Interoperability driving evolution among European CCPs

The current CCP landscape in Europe broadly consists of two types of players. In the first category belong the national CCPs that focus on a single market; the second category consists of the “interoperable” CCPs that clear trades conducted at multiple trading venues. With the growth in electronic trading and launch of alternative trading venues, firms trading in multiple markets needed to connect to different CCPs and fund collateral on separate positions. Such firms increasingly demanded a single CCP for efficient settlement and collateral management purposes. Regulators responded by allowing interoperability among CCPs whereby investors could choose at which CCP they wanted to clear their trades, and the two counterparties’ CCPs could interact among themselves to clear a trade. This introduced an element of competition in the CCP space as the CCPs vied to become the CCP of choice for trading participants. However, the extent of competition was still limited, as some vertically integrated exchanges refused to open up their clearing functions to other CCPs, while others gradually allowed access to multiple CCPs for trades executed on them. Interoperability among CCPs, albeit limited, has already resulted in significant efficiency improvement and cost reduction in the European equities clearing space. Moving on from voluntary provision of CCP interoperability by the trading venues, the next phase of evolution will center around mandatory opening up of clearing function through regulatory changes. Regulations such as the Markets in Financial Instruments Directive (MiFID) could force the vertically integrated infrastructures that were not inclined to allow interoperability for trades conducted at them previously, to open up and allow interoperability. This is likely to bring about more competition among the CCPs in Europe. Like CSDs, currently there are too many CCPs in Europe, all of which may not survive the increased competition. Players with wider market coverage, efficient technology and operational capabilities, strong capital base, and advanced risk models will be able to capture market share. Having achieved interoperability in the equities space, there are now talks of allowing the same for derivative instruments as well. But the case of derivatives may be different from that of equities. Under the interoperability model, the linking of two CCPs introduces an additional element of risk into the system. The risk could be more severe for derivative operations given the inherent higher risks associated with derivative instruments. Different CCPs may follow different risk management policies and practices, and this may create problems in mitigating overall risk and resolution mechanisms in case of default. Furthermore, some argue interoperability may disincentivize innovation in the context of derivative product development. Launching derivative instruments requires a good deal of research and development by the exchanges and only a few of the launched instruments succeed in the market, a situation analogous to the case of drug developments. Therefore, it is argued if exchanges lose out on the derivative clearing revenue because of interoperability that may discourage them from developing new products in the future.