The LSE, LCH and Euroclear Deal: Who Benefits?

Euroclear has honoured its promise to switch strategic focus from Clearstream to building relationships with other European trading platforms, CSDs and CCPs. Considered cynically, the Brussels based ICSD rushed out news today it had agreed with the London Stock Exchange

By None

Euroclear has honoured its promise to switch strategic focus from Clearstream to building relationships with other European trading platforms, CSDs and CCPs. Considered cynically, the Brussels-based ICSD rushed out news today it had agreed with the London Stock Exchange (LSE) and the London Clearing House (LCH) to settle transactions struck at the LSE and cleared and netted via LCH purely because it needed some good news in the wake of Friday’s decision by Clearstream to negotiate exclusively with Deutsche Borse. Certainly haste would explain the lack of detail. The three parties are only now consulting their customers over whether the plan is a good idea; the assumptions behind it have still to be validated; the cost of implementing it is unknown; and any service will not be launched until the second half of 2002. “The agreement with LSE and LCH is in line with the Euroclear strategy of maintaining an open architecture, which means we have no exclusive relationships with any stock exchange or trading platform,” says a Euroclear spokesman. “It is also in line with our philosophy of offering users a choice, until the day comes when we have a single settlement platform for both bonds and equities on a pan-European basis.” This statement can be taken at face value: what Euroclear gets out of this deal is additional transaction volumes, and in the hitherto elusive equity market as well.

For LCH, the deal also looks to be all jam. If it works as intended, it will deliver more transactions into LCH for netting and clearing. It will cost virtually nothing to put the necessary links in place, since LCH and Euroclear recently completed a connection between their respective clearing and settlement offerings to service the Virt-X market. That link will be used to service the new LSE relationship as well. In fact, LCH has a long record of working happily with Euroclear, though not always successfully. Back in November 1999 LCH joined Euroclear and the DTCC subsidiary, the Government Securities Clearing Corporation (GSCC), as a founding partner of the European Securities Clearing Corporation (ESCC). The three parties had hoped the French CCP, Clearnet, would join ESCC as well to create a combined central counter-party clearing and settlement service for both repo and cash market transactions in the European (and perhaps eventually the transatlantic) government bond markets. Then and for some time afterwards Euroclear was hoping that a combination of TradeGo, the CCP it created for the COREDEAL bond trading platform then being built by ISMA, and its option over a fifth of Clearnet would give it a seat at any talks aimed at creating a single European CCP. But Clearnet refused to join the ESCC, and the COREDEAL platform attracted so little business that it was more or less acquired by Euro MTS earlier this year. ESCC has shrivelled into a form of user governance for the RepoClear service offered by LCH.

One dream which has not died is the idea of a single European CCP. Indeed, the Euronext acquisition of LIFFE has revived the idea of a merger between LCH and Clearnet. Euronext also controls Clearnet, and the 20 per cent it does not own belongs to Euroclear, its favourite settlement provider and a happy seller to the right buyer. The purchase of LIFFE has now given the French-led trading platform a 17 per cent stake in LCH. This has changed the terms of the debate about how CCP consolidation in Europe will be achieved. Until LIFFE was sold to Euronext, LCH had reason to believe that it could compete Clearnet out of existence or into a merger on its terms. That now looks less certain. “It is probably right to say that, two or three months ago, a merger with Clearnet looked unnecessary,” says Arun Aggarwal, managing director, business management, at LCH. “The thing that has obviously made a difference to the debate is the takeover of LIFFE, since LIFFE is one of our most important customers and partners.” But the debate is not yet over. In each of the four securities businesses LCH conducts – RepoClear, SwapClear, EquityClear, and the LIFFE business – Clearnet will not add a great deal. Only SwapClear has struggled to build volume, and even there the deal with OTCDerivNet has brought an additional twelve key players into the CCP. The eighteen banks using SwapClear now claim a total value of Euros 2 trillion in outstandings and a 55 per cent market share. If LCH could persuade market leader JP Morgan – which owns most of the rest of the OTC derivatives market, a large enough slice to net across its own books – to join SwapClear, it would more or less own the business. “We would still say that – from a purely business perspective – we do not have to merge with Clearnet,” says Aggarwal. “If it was left to the marketplace, and the trends remain as they are, we would not feel any great need to do anything.”

