Commodity derivatives: The era of clearing and trading under one roof

It is time! The lines are thin, stakes high and the battle has already started! It is a case of annoying intrusion where clearing houses are stepping into the trading arena and commodity exchanges, vying for a chunk in clearing business!

A non-core activity in the past, exchanges are realising that outsourcing clearing activity would be like swimming with tied down hands and clearing houses are enlightened that providing an exchange platform for products is like having two wings!

The LME dilemma

LME has long been outsourcing clearing operations to LCH. Clearnet, which in turn had many other exchanges in their client list including NYSE Liffe and ICE. But with both of them deciding to go ahead with own clearing houses, LME (London Metal Exchange) is in a dilemma, which has prompted the world’s biggest metal exchange to think of a divorce with LCH. Clearnet.

No definitive decision has been taken by LME in this regard and no deadline has been set.

In a communiqué to members, London Metal Exchange primarily cites two reasons for the proposed ‘divorce’:

With the major exchanges in the globe doing away with LCH. Clearnet, the latter has moved into OTC clearing as well. This has questioned the viability of LCH Clearnet as a clearing house and its business mode. Partnering further with LCH Clearnet poses a strategic risk to LME.The clearing house has floated products in steel independent of LME. LME currently pays around 10 million pounds to LCH.Clearnet in clearing fees. “A clearing house competitive to its exchange partners would be detrimental to LME shareholders and members.” –says LME.

LCH Clearnet was started in 1888, and has evolved since then. The clearing house has a firm partnership with LME and has opined : “We value our relationship with the LME and shall continue to provide the LME and its members with an excellent service and the benefit of our unique experience in clearing for this complex market - we are a leader in commodities clearing globally. Market participants tell us they are looking for proven, efficient and consolidated clearing offerings. LCH.Clearnet is best placed to continue to deliver this.”

Advantages for LME

Nonetheless, the proposed move by the LME is a clear indication of a trend that is fast catching up.

With the commodity markets booming, exchanges which were mute inglorious entities are now the cynosures of attraction and have realized that clearing—a non-core activity in the past—is now core and strategic and if done on its own, could generate additional value.

The strategic reasons always outweigh value-generation considerations. But, if a strategic decision can bring additional value, it is an incentive to start thinking about the same.

The LCH.Clearnet’s move to launch LME-independent steel products is itself an indication that the clearing agency desperately wanted to become a full fledged player.

So, if a clearing agency moves up in ranks and wants to become a vital player in metals exchange business, why can’t the LME step down a bit from its pedestal or move to a parallel pedestal, so to speak, and take advantage of the situation?

After all, it cannot shut its eye on what other players are doing in the markets. CME Group’s recent move in setting up its own clearing house has been taken note of by the investor community.

The proposed move by the LME has multiple advantages.

--By launching its own clearing house the exchange can gain control on product introduction in markets. LME doing nil clearing meant it had no control or legacy experience in clearing. This scenario would undergo a sea change if the LME start-off clearing transactions.

--Generate additional revenues, which has already been explained.

--The move would make LME strong (in terms of acquisition power) and handsome (in terms of being an apt entity to be sold).

--With CME group launching OTC clearing in over 150 OTC products, LME has understood what it has been losing in terms of revenues and value. LME can fully leverage the OTC space as well if it introduces a clearing house.

--Further, a clearing house would help LME to shoulder responsibilities as and when legislation in the lines of Dodd-Frank in the US and “Emir” in Europe kicks in with severity.

Action modality

Subsequent to launching a clearing house, LME would maintain the current rates in clearing transactions, the communiqué to members said.

The question however on the horizon is how LME would set up a default fund to address the responsibility that comes with clearing. (The fund acts as a buffer and reduces the counterparty risk involved in trading).

LME speaks about this:

“Work on establishing the size of any potential default fund has not begun. LME clearing members pay into the LCH.Clearnet default fund based on the size of their LME business. LME clearing members that are also clearing members on other exchanges, or for other types of products, will have further contributions to make for this business. Should the implementation of LME’s clearing house go ahead, it is envisaged that there will be little change to LME clearing member default fund contributions. Default fund contributions for LME business will switch from LCH.Clearnet to the new LME operated clearing house.”

Also, the exchange has not ruled out partnering with clearing houses like ICE Clear and CME Clear to undertake clearing operations.

Regarding the governance structure of LME owned clearing house, the exchange informs this:

“If the creation of an LME owned and operated clearing house is agreed by the LME Board, initial assumptions are that the clearing organisation will be a Limited company under LME Holdings Limited and separate from the exchange, but with some shared services. The clearing organisation would be a limited company under LME Holdings and would share some services with LME Ltd.The clearing and exchange organisations would both report to the group holding company. “

Invariably, exchanges’ own clearing house is an idea whose time has arrived!

As published in: http://www.commodityonline.com/news/Commodity-derivatives-The-era-of-clearing-and-trading-under-one-roof-39563-3-1.html