+++ (FT) Derivative investors doubt benefits of LSE-Deutsche Börse tie-up

…I still think that it’s not going to happen…
(FT) Deutsche Börse’s $20bn combination with the London Stock Exchange Group promises an “industry-defining combination” but there are doubts that traders and investors relying on derivatives in a post-crisis world will see the benefits.The deal will bring together London, Europe’s leading financial hub with Frankfurt, the home of the European Central Bank and the eurozone, into a behemoth able to trade in equities and futures, benchmarks, index and data analytics.

But it is in the world of risk management, or post-trade as it is known, where the new exchange promises the biggest changes. A combination offers clearing of futures and swaps and collateral management on a scale no other exchange operator in the world can match.

For some, it is an indication of how global markets are changing rapidly, overturned by the impact of capital rules on banks and the growth of exchange traded funds (ETFs) and other passive investing.

exchanges

Anthony Perrotta, a former broker and head of research at Tabb Group, the US capital markets consultancy, says the capital rules were the “single biggest issue” affecting over-the-counter markets.

“I think exchanges are recognising the need for expanding their roles as intermediaries by utilising scale and services to connect asset owners,” he adds. They are in an arms race and “establishing true verticals — pre-trade information flow, execution, clearing, and settlement — in the market”.

The deal is expected to improve the efficiencies of the exchanges themselves, to the tune of at least €450m over three years. But how much will it benefit markets?

In an interview last week, Xavier Rolet, chief executive of the LSE, said a combined company would be a model for the future as it seeks to provide services for customers who trade globally, like Fidelity, BlackRock and Pimco. He argued that the combined settlement assets would be able to offer collateral management immediately after the market close.

“Would they accept their business siloing, you know, that you have to deal with these guys here, with those guys there? There’s hundreds of billions of dollars or pounds or euros of margin that is posted and a whole bunch of silos around the world — inefficiently.”

There are concerns among futures markets participants that a deal will lead to trading fee rises in an already costly industry.

It is a charge the LSE is sensitive to. Mr Rolet says: “Our American futures friends have kept on increasing fees every year — in 2009, 2010, when everybody was on their back bleeding to death. Total cost of trading is too high, so it’s going to change.”

But clearing is a mandatory part of derivatives trading and will always require costly margin to offset risk. That has led others to question whether the exchanges can really promise more savings for traders. “Regulatory capital isn’t margin,” says one high-speed trading executive.

Few banks and fund managers are willing to go on the record backing the deal. “It might make European ETF listings a bit easier but overall, for us, it’s largely a non-event,” says one fund management executive.

The new exchange promises banks and investors savings of billions from the related costs of trading in OTC markets as new Basel regulations kick in.

New rules force banks trading in derivatives to post large amounts of collateral and margin at central clearing houses as insurance to back their deals. The main customers, the investment banks, are also being hit with heavy capital charges on those deals.

Netting the margin that traders post to back both their futures and swaps derivatives — called cross-margining — is a more efficient use of capital, the exchanges argue.

Michael Spencer, chief executive of interdealer broker ICAP, is a fan of the deal, arguing that it “offers the best margin-netting opportunities”. Deutsche Börse’s dominant position in longer dated bond contracts cleared on Eurex’s futures markets can be matched against LCH’s dominant position in euro rate clearing, he says.

It seems to sacrifice many of the benefits of a merged clearing house, while creating ambiguities and legal risks. It also will inevitably be more complex than simply merging the two clearing houses

Craig Pirrong

It promises further risk management via a rapidly growing trend in the swaps market known as compression. Swaps in derivatives portfolios can be torn up or compressed when two positions are hedged, rendering them redundant and reducing the capital held against the position.

Some clearing executives point out they have enjoyed the benefits without a need for an exchange deal. LCH’s SwapClear has torn up more than $320tn in trades in the past year for market participants and saved them more than $25bn in regulatory capital requirements.

Mr Rolet says that for a listed derivative and swap trade, “you’re going to be able to net this. Not only do you save collateral for the customers but you actually tear up a lot of the risk”. He argues that the savings accrued via compression are far greater than savings from cross-margining.

But others are less convinced that the tie-up of an OTC and futures clearing businesses would work in practice. Craig Pirrong, a finance professor at the University of Houston, says it is not clear how a “baroque” cross-border link would work legally, especially if the UK leaves the EU.

“It seems to sacrifice many of the benefits of a merged clearing house, while creating ambiguities and legal risks. It also will inevitably be more complex than simply merging the two clearing houses,” he says.

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