Roundtable: Market infrastructure in starring role

Roundtable: Market infrastructure in starring role

The role of central securities depositories (CSDs) and central counterparties (CCPs) has become more diverse and vital following the 2008 financial crisis. In our monthly Q&A roundtable, Dialogue asks market participants how CSDs and CCPs are adapting to the limelight.

Marc Bayle, principal adviser in the T2S project, European Central Bank

Marc Bayle, principal adviser in the T2S project, European Central Bank

How has the role of securities and derivatives market infrastructures changed post-financial crisis?
Tomas Kindler, head of clearing relations, SIX Securities Services: Since the financial crisis, the role of CCPs has not changed fundamentally. The purpose of any CCP remains to mitigate systemic risk. What has changed, however, is the regulatory environment. Regulators are pushing for more financial instruments to be centrally cleared in an effort to make the markets safer and more transparent.

Most notably, OTC derivatives must be cleared by CCPs under Dodd-Frank and the European market infrastructure regulation (EMIR). In this sense, CCPs have been beneficiaries of post-crisis regulation. In Europe, another major change is the result of interoperability being introduced at the clearing layer of equities trading. Under interoperability, trading venues offer a choice of clearers to participants. This is intended to promote competition among CCPs and reduce end-to-end costs for clients.

Alberto Pravettoni, CEO, repo and exchanges business, LCH.Clearnet: Clearing houses are now seen by regulators and the market as a key mechanism for managing counterparty risk. As regulations impacting clearing continue to evolve, we’re also seeing continued market volatility and the macro-economic environment remains uncertain. During the life of a trade, markets can move significantly and a CCP’s risk and liquidity management capability becomes vital.

Diana Chan, CEO of EuroCCP: Market infrastructures have developed to become better equipped to help identify and manage systemic failure. CCPs, for example, have been a vital part of these efforts and are one of the most critical components of the risk management process to have emerged from the financial crisis.

Alain Pochet, head of clearing, settlement and custody, BNP Paribas Securities Services: On the CSD side, the landscape is changing and they have to change the way they see themselves because of Europe’s TARGET2-Securities (T2S). The new platform for all European securities settlement has obliged CSDs to rebuild their offer to adapt to the new environment.

Marc Bayle, principal adviser in the T2S project, European Central Bank: T2S is a revolution for CSDs because today there is fragmentation of market infrastructure while tomorrow it will be one big market infrastructure allowing competition. Each of them are playing in their own country and their own language, while T2S gives one platform with a single language for them to all play together.

How are market infrastructures adapting to the new environment?
Kindler: Regulatory changes have been something of a mixed blessing for clearing houses. Regulation and increasing competition have presented some clearing houses with opportunities while others have been forced to review their cost bases and long-term strategies. As far as SIX Securities Services is concerned, we have largely benefited from interoperability.

While our flows on certain venues may have dropped, market share on others has increased dramatically. Our share on the London Stock Exchange, for example, has more than doubled. On the other hand, competition has brought clearing fees down significantly, meaning that most clearers are now taking far less revenue per trade.

Bayle: What we’ve seen with CSDs is that they are evolving before migration to T2S starts in 2015. The settlement dimension of CSDs will be commoditised, and therefore, their business model will need to look at how it will use the commoditised service to sell other services and possibly extend their customer bases. We are seeing that they are developing in the area of collateral management, which is a critical in the market today. T2S will help them eventually make more comprehensive and efficient collateral management services available to their customers.

Pochet: Some CSDs are taking the opportunity to do more as a result of new regulation, which requires for instance OTC or listed derivatives trades to be reported to a trade repository, for example. The Depository Trust and Clearing Corporation has done a lot of work in order to become an important player in this area and not only in the US.

How will market infrastructures cope with the changes?
: We have an OTC clearing business, which dates back long before mandatory clearing of OTC derivatives arrived. We continue to ensure that our clearing infrastructure is prepared for the expected increase in client clearing of OTC derivatives. We have reinforced our default management approach, segregated default funds and enhanced default management capabilities for the clearing of interest rate swaps, FX products and repos.

Chan: CCPs need to collect sufficient margin to cover volatility in the price of the contract. But without ready access to reliable prices, CCPs cannot calculate margin accurately. For OTC derivatives, CCPs may need to margin by mark to model, instead of mark to market. Clearing houses will also need to factor in how long it would take to liquidate a portfolio of positions if a customer goes into default. While publicly listed and traded cash equities typically have a three-day liquidation period, for example, it could be much longer for OTC derivatives because of limited liquidity in the contracts. The longer the period the higher the potential volatility.

Kindler: CCPs need geographic access to many markets, a robust and real-time risk-modelling capability, capital strength and competitive pricing to survive in the new regulatory environment. A lot of attention has been placed on OTC derivatives. While I don’t want to play down the risk associated with them, from the CCP’s perspective, they are ultimately just another asset class provided you have the right risk model in place. While the clearing of OTC derivatives is more complex than some instruments, it does not require a fundamental change of business model and risk operations. That is why in December 2012 SIX Group agreed to buy Oslo Clearing, which has derivatives clearing capability, enabling us to re-enter the derivatives market.

Pochet: CSDs need to make a choice between being an important player in their own market, or trying to invest to enter all the other ones, with all associated risks. We can’t imagine seeing big and small infrastructures behaving equally. For the past few months there seems to have been more clarity about what they will offer when T2S starts.

How do CCPs address the need to be secure and safe, while competing for business?
: All CCPs will say that they do not compete. If you look at the behaviour of the customers of the CCPs, they are looking for the CCP that collects the least amount of margin from them. Competing CCPs would have to react to this commercial reality. Fortunately EMIR sets minimum safety standards, which will prevent a race to the bottom on margin requirements.

Up until EMIR came into force, there were no minimum safety standards. Now you have the assurance that there is at least a floor, below which CCPs will not be allowed to go. That is an essential condition for competition.

Pravettoni: CCP competition is very healthy, which is good for the market, but it’s important that risk management standards are not compromised for commercial gain.

Pochet: CCPs are here to secure the business and not to compete. People think that competition between infrastructures is good, in terms of price. What I’ve seen over the last year is that competition between CCPs is bringing additional risk to the market because you can see a dumping in terms of risk management. At the end, we need to ensure that CCPs are working well, delivering a good service at a small price. CCPs are infrastructures that need to be not-for-profit, or for really small profit, and perfectly secure.

What can we expect in the future for market infrastructures?
Chan: There will be some CCPs that may not have a sustainable business because the cost of compliance is very high, and they don’t have sufficient customers and revenue. Having said that, there are exceptions. It’s hard to predict what will happen because there is a very diverse range of business models among CCPs.

Kindler: In Europe the CCP space is already too crowded. The reduction of systemic risk is no longer as efficient with so many CCPs. Our clients are already seeing the benefits of consolidating their flows with a preferred provider so that they achieve the highest level of efficiency. With this in mind, we should see more consolidation in the clearing space. Those CCPs that operate unsustainable pricing models will also have to change their models if they are to survive in the long term. While our clients view price as important, it is not the final factor.

Bayle: We have a very fragmented infrastructure in CSDs space today. That is why the Eurosystem, together with European institutions, is pushing for a more integrated market. And more integration could mean more consolidation. This will mean that market infrastructure might either have a structure of niches were they can serve specific group of customers or local investors, or they can choose to come together with other market infrastructures. We will probably see both.