In a speech to the European Financial Markets Convention in Zurich earlier this month Chicago Mercantile Exchange CEO Craig S. Donohue gave a brilliant exposition of the case for market-driven solutions to clearing and settlement, in preference to the centrally planned, user-owned, user-governed approach that is still gaining ground in Europe. We believe the case he made to be so powerful that we have reproduced his speech in full below.
EFFICIENT CLEARING AND SETTLEMENT SYSTEMS:A CASE FOR MARKET-DRIVEN SOLUTIONS
Craig S. DonohueChief Executive OfficerChicago Mercantile Exchange Inc.10th European Financial Markets ConventionZurich, SwitzerlandJune 8, 2006
Massimo, thank you very much for your kind introduction. I also want to thank Judith Hardt for her invitation and for graciously accommodating my schedule so that I could be here.
I want to begin by applauding the members of the European commission, the chairmen of the various European regulatory agencies and the FESE membership for their efforts to ensure the competitiveness of European markets. I wholeheartedly agree with President Capuano’s comments that this is a very timely topic in our fast changing and increasingly competitive global markets.
The CME, which is now the world’s largest and most diverse financial exchange, has worked hard to advance our industry and our own place as a leader in product innovation, electronic trading technology and clearing and risk management solutions. In 2005, CME facilitated the trading and clearing of over one billion contracts covering interest rates, stock indices, foreign exchange and agricultural commodities, representing an underlying value of $638 trillion.
The CME clearing house last year cleared more than 1.6 billion contracts traded on the CME and the Chicago Board of Trade 42% more than CME’s nearest clearing competitor. The CME clearing house holds approximately $47 billion of collateral on deposit and regularly moves approximately $1.5 to $6 billion per day among market participants. The success of our business model has led to tremendous growth. During the past two years, our average rate per contract has declined as we reduced costs for market users. During the same period, average daily volumes increased from three million to more than five million contracts.
In 2005, the CME Clearing House cleared approximately 90% of North American futures and options volumes and 43% of total North American and European derivatives exchange volumes.
Today, I would like to add CME’s perspective to one of the important topics that you will be discussing. I think our experience gives us some insight into the central question of whether European regulators should mandate the establishment of a single monopoly provider of central counterparty clearing (CCP) services or whether existing and variously organized CCPs should be permitted to evolve in response to the very dynamic and competitive market forces that are evident in today’s global financial markets.
To begin with, I am confident that everyone here understands the critically important role that central counterparty clearing organizations, or CCPs, play in the functioning of our financial markets. Among other benefits, CCPs:
“Reduce and contain certain systemic risks;”Ensure and guarantee the performance of all obligations between and among market users;”Limit bilateral credit risks and exposures;”Reduce capital and operational costs for market users through multilateral netting arrangements; and”Better align risk and margin or performance bond requirements through risk-based portfolio margining.
In thinking about industry organization of CCP functions, and the related issues of ownership composition and governance, it is important to recognize that derivatives markets are fundamentally different from securities markets.
First, derivatives exchanges are centralized transaction systems for a wide array of innovative risk management products. Exchanges like CME continually develop and create new products, usually following lengthy and expensive periods of research and development. In some cases, our innovations have protectable intellectual property interests.
In contrast, newly public companies list their stock on a securities exchange, which does little more than provide transaction execution facilities.
CME’s innovations are well established. We invented financial futures in 1972 (CME was the first exchange, under the leadership of Leo Melamed, CME Chairman Emeritus, and Nobel Prize winning economist Milton Friedman, to introduce futures contracts on foreign exchange instruments), we developed the first cash-settled contracts (This innovative breakthrough was developed by Dr. Frederick Arditti, CMEs former Chief Economist), leading to the development of structured derivatives on intangible assets not readily deliverable and we created the world’s first successful stock index futures markets.
More recently, we have innovated new risk management markets in areas such as weather and residential real estate indexes. Apart from our R&D investments and calculated risk taking, we invest considerable resources in education, training and marketing of our new innovations. In securities markets, the issuer invests in marketing and developing its own brand in order to attract investors and traders. In derivatives markets, it is the exchanges that must promote awareness and interest among market users. We believe that continued innovation and calculated risk taking will suffer in a single monopoly CCP system where all exchange competitors can freely usurp the innovations and investments of market leaders.
