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Categorized | Equities

LSE says openness is key to Clearnet

Posted on March 31, 2013

In coming weeks, the London Stock Exchange is set to close its 18-month pursuit of a controlling stake in LCH.Clearnet, the transatlantic clearing house. It is potentially its most significant deal in years.

Last week, both sets of shareholders and UK regulators approved the transaction, in which LSE will take a 57.8 per cent stake, valuing LCH at €633m.

    “The LCH.Clearnet transaction could be transformational for London Stock Exchange Group,” says Peter Lenardos, an analyst at RBC Capital Markets. “The market continues to view the LSE as a volume-driven stock exchange. In reality it is transitioning to a diversified technology, intellectual property and risk management company.”

    Whether that potential turns into profit will be a challenge.

    Short-term, the deal will help LCH meet a €320m funding shortfall under tougher capital requirements that are being introduced for clearing houses in Europe to reflect their critical role in the functioning of financial markets.

    It is part of a global regulatory push to safeguard the world’s financial markets in the wake of the financial crisis. Authorities want to move more of the opaque over-the-counter derivatives market on to electronic trading venues and have trades processed through clearing houses. A clearing house stands between two parties, guaranteeing a deal in the event one party defaults.

    Xavier Rolet, chief executive of the LSE, sees these changes as benefiting his company and LCH, as open-ended derivatives contracts require regular risk management fees.

    Warehouse race

    IntercontinentalExchange, CME Group and London Stock Exchange are among those applying to run Europe’s electronic data warehouses, a component of a global push to reform derivatives markets, writes Philip Stafford

    The operators have been joined by the Depository Trust & Clearing Corporation of the US, and by Regis-TR, a venture between Deutsche Börse’s Clearstream and Spain’s Iberclear.

    The warehouses, known as data repositories, have become a key component of regulatory moves to safeguard markets since the financial crisis. They will keep records of buyers, sellers and prices and are meant to give authorities a better view of potential systemic risk in the $640tn swaps market.

    However, how best to achieve that goal is controversial in the US. CME and ICE have built their own operations and are offering it as an adjunct to the derivatives trading and clearing businesses they run.

    The DTCC, a clearing house owned mainly by its banking users, has argued that this approach will split data between repositories, fragmenting it and contravening policy makers’ aims, as laid down in legislation such as the Dodd-Frank act. Last month, the Commodity Futures Trading Commission, the US regulator, sided with the CME in the bitter dispute.

    Analysts said early proposals from the European Securities and Markets Authority have shown that the regional regulator is keen to stop
    a similar battle developing in Europe.

    “Esma will struggle to circumvent the current furore ongoing in the trade repositories space in the US,” said Virginie O’Shea, an analyst at Aite Group. “It has quietly indicated it’ll allow derivatives trades to be reported to any repository, rather than having them automatically routed by a clearing house. It hasn’t explicitly banned the CME practice. If there is any room left open to interpretation, then market participants will take advantage of these loopholes.”

    LCH would give the LSE the long-term growth market that it has lacked since it missed out on buying Liffe, the derivatives exchange, more than a decade ago. The LSE has agreed to contribute €185m cash for its pro rata participation, included in the purchase price.

    LCH is an attractive target as it is world’s largest clearer for interest rate swaps, which are used by big global banks and corporations to hedge against interest rate moves. It is also the second-largest clearer for repo trades, the main source of short-term funding for banks.

    Ian Axe, chief executive of LCH, has been transforming the clearing house from a broker- and user-owned utility into a more commercial business since his arrival from Barclays nearly two years ago.

    Senior management has been overhauled and LCH bought International Derivatives Clearing Group to expand in the US. Nasdaq OMX has also become a 5 per cent shareholder. LCH’s OTC clearing business, SwapClear, generated clearing revenue of €72m last year, up 62 per cent on a year ago.

    Yet underneath the optimism, some questions about LCH’s business model remain.

    The LSE is committed to retaining LCH’s so-called “horizontal” operating structure, allowing other trading venues to connect to it. However, rivals CME Group, IntercontinentalExchange and Deutsche Börse all run a “vertical silo”, which prevents other venues from accessing their clearing house.

    LCH’s SwapClear is governed by a group of banks that have agreed a profit-sharing deal with the LSE. How much will go to the LSE is unclear.

    Revenues from LCH’s cash equities business in the last five years have slumped to a quarter of what they were. Competition remains fierce in Europe.

    Observers and analysts expect the global regulations will mean investors turn to listed derivatives rather than OTC markets, but fees in LCH’s commodities and listed derivatives business have nearly halved to €105m in five years.

    From June, LCH will lose its revenues from NYSE Liffe as it switches to ICE European clearing house. But LCH will begin clearing for NLX, the new European fixed income trading platform set to be launched by Nasdaq OMX, in April.

    “It’s a real mixed bag,” says Richard Perrott, an analyst at Berenberg Bank in London. “Some parts of it, like repo, are great. The price isn’t too high but what you’re getting isn’t a slam dunk by any means. They are relying on adding new services,” he said.

    Mr Rolet plans on expanding the scope of Turquoise and MTS, the LSE’s equity derivatives and fixed income trading platforms, and using FTSE International, the index compilation group.

    He is undeterred by critics. “Open access, we believe, is a superior economic model for the operator,” he said last month when the final deal terms were announced. He will soon have the chance to demonstrate it.