But both post-LIFFE reality (LIFFE accounts for a third of LCH revenues) and the broader politics of European infrastructural consolidation dictate that LCH draw closer to Clearnet. Some say it follows that the LSE has also gravitated away from an independent or German future towards the Euronext grouping as a whole. After all, LSE and Euronext now have a settlement provider in common (Euroclear) and may soon have a CCP in common too (LCH plus Clearnet). Spokesmen on behalf of both Euroclear (“We are certainly not pursuing this relationship with the London Stock Exchange on behalf of Euronext”) and the Stock Exchange deny this (“We have got a number of interesting options open to us, and we are talking to a range of organisations”). But the truth is that, by losing LIFFE to Euronext, the London Stock Exchange has narrowed its strategic options considerably: a London-based vertical silo incorporating LSE, LCH, CREST and LIFFE is no longer a plausible alternative. LIFFE now belongs to a rival. And this latest deal with Euroclear cannot have helped relations between CREST and the LSE, since CREST cannot rule out a loss of business to Euroclear. The LSE concedes as much. “This is very much complementary to our relationship with CREST,” pleads an LSE spokesman. “It offers a choice of clearing and settlement agents to member-firms. It is a matter for the member-firms where they want to send their settlement business. But it is fair to say that Euroclear and CREST will be in direct competition for it.”

Whilst the news of the deal with Euroclear was not a complete surprise to CREST, its timing certainly was, and the London-based CSD was not officially informed about it until the day before. Ill-will between CREST and the LSE dates back to the failure of the TAURUS settlement project in 1993, when the Bank of England was forced to take settlement away from the Stock Exchange. It cost the LSE both respect and substantial revenues. The embarrassing scrapes the LSE subsequently got into with Deutsche Borse – not once, but twice – never failed to irritate CREST, who was often assumed to be tagging along. It is well-known that CREST was not best-pleased to find itself obliged to work with Clearstream during the second of the short and unhappy liaisons between the LSE and Deutsche Borse last year. But even disinterested observers have found it hard to admire the management of the LSE over the last decade and a half, and many share the view of CREST executives that the Germans were all along pursuing a Machiavellian strategy to stymie the London market as a whole with what CREST CEO Iain Savile memorably dubbed “planning blight.” Certainly, CREST seems increasingly happy to pursue a strategy independent of the LSE. This division between CSD and trading platform would be unthinkable in France, and even in Germany, where supposed “national” interests invariably trump those of individual firms and institutions. But tat does not mean it is wrong.

Indeed, it can be argued that one of the main ingredients of the success of London as a financial marketplace is precisely its unwillingness to draw a distinction between the interests of the market and the interests of market participants. (This is arguably the main difference between Anglo-Saxon capitalism and Franco-Teutonic capitalism, tout court.) There is a strong sense in which the LSE and LCH deal with Euroclear is completely in step with the CREST approach. “We strongly believe that trading counter-parties must have a choice in settlement locations for their stock exchange trades,” says Clara Furse, chief executive of the LSE. “We also want to encourage transparent and fair competition, and horizontal consolidation among service providers.” Paul Symons, head of public affairs at CREST, accepts the challenge. “At a high level, this is exactly what we have been working towards with Virt-X, Euroclear and SIS SegaInterSettle, in that it says a user of a trading platform should have the choice as to where they settle,” says Symons. “They should not be forced to settle in one location just because the local trading platform dictates it. We support competition in all areas, from network provision through payment bank provision to settlement. We believe in competition. We are not frightened by extra competition at all.”

In practice, CREST will not be that worried about losing business to Euroclear. The real objective of the LSE is to attract new business to SETS, which now accounts for over two thirds of equity trading on the London market, rather than redistribute the settlement of existing business. The Exchange already has remote members, and would like more, especially if they are Continental Europeans expected to prefer trading on Euronext or Deutsche Borse. “The benefit to the London Stock Exchange is the possibility of attracting more remote members to its market by virtue of the fact that they have access to the Exchange via their Euroclear account,” agrees a Euroclear spokesman. The LSE chief executive says as much. “We are of the firm view that a relationship with Euroclear should make access to the Exchange more attractive for a larger number of non-UK member firms,” argues Furse. It is this ostentatiously European focus which accounts for the sanguine public response of CREST. “It is aimed at potential new users of SETS, who may be small or medium-sized European institutions who do not want to connect to us directly but do have a relationship with Euroclear,” says Symons. “They can trade on SETS and gain access to central counter-party and settlement services through LCH and Euroclear and that may be very advantageous for them. For the London Stock Exchange, it may actually create a new market for SETS. I do not actually foresee much, or even any, liquidity moving out of CREST to Euroclear.”

