IN THE fast and exciting world of trading it is all too easy to overlook the importance of the necessary but rather administrative post-trade activities, of which clearing and settlement are the most important. But these play a vital role in the functioning of the European securities markets.
And the European clearing and settlement space is starting to become more exciting thanks to the Markets in Financial Information Directive (Mifid) which has already shaken up the trading space with the arrival of multilateral trading facilities (MTFs) such as Chi-X and BATS Europe.
The financial crisis has shown the relevance of post-trade activity, says Steve Grob, director at Fidessa. “Events over the past year have shown that big financial institutions can disappear overnight and so the primary role of central counterparties (CCPs) in terms of guaranteeing trades should not be overlooked.”
And just as new trading venues have popped up all over Europe, fragmentation has also occurred at the clearing level with central clearing counterparties (CCPs) now offering their services to the incumbent exchanges and the MTFs.
Grob says that the rise of MTFs opened the door for lower cost clearers such as EMCF to step in with lower fees and it now looks like the primary CCPs are starting to fight back. Just as with MTFs, the increasing competition among CCPs has started to drive down the costs of post-trade settlement.
But it is no good the costs of trading falling lower and lower if post-trade fees are prohibitively high and discourage participation in the market. A lower cost of clearing means we are likely to see added volumes come into the market.
However, in an increasingly fragmented market, the multitude of clearing and settlement regimes across Europe is a big headache.
“This creates extra cost and complexity for everyone involved in the trading process and, despite the regulator’s encouragement, it looks unlikely that a complete cross-border clearing regime will appear any time soon without a further nudge or two,” says Grob.
Roger Liddell, group chief executive of LCH.Clearnet, told a conference earlier this month that interoperability – which is where clearing houses co-operate to give end-users a choice of where their trades are ultimately cleared – is a step towards consolidation and fewer CCPs. His own group is currently the takeover target of a consortium of 11 banks and broker ICAP.
Interoperability is happening, albeit slowly, says Diana Chan, chief executive of the pan-European EuroCCP, which yesterday proposed the adoption of a single, standard European convention for interoperability between providers of (CCP) clearing services.
Interoperability does have a potential downside. It increases the risk of contagion whereby the links between clearing houses mean that the failure of one CCP could bring down the rest. Post-trade services providers perform an important role in reducing market participants’ credit, market, and liquidity risks. It is crucial to their function that their own risk remains as covered as possible.
It is partially for this reason that Miranda Mizen, senior consultant at Tabb Group, says that large-scale interoperability is not the answer. “Consolidation must either precede or accompany competition to ensure that CCPs provide sufficient stability, breadth of coverage and services, innovation and economies of scale.”
“Three pan-European CCPs would provide the optimal level of competition and clearing services that are robust and efficient enough to facilitate growth at an affordable cost. Without consolidation, CCP participants face the possibility of an increase in cost, complexity and exposure that will drive them to find more risk-averse routes to execute and clear their business,” adds Mizen.
Ignace Combes, deputy chief executive officer of Euroclear, the European provider of domestic and cross-border settlement, says that the industry will really have to think about how far it can go in terms of competition, and he also thinks that some CCPs may well disappear because of consolidation at the clearing level.
But Combes’ business Euroclear is also an integral part of the post-trade process and like clearing, settlement has been brought into the limelight by the regulatory upheaval that is currently surrounding the post-trade process.
Settlement is the effective transfer of ownership of securities from a seller to a buyer, and the respective transfer of cash from a buyer to a seller. This ensures the trade is legally concluded.
Tim May, chief administrative officer of Euroclear, says that the settlement aspect has been fairly resilient to the financial crisis and has demonstrated its ability to cope in volatile and uncertain trading conditions.
Euroclear is in the process of developing its single platform for pan-European settlement, which is expected to be completed by the end of 2011. It is expected to bring with it the benefits of harmonisation and consolidation and a single, direct access point for all markets served by the Euroclear group.
Euroclear UK & Ireland will provide the investment fund business in the UK with its first automated settlement solution to exchange fund units for cash and vice versa by the end of this year.
Until now, there has been no automated settlement process for funds, meaning that the status of any transactions could not be tracked which has made it very difficult for fund managers to control their accounts.
Following the financial crisis, the relevance of clearing and settlement to risk management and trading functionality have become crystal clear. Developments at this level, however mundane they might seem, are now as important as the trading process itself.