The case against a second clearing house

Proposed changes to the Australian clearing mechanism offer no benefit to users or competition, while introducing new risks to the system.

This article is an edited excerpt of a speech by Elmer Funke Kupper at the Australian Council of Superannuation Investors AGM on Monday, November 19.

Australian regulators are currently looking at the market structure for clearing of equities. As you may be aware, ASX provides this service to you today. Regulators are considering if the government should license a second clearing house, potentially located overseas.

Not many people understand what clearing is, or why it matters to them. It is invisible and so it should be. Nevertheless, clearing is one of the most important functions of an exchange.

By offering a clearing service the exchange becomes the central counterparty to all equity transactions, removing substantial counterparty risk from the process. The exchange effectively becomes the buyer to every seller and the seller to every buyer. It is a systemically critical function that is supported by substantial amounts of collateral and capital, and is highly regulated.

To put some numbers to this, the ASX clears some $4 billion of equity transactions each day and holds more than $3 billion in collateral to support Australia’s derivatives markets. These numbers will increase as more products are cleared on an exchange platform under new regulations.

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Earlier we saw that the total cost to the Australian economy of equities clearing is $46 million per annum – or 27 cents for the average transaction. This is therefore the maximum ‘size of the prize’ from a change in market structure. It's not a lot when we compare it to the risks involved.

Given the importance of clearing to our financial markets, any change to the current market structure should be supported by a convincing cost-benefit analysis. And this analysis should be published to ensure that end users have an opportunity to provide input.

The cost-benefit analysis has to answer three simple questions:

– Will a change in market structure provide tangible benefits to end users – retail investors, fund managers, superannuation funds?

– Can regulators give an assurance that risks will not increase and that they can manage the risks, particularly if the activities, capital and collateral are located overseas?

– Does a new market structure improve Australia’s competitive position, does it support the development of a financial centre, and does it advance our ambitions in the Asian century?

Let’s take them one by one.

First, the financial business case.

Given that the total cost of cash equities clearing is only $46 million per annum, most analysts estimate that the introduction of a second clearing house could reduce these fees by $15 to $20 million.

ASX does not comment on what it would do, or if it would do anything at all, but let’s for now assume that $15 to $20 million is the maximum gross benefit to Australia.

Unfortunately, there are material costs that more than offset these potential savings. These costs come from reduced netting efficiencies in the clearing and settlement processes, higher technology costs and higher regulatory costs. Australia is a relatively small market and inefficiencies show up very quickly. ASX estimates that the additional costs to end users would be in the range of $20 to $30 million – that is, higher than any potential savings.

Second, the risks involved in clearing.

Risk will increase, and if clearing takes place overseas it will increase materially. Australian regulators will not be able to manage this directly; they will have to rely on overseas regulators, mainly in the UK.

We know from experience that there is a significant difference between agreeing with another regulator and actually getting your money back when there is a material default. The collapse of Lehman and, more recently, MF Global show us that this risk is very real.

In the case of MF Global, Australian clients are still waiting to recover several hundred million dollars, with money tied up in overseas insolvency processes. MF Global collapsed 12 months ago.

We believe that some large US investors have told their executing banks that their collateral will not leave American soil. Why would they take the risk on an overseas clearing house and expose themselves to overseas insolvency laws when there is no benefit attached to this risk? You should ask the same question of your regulators and banks.

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And finally, there are our ambitions as a country. Australia’s current clearing market structure is one that has been adopted by every other key country in the world, including the US. There is one exception and that is Europe, driven by the creation of the eurozone.

We are currently discussing doing something that no other single market in the world has done. It makes no sense, particularly when we consider that the upside is small and the risks are material.

Moreover, ASX is making significant investments that will give Australia one of the best market infrastructures in the world. We will offer services to our clients that few other exchanges can offer and that will deliver real savings to them – and ultimately to you.

We estimate that these savings will be in the range of $100 to $150 million per annum. In other words, our level of innovation and investment will put us in a very strong position and will allow Australia to compete on global markets on its own terms.

The summary above makes it clear that your exchange does not see the business case to fragment clearing. No other market has done it. We have done our homework and provided our regulators with the supporting facts. We hope they agree with us.

If they don’t and proceed with a change anyway, then it is important that they publish the tangible benefits you will receive from the change. It cannot be based on an undefined belief about markets and competition – we have seen where that gets us with equities trading.

We cannot afford to get this one wrong as the changes we implement will be permanent and go to the heart of market stability. `

Elmer Funke Kupper is managing director and chief executive of the Australian Securities Exchange.

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