Symons did not say this, but CREST will not remain sanguine for long if Euronext and Deutsche Borse do not follow the example of the LSE and offer their participants choice and competition in settlement services. A refusal by Euronext to allow its participants to settle in CREST would make the LSE look foolish, however much its own openness conforms with the law of comparative advantage, but it may yet happen. The prospects for choice and competition in European settlement services are certainly less than promising. Clearstream is now engaged to Deutsche Borse. The position at Euronext is more complicated, but still vertically rather than horizontally inclined. The Dutch CSD (Necigef) and its French (Sicovam) and Belgian (CIK) equivalents all settle trades on Euronext, and are all part of the Euroclear group, but remain quasi-independent entities. Euroclear Bank itself in Brussels has yet to start settling trades for Euronext. But the stated aim at Euronext is to match the progressive migration of trading activity on to a single platform with a progressive migration to a single settlement platform as well. If Euroclear fails to deliver this, or the price or quality of the service falls below acceptable levels, Euronext is theoretically free to choose an alternative provider or open its platform to all-comers. This is not unthinkable – Easdaq did replace SISSegaIntersettle with Euroclear – but in reality it is highly unlikely to happen, because there is nowhere else for Euronext to go. Apart from Clearstream, the European depositories are all little more than domestic settlement systems, and linking with them would contradict the Euronext strategy of consolidation rather than co-operation. Yet the only logical alternative provider of settlement services to Euronext (Clearstream) is precluded by understandable reluctance to subsidise a competitor.

Market participants who despair of getting what the largest of them say they want in Europe – competing trading platforms, a single CCP, and either one or very few settlement engines – will take comfort from the fact that the vertical strategy of Deutsche Borse looks more conspicuous than ever. After all, with this announcement, Euroclear has indicated that it is not tied to the Euronext platform, and the London Stock Exchange has rejected the creation of a vertical silo with CREST. “We certainly would have liked to include Deutsche Borse in the arrangement with LSE and LCH, but the decision last Friday means that either that will not happen, or it will take a long time to happen,” says a Euroclear spokesman. In other words, the consolidation of the infrastructure of the European securities markets now depends largely on competition. This is congenial to the London-based contestants. “We have always believed that consolidation at the settlement level will probably occur through competition rather than anything else,” says Symons of CREST. At LCH, Arun Aggarwal argues that he can win any commercial competition, while he would probably lose a contest umpired by European politicians and regulators. He points to the relative success of both SETS in London-listed equities and BrokerTec in European repo. By common consent, the success of both is attributable largely to the fact that they appointed LCH subsidiaries as their CCP providers, and so gave market participants the benefits of anonymity and netting. “At a general level, consolidation through competition is what LCH is doing,” says Aggarwal. “The market is looking for a consolidation of European clearing and settlement activities, and what LCH

has been doing for the last two or three years is consolidating clearing activity in a bunch of markets. We are doing it by offering a service in them competitive enough for market participants to want to direct their trades through us. Be it on RepoClear or SwapClear, the market has recognised the benefit of channelling its activities through LCH. No one is forcing them; there is no vertical silo; they simply make that choice on a day-to-day basis. Through competition, we are effecting a European consolidation.”

The intermediaries least pleased by consolidation in general – and the LSE-LCH-Euroclear alliance in particular – are the custodians. They are already hostile to Euroclear, which is steadily replacing its agent banks in Europe with direct links to CSDs. Claims for this deal that it will reduce the costs of cross-border transactions will irritate them still further. On the face of it, they certainly look far-fetched, since the Brussels-based clearing house is notoriously expensive. “We can’t see any service that Euroclear offers that we don’t, or any service which they offer at a lower cost,” says Symons. But that is not the point in this case. First, the institutions the new service will attract will be doing a lot of business with Euroclear already, so the marginal cost of adding further transactions will not be high. Secondly, any foreign institution active on the LSE who does not have an account of its own at CREST must use a London custodian, adding another layer of cost. By allowing actual and potential SETS participants who do not have an account with CREST but do have one with Euroclear to trade on the market without using a custodian bank, the new arrangements probably will be cheaper than the current alternative.

“The benefit from the LSE-LCH-Euroclear relationship is that those entities who are not CREST members directly will now derive cost savings from using their Euroclear account to settle LSE trades cleared through LCH without having to resort to intermediaries to access CREST,” says a Euroclear spokesman. “Our estimate is that it will save those entities up to 75 per cent of their settlement costs.” This is precisely the stance which has alienated custodian banks such as BNP Paribas Securities Services, who have come to believe that the ICSDs are competitors already and potential disintermediators in the long term. In seven European markets – Austria, where Bank Austria Creditanstalt was sacked a few weeks ago, is only the latest – Euroclear has dispensed with sub-custodian banks and opened accounts at the local CSD instead. It is not as if custodians are unaware of the Euroclear strategy – several senior custodians, including Jacques-Philippe Marson, chief executive of BNP Paribas Securities Services – sit on the Euroclear board. Yet they seem powerless to stop it. “One of the expenses inherent to such a fragmented infrastructure is the fact that you have to have multiple accounts with different CSDs – that is, assuming your business warrants a direct relationship – or use multiple intermediaries to access different markets,” admits a Euroclear spokesman. “The consolidation process will reduce the need to use those types of intermediaries, at least for the bigger players.” Coupled with the fact that the interpolation of CCPs in so many markets means fewer transactions proceed to settlement, it is not hard to see why European custodians are having to make the case for their continued existence.