the liabilities they have, then they will have to manage them more actively, banks themselves will have to manage them more actively That means that yesterday

9 Refer to the findings of section 5.1.4.2 for details on the interviewees’ assessments of the cost of capital.