Should utilities be commercial entities?

The CME has proudly announced that its business generated $3.4 billion over the last twelve months and has an operating margin of just over 60%. Given its dependence on interest income and the microscopic rates currently available, the future, with planned US rate rises, looks ever brighter. CME, and indeed several other industry infrastructures, have been described as licences to print money for some time. That has raised again the question of the best corporate structure for a utility.

There was an orchestrated wave of rage against so called unfair competition from infrastructure a decade or so ago. But the reality is that infrastructure and commercial banks have co-existed to mutual benefit for many decades. There are areas of friction but these are relatively modest by comparison with the total footprint of the different industry players. Unfortunately, some are viewing the CSD Regulations in the EU as a door opener for a broader CSD business model and one that may not be totally aligned to all stakeholders’ best interests.

I have always believed in a simple role for infrastructure. They need to offer their clients benefits of scale and lower risk in their fields of operation. I have also, as a fully certified capitalist, believed they need to generate a return commensurate with the cost of their capital, the investment needs of their remit and a sensible reserve to accommodate periods of revenue downturn without having to raise their prices of service.

The CME definitely passes these tests. As a CCP, they take high volume transactions and net them down within a secure and trusted legal framework to much lower settlement volumes. They also manage a collateral pool commensurate with their open market risk and take a sensible haircut to accommodate an admittedly actuarial evaluation of prospective market volatility. They have, currently, major surplus revenue but this is sensible given the incremental volumes that have been generated by regulatory pressure for derivative transactions to move from bilateral to centrally cleared processing. Quite simply the quantum of their risks has increased and their traditional capital and reserve position needs to be strengthened to accommodate this. At some point, it will be deemed adequate, perhaps through more stringent rules on member liability as well, and then the CME can apply, more fully, subsequent volume growth to fee reduction.

The ICSDs, perhaps the most maligned of the infrastructures, are unique in that they include meaningful, but limited purpose, banks as part of their design. It is possible to imagine the current financing of the bond market, the source of the creation of the banks, being replaced by a series of third party, commercial arrangements. But it is questionable, especially as liquidity becomes ever more costly and the challenge of collateral movement is better appreciated in this age of relative scarcity, whether a more efficient and reliable system could be created rather than that one stop, dedicated facility at the ICSDs. The ICSDs have also benefitted from decades of operating as a duopoly. That remains but competition is growing or demand has pushed them into spaces, such as collateral management itself, where they need to be both efficient and cost effective to succeed. The ICSD model has its flaws. But the major one is linked to the commercial sector and is found in the complex world of common depository, where fees are still too high and specific activity prices are not aligned to cost. But here new competitive forces exist, as domestic issuance is fast gaining equivalence with euro issuance. Furthermore, the well populated world of collateral management and loan activity drives the major revenue flows associated with, especially, bond portfolios. In reality, in today’s global economy, competition is acute and efficiency drives success. Price gouging or service lethargy, both of which existed in the past, are long gone.

But many worry about the future divide between infrastructure and the commercial sector. There are areas where infrastructure must not tread. Firstly, they must not become full service banks for users will not supply the required capital. Secondly, they must not become fiduciaries as potential losses, with events such as Madoff being a case in point, would need to be absorbed by their utility flows and could place their total business at risk. And finally they must examine their operating model with investment banks for although it is logical, especially in the case of the ICSDs, to provide those higher risk clients with secured intraday settlement funding, it is questionable whether they should be doing so to the quantum and with the haircuts and collateral range they adopt. At the client level, they, and CSDs, should be more open to financial institutions, for that would facilitate the operator model which could remove risk from the process, but would not be as threatening as many custodians believe. Custodians are preferred by clients for their wider market coverage, their broader product range, their cash and capital market products and the insurance value of their capital base. Most of these attributes are outside the scope of the ICSDs or their smaller CSD colleagues.

Without infrastructure, we would depend on bilateral trading rather than central markets. We would have bilateral settlement rather than central counterparties. We would be in manual matching rather than operating through facilities such as OMGEO or SWIFT. And we would have paper in the vault rather than dematerialised, or at least, immobilised settlement across the globe.

I have been around long enough to know the risks of the bilateral world. I have lived through the great resistant phases to change. There remain activities that should be commoditised, consolidated or centralised. The purpose of our infrastructure, whether it is part of a commercial bank, for profit undertaking or utility service is to reduce risk and improve the efficiency of the securities markets life cycle. That drives capital market activity and that drives the profitability of every segment from new issuance, through trading and down to our post trade world.