Some 40 months after the London Metal Exchange put out a short, cryptic statement that it was thinking about bringing clearing inhouse and cutting off LCH.Clearnet, the Hong Kong Exchanges and Clearing-owned exchange did exactly that on Monday.
LME Clear is a boost for the LME and puts
it on a par with some of its larger rivals such as the IntercontinentalExchange, CME Group and Eurex, all of which own the clearing houses that clear trades executed on their exchanges.
Owning your own clearing house is sensible from a product development point of view.
LCH.Clearnet has multiple clients, including the London Stock Exchange, Euronext and Nasdaq OMX NLX to name but a few, which means clients are constantly vying to have their product innovation accommodated by LCH.
By contrast LME Clear will have (at least at the outset) one exchange client, the LME itself, so that business knows its requirements should be properly looked after.
An inhouse clearing function is also commercially compelling.
Clearing is the new black in derivatives after regulators pledged in 2009 to force standardised swaps to use clearing houses and, more recently, tightened up and made more expensive the processes around uncleared swaps, thereby making their cleared cousins more attractive.
European authorities have set 2016 as the deadline for the introduction of mandatory clearing, which seems like a long way away but many firms are still smarting from the tough February deadline for trade reporting which left many unprepared.
Clearing is also a much bigger undertaking and requires the buy-side to take for the first time full responsibility for their cleating operations, something that today they effectively outsource to banks or brokers.
LME Clear is one of many eyeing 2016 however.
Already some 11 firms have been approved to clear swaps under the so-called European Markets Infrastructure Regulation and these include LCH.Clearnet, Eurex Clearing and CME Clearing Europe.
ICE Clear Europe was, at the time of writing, the only heavyweight European clearing house that had not won its approval but it is hard to believe this rubber-stamp will not be forthcoming in the near future.
Market participants may have been able to sustain various accounts with multiple clearing houses for the purposes of clearing listed futures but the valuations and margin treatments on swaps are very different.
Given the sums involved, most firms will only be able to afford to maintain accounts at a handful of clearing providers but these enterprises, naturally, need to be sustainable in their own right.
The challenge for banks, asset managers and other traders at this stage is which clearing houses will be viable over the medium term and which will struggle to reach critical mass and fall by the wayside.
The Holy Grail for clients and providers alike is the fabled cross-margining, where firms pay margin based on their net rather than gross exposure across a portfolio of similar products, a trick that can dramatically reduce their margin commitments.
Citigroup, Commerzbank and Morgan Stanley were among the banks lining up to back Eurex when it launched in June Europe’s first cross-margin service, between interest rate futures and swaps
LCH.Clearnet has the most to gain by opening up cross-margining because it has a massive swaps book against which clients could offset their futures but it has been more circumspect about its cross-margining plan.
LCH did however make a couple of breakthroughs this week by upgrading its collateral system and rolling out a new swap compression service.
Swap compression is not as transformative as cross-margining but it’s a nice distraction in the meantime, as suggested by the support for the new LCH offering of Deutsche Bank and Credit Suisse.
LME Clear makes sense for the LME and its current clients but it is impossible to know at this early stage who will be the winners and losers under the new Emir clearing regime.