Second, users of derivatives markets like CME are predominantly large wholesale financial institutions, not retail customers. Our customers include the world’s leading banks, swap dealers, asset and liability managers, mutual funds, hedge funds, insurance companies and pension and retirement systems. These same customers are accustomed to trading in the over-the-counter derivatives markets and can replicate many of our products in the unregulated and non-centrally cleared segment of the derivatives market. Encumbering exchange-owned CCPs will remove incentives to innovate or to improve market efficiencies; consequently, more business may flow away from centralized and transparent exchange markets, thereby increasing costs for market users.
Third, the notional value of risk transferred in derivatives markets, and the risk of loss associated with highly-leveraged derivatives contracts dwarfs that of the world’s largest securities markets. In addition, CCPs for derivatives markets tend to warehouse and manage risk exposures over time, whereas securities CCPs manage risk on a very transient basis during a brief settlement period. At CME, we strongly believe that market supervision and market integrity are inextricably linked to sound financial and risk management programs. We believe that our ability to holistically manage market disruptions is better when we can rely upon our integrated exchange and clearing house knowledge and expertise.
In terms of clearing and settlement, 69% of futures and options contracts traded in 2005 were cleared through exchange-owned/controlled CCPs. This compares to 100% of U.S. securities and securities options contracts that clear through large intermediary controlled CCPs. Notwithstanding that dichotomy, futures and options markets have experienced substantially higher growth rates than U.S. and European equities markets. For example, the compounded annual growth rate of the global futures and options industry from 2000 through 2005 was 22%, compared to only 4% for equity securities markets.
As the European commission looks to streamline cross-border trading, there has been much debate about the optimal industry structure of CCPs. While the high cost of cross-border securities trades is attributable to many factors, much of the discussion has been focused on the relative merits of a single large intermediary owned/controlled CCP versus a decentralized structure with competing and differently organized CCPs ─ including, for example, exchange-owned/controlled CCPs.
Of course, large intermediaries and CCPs owned or controlled by them distinctly favor the so-called horizontal model. They assume that a single, large intermediary-owned/controlled CCP will minimize clearing and settlement processing costs and reduce cross-border trading expenses.
Surprisingly, and despite the fact that the April 2004 communication from the European Commission recommended, and the European Parliament agreed, to allow the market to decide the optimal structure for clearing and settlement services, the debate about mandating a single monopoly CCP has continued. For example, last September, the EU’s internal market commissioner argued “that the introduction of . . . A single pan-European central counterparty&.could help cut the high costs of cross-border trading.” (GT News commentary http://www.gtnews.com/feature/91.cfm)
In February, LCH.Clearnet presented a discussion paper to the European Commission’s Clearing and Settlement Advisory and Monitoring Expert Group (CESAME), calling for the “full consolidation of CCPs serving all European markets and asset classes.” And just two weeks ago, the EU’s competition dg issued its paper(Competition in EU Securities Trading and Post-Trading) , arguing that CCP services could, and probably should operate in a competitive environment. However, they voiced their opposition to vertical integration by finding that, “vertical integration may result in foreclosure at all levels of the value chain and therefore lead to welfare losses. Whilst there may be efficiencies, so far the commission has seen no convincing evidence to substantiate this.”
While we at CME agree that CCP services should operate in a competitive market, our view of vertical integration differs from that of the competition dg. We believe that a directive that creates a single monopoly provider of CCP services is inconsistent with a call for competition. In fact, that proposal spells the end of competition for providing innovative and efficient clearing and settlement structures. If competition is the goal, regulators and policy makers should support a competitive environment that fosters innovation and the development of new and alternative solutions that allow the market to advance. There are several reasons underlying our belief that the case has not been made for mandating a single monopoly provider of CCP services for all asset classes and all European markets.
First, the true cost savings of moving to a single monopoly CCP or creating interoperability among multiple CCPs has not been quantified.
Second, post trade processing is only a small portion of overall trading costs. Bid/ask spreads, frictional costs on large orders and intermediaries’ fees far outweigh clearing and settlement processing costs. A single intermediary owned/controlled CCP with inter-exchange fungibility may fragment market liquidity, thereby negatively impacting effective spreads and frictional costs.
