Sunday, November 29, 2009

LCH.Clearnet needs clear path to Washington

Posted in the Financial Times by Jeremy Grant:

In recent weeks an executive at LCH.Clearnet has been shuttling back and forth from the clearing house’s headquarters in a drab London office block to Washington DC.

For a business that has its roots acting as a clearer for the London coffee markets of the 19th century, this may seem like a distraction.

But as the business of clearing moves centre stage while regulators move to clean up the financial system, having an ear on the ground in the US capital is crucial. US politicians are busy making laws that will reshape the structure of the global over-the-counter derivatives markets – and clearing is central to that.

A clearing house stands between two parties to a trade, guaranteeing that a transaction is completed even if one party defaults. The lack of such a mechanism in most of the OTC markets prior to the Lehman Brothers default was one reason why shockwaves were sent through the financial system.

The big idea that has gripped the imagination of politicians is to insist on more clearing, so that if there are future shocks, the systemic ripple effects can be limited.

But the sometimes tortuous process of producing legislation in the US Congress has reached a crucial stage, with final legislation possible early next year.

That makes it critical that LCH.Clearnet, Europe’s largest independent clearing house and already a big clearer of OTC derivatives, has a voice in the corridors of power. And the air miles being clocked up by its executive show how the big players, from exchanges to clearers to the big banks active on the OTC markets, are muscling in on the process.

For Roger Liddell, the clearer’s chief executive, the machinations of US politicians have already caused relief and anguish in equal measure.

He is “delighted” that Barney Frank, powerful chairman of the House of Representatives’ financial services committee, changed his mind last week on whether OTC foreign exchange contracts should be exempted from clearing. Mr Frank now believes they should be cleared, altering a key bill accordingly.

Mr Liddell sees this as an opportunity. His focus is now on expanding further into OTC derivatives clearing – with FX clearing a top priority, and plans for OTC equity derivatives next on the list.

Key developments

1888: The London Clearing House is established to clear commodities contracts in London

1980: Ownership of LCH passes to a consortium of six British banks

1987: LCH starts clearing for the London Metal Exchange

1996: Introduction of clearing for cash equities

1999: LCH subsidiary SwapClear clears the first OTC interest rate swaps. RepoClear, an OTC fixed income clearing service, is launched

2003: LCH.Clearnet Group is formed following the merger of the London Clearing House and Clearnet SA

2006: Roger Liddell becomes chief executive

2009: LCH.Clearnet streamlines shareholder base

“We are very keen to develop foreign exchange clearing – options and forwards. So that’s a big initiative for 2010,” says Mr Liddell, a former Goldman Sachs head of global operations who spent half his career immersed in the unglamorous post-trade services that underpin much of the world’s trading.

Mr Frank’s change of mind alarmed the FX community, some of which believes that the FX derivatives market is so big that clearing it would concentrate too much risk in clearing houses.

But as much as Mr Frank’s change of mind on FX was a gift for LCH.Clearnet, another issue on his desk could prove a nightmare.

One idea being bandied around Congress is that banks should not be allowed collectively to own more than 20 per cent of a clearing house.

Its backers argue that if banks could control a clearer, they might be able to design OTC contracts in such a way that they dodge legal requirements that they be cleared. The non-cleared OTC markets have hitherto been lucrative for dealers at the banks and there are concerns that clearing could crimp those profits.

For LCH.Clearnet, the inclusion of any such threshold in US legislation would be a disaster. Under its new shareholder structure, it is owned 83 per cent by banks active in the OTC markets – in effect disqualifying it from operating in the US.

Yet Mr Liddell has plans to expand in the US. Industry observers suspect that rival clearing businesses are lobbying Washington lawmakers in favour of the threshold. Nasdaq OMX is building an interest rate swaps clearing business that would compete with LCH.Clearnet’s SwapClear swaps clearing business.

Mr Liddell admits that any proposal to limit bank ownership of a clearer “could be a problem for us, and we are obviously hoping that it won’t get through to the legislation”.

He also dismisses the idea that banks in the OTC markets would be reluctant converts to clearing in any case.

“The strange thing is it seems there are people who believe that there is some reluctance on behalf of some of the banks to have this stuff cleared. We just don’t see that.

“The fact of the matter is we want to clear more types of activity, our customers want to clear more types of activity, the regulators and politicians want us to clear more OTC derivatives. So I am not sure who’s resisting it.”

LCH.Clearnet’s need to focus on Washington has come just in time. For the past year it has been distracted by uncertainty over its future ownership.

Last week the clearer drew a line under this by re-organising its shareholder base, and seeing off a potentially hostile bid from a consortium of banks active in the OTC markets, together with Icap, the inter-dealer broker. A bid from The Depository Trust & Clearing Corporation, the nearest, and much larger, equivalent to LCH.Clearnet in the US, has also come and gone.

But Mr Liddell, who spent 10 years in the British coal industry – even running a coal mine during the country’s famous miners’ strike of the 1980s – says: “Because of where we sit, because of what we’re involved in we’re always going to be involved in different conflicts, different tugs of war, things like that. It sort of comes with the territory.”

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