The CEO of Deutsche Börse made some very interesting remarks at the recent IDX derivatives industry conference in London. He argued that the proposed merger between Deutsche Börse and LSE would aid the development of trading in global markets because it would unite and harmonize the European capital markets, which are more fragmented than those in the US and Asia according to him. However, in this author's view, the merger of two large global exchanges raises as many questions as it answers. While one can agree that there would be less fragmentation and more harmonization, the main issue is whether the European market has a high level of fragmentation when compared with its global counterparts. Due to the European Union, European capital markets are much less fragmented than the Asia-Pacific, Middle-East and Africa, and Latin America. There has been a great degree of harmonization over the years, driven both by common regulation and industry mergers & takeovers. It is difficult to argue that there is a pressing need for more integration at this point. Instead, the main argument for the merger of LSE and Deutsche Börse is the fact that it would create a larger exchange that would be able to take on the likes of CME, Nasdaq and some of the leading Asian exchanges more easily. The expected reduction in headcount would also make for a more efficient, streamlined, and competitive exchange. But there are concerns that remain from an antitrust point of view and it is quite likely the Deutsche Börse CEO was trying to assuage these when he spoke about the positive effect of such a merger on global markets. If the merger does go ahead with regulatory approval, the advantage for other leading exchanges would be the higher possibility of such mergers and takeovers being approved in the future as well, since these could well be expected in an industry that is undergoing heavy consolidation due to economic and technological factors.
The Bank for International Settlements (BIS) recently reported that there was a decline in the cost of replacing outstanding OTC derivatives, the first since the financial crisis. There was a similar decline in the gross notional amount outstanding as well. While this indicates the tough regulatory regimes worldwide in the aftermath of the crisis, it also a sign of a healthier and more resilient OTC derivatives market. Due to the rising regulation-related costs of trading, market participants are looking to make their OTC derivatives trading more efficient. Tools such as trade compression and collateral optimization are being used for this purpose. So the decline in outstanding is also an indication of more efficient trading due to compression. Another sign of the efforts to reduce systemic risk is the rise in volumes of OTC derivatives that are being centrally cleared. The greater use of clearing houses is something that regulators have been espousing for some time, and an approach that most market participants and observers agree with. Besides the internal factors, external economic ones such as interest rates and exchange rates also explain some of the decline in value of OTC derviatives trading. Again, these are a sign of market fluctuations and do not necessarily represent any market decline. In our view, the BIS numbers are indicative of both the changes that regulators have put in place over the last 7-8 years and of a global economy that is still recovering from the financial crisis and the following economic challenges.
In an interesting development Australian authorities are looking to end Australian Stock Exchange’s (ASX) monopoly on equity clearing and relaxing ownership restrictions that removes a potential hurdle to the ASX’s participation in overseas mergers. First, some background: Australia for long was like many other Asian markets with a single incumbent national exchange that is vertically integrated carrying out clearing and settlement activity. Departing from other Asian market practices, regulators introduced competition in the local exchange space by allowing a foreign player Chi-X, which entered the market in 2011 and quickly took significant share away from ASX. However, clearing of trades, including those conducted at Chi-X, was still conducted by ASX as it was the only clearing agency in the country.
Chi-X has been complaining for some time that this situation gives ASX unfair advantage and possibly creates conflicts of interest in that Chi-X has to depend on its competitor for clearing of its own trades. They have therefore called for introducing competition in the clearing space to mitigate the situation, bring down clearing fees, and accelerate innovation. ASX has cut clearing fees in the past, and again indicated that it would further cut fees by 10% from July, 2016. It has also argued that the Australian clearing market size is not big enough to make multiple clearing houses viable.
While the new changes indeed pave the way for newer players to enter, whether and when that materializes would be interesting to see. The Financial Times observes that these changes are “unlikely to result in the establishment of a rival clearing house in the near future”, but will “create a regulatory framework that gives competition authorities the power to arbitrate disputes about access by rivals to the ASX’s clearing and settlement services.” It may be noted that competition in the OTC clearing space was introduced a while back and LCH.Clearnet has already entered and captured significant market share. Merger with an overseas player, in spite of the rule changes, may not be easy. In Asia, the issue of national pride associated with national entities such as exchanges is a particularly important factor, and can make mergers and acquisition by foreign entities tricky, as was seen in Singapore Exchange’s failed bid to acquire ASX previously.
ASX on its part has been active in upgrading its technology and systems to stay abreast with international best practices and ahead of potential competition. In some cases it is taking the lead in the industry and looking to build innovative solutions that could transform trade processing operations. It would be interesting to observe how these initiatives shape up and what impact these changes have on the Australian and global exchange landscape.