Third, there has not been sufficient discussion of the potential problems associated with an intermediary-owned/controlled CCP. While one can reasonably argue that some exchange-owned CCPs may seek to extract monopoly rents, one must also be willing to acknowledge that intermediary-owned CCPs may limit CCP activities in some markets in order to maximize trading and dealing profits for their owners at the expense of smaller members of the CCP and true end-users.
Fourth, experience demonstrates that the conflicting interests of the exchange user/owners and the intermediary owners of certain CCP’s impair their efficiency in terms of technology development and bringing new business innovations to market. Advocates for a single monopoly CCP solution appear unconcerned with the potential for these efficiency losses.
Finally, and despite the EU report, there is, in fact, clear evidence of efficiencies created by exchange-owned CCPs providing tangible value to both intermediaries and end-users. Let me explain each of these points in greater detail.
The structure of clearing and settlement services is being examined in the context of integrating the European securities markets and lowering cross-border trading costs. In 2001, the Giovannini group identified fifteen barriers to reducing these costs. The majority of these barriers are directly related to differences in national policies related to finality of settlement, settlement timeframes, taxation, securities issuance and custody requirements, treatment of corporate events, and restrictions on participation. It is far from clear that creating a single intermediary-owned/controlled CCP will eliminate any of these barriers or lower costs. Ironically, just yesterday, LCH.Clearnet made yet another public argument this time in the financial times for a single monopoly provider without describing how that structure would, in fact, reduce cross-border barriers and resultant costs.
Without the removal of these barriers, a single monopoly CCP would need to maintain the processes and procedures required in each national market. Today’s CCPs are optimized for the local markets in which they operate. It is entirely likely that it is more efficient to continue this separate optimization than to force a central CCP to build and operate the infrastructure necessary to duplicate what already exists.
The main arguments in favor of adopting a single intermediary-owned/controlled CCP are cost reductions through economies of scale and scope and capital efficiencies. Some even argue that the cost reductions achieved by consolidation will drive additional trading activity, positively impacting European GDP (Discussion Paper: The Need to Remove Structural Barriers to the Consolidation of CCP Clearing; LCH.Clearnet presentation to CESAME; February 20, 2006).
Where this argument fails is in its assertion that modest CCP cost savings will have a significant impact on trading activity. To significantly increase trading activity, the all-in cost of trading must be significantly reduced. CCP-related costs are only a fraction of total all-in costs, which include:
“The bid/ask spread;””frictional costs” on large orders;”Intermediaries’ fees, and;”Minor exchange and CCP fees.
Allow me to use the CME markets to illustrate the effects of CCP costs on the overall trading costs borne by the end user. In 2005, slightly over 1 billion futures and options contracts were traded at CME. Let’s look at the market impact costs associated with those 1 billion contracts. If each trade happened at one-tick, the smallest possible bid/ask spread, a minimum of $12.7 billion would have been paid in bid/ask spread by market participants. Each penny saved in clearing and settlement, however, would only eliminate $11 million dollars from the all-in cost of trading, less than one percent of the impact of the bid/ask spread. If we use the 5 cent fee charged by the CBOT as a proxy for clearing and settlement costs, market innovation that yields a 1% change in the $12.7b captured in bid/ask spread would reduce trading costs by $127 million, a result that is almost $20 million more than the $110 million that could be achieved with the elimination of all clearing and settlement costs.
As you can see, CCP direct costs are negligible compared to other trading costs. However, the ownership composition and governance structure of CCPs can have a direct bearing on the adoption of CCP’s policies and practices that are critical to the creation of efficient markets. Let me explain what I mean.
The claim has been made that “no-one is likely to take a keener interest in the controls safeguarding their assets and demand more innovative services than the user/owners themselves.” (Euroclear Position Paper on Clearing and Settlement, March 2005)
However, large intermediaries are only a subset of market users. The European Central Bank and the Committee of European Securities Regulators’ Standard 13 states that “governance arrangements for entities providing securities & settlement services should be designed to fulfill public interest requirements and promote the objectives of owners and users”. The standard goes on to define public interest as the “safety and efficiency of the system”.
While safety and efficiency are of paramount concern to all market users, true public interest transcends those factors. A single intermediary-owned/controlled CCP can and likely will establish policies and practices that promote the interest of large intermediaries with little or no regard for the best interests of smaller intermediaries or true end-users.
Exchanges with vertically integrated clearing functions better serve the public interest by developing clearing services that can make markets more accessible, transparent and efficient. Why? Because exchanges are centralized transaction processors who neither act as principal nor agent on behalf market users. As such, exchanges do not seek to capture spreads or profit from large orders. Moreover, exchanges have no vested interests in taking trading profits at the expense of improving market transaction costs.
Second, a compelling argument can be presented that a demutualized, publicly owned exchange CCP presents a stronger governance framework for end users than an intermediary-owned/controlled CCP. The former will differ from the latter in two significant ways: its shareholders will represent the full spectrum of participants in the trading community; and its success will be measured in terms of shareholder returns and not merely by its ability to operate “safely and securely.”
By measuring success in terms of returns to shareholders, policies will be determined based on their ability to attract additional trading volume and maintain an appropriate level of risk controls. How better to ensure that CCPs truly serve the public interest than by having them be owned by the public?
Swapclear is an example of how a user-owned, user-governed clearinghouse could choose to create a solution tailored to a small group of market participants.
Swapclear caters to the interests of the 19 largest swap dealers rather than the broader universe of market participants. Additionally, it has limited its product set to plain vanilla interest rate swaps in major currencies. The highest profit margin products, including credit derivatives and equity swaps, have been excluded, benefiting dealer profitability at the expense of reducing systemic risks and transaction costs in these markets.
In contrast to the limited participation approach taken at Swapclear, at CME, we seek to provide the benefits of CCP services to a significantly wider audience. For example, we have maintained our mutual offset system linkage with the Singapore Exchange, SGX, for more than twenty-five years, allowing Eurodollar market participants to execute Eurodollar transactions in either the CME or SGX market and to transfer established positions between clearing houses. This is an excellent example of how exchange-owned CCPs can enhance trading alternatives and promote efficiency for market users. It also raises the question of whether, when CME first sought to establish MOS in 1980, a third party CCP, if it had existed, would have shared our vision or our incentive for globalizing trading interest in our Eurodollar futures market.
More recently, CME entered into a linkage arrangement with the China Foreign Exchange Trading system (CFETS) that will allow easy access to CME’s foreign exchange and interest rate markets for Chinese market participants who might otherwise encounter obstacles to obtaining such access. CFETS will become a “super clearing member” of CME carrying the accounts of the Chinese banks who trade at CME.
Very recently, in May, CME and Reuters announced FXMarketSpace. This joint venture heralds a new era in global foreign exchange markets, and will be perfectly positioned to capitalize on growing demand for an efficient, anonymous and centrally-cleared alternative to the current spot and forward markets. FXMarketSpace will differentiate itself from existing platforms linking to the CME Clearing House and providing a level credit playing field to all market participants. The combination of our anonymous CME Globex trading platform and our CCP services should enhance liquidity and trading opportunity for all market users.
As a shareholder value-driven organization, we can take calculated risks and make speculative investments that have the potential to generate returns for our shareholders. Intermediary-owned/controlled utilities are generally rewarded for cost minimization rather than growth and value creation for shareholders. In consequence, in the long run they neither minimize costs nor create value. For that reason, regulators and policy makers should more carefully assess the impact of the structure on innovation, market development and industry growth.
Finally, we come to the question of whether an exchange-owned CCP can create efficiencies and benefits for both intermediaries and end-users. While the competition dg may not have been able to find examples of these efficiencies in European securities markets, there are clear and compelling examples in U.S. derivatives markets. Let me share some of them with you.
Our historic common clearing link with the Chicago Board of Trade reduced capital and performance bond requirements for market users by approximately $2 billion, while creating additional expense savings for clearing member firms;
Our cross-margining agreements with the Chicago Board of Trade, the Singapore Exchange, the Options Clearing Corporation, LCH.Clearnet, the New York Mercantile Exchange and the Fixed Income Clearing Corporation provide capital efficiencies to market users by including positions held in other clearinghouses in the calculation of portfolio risk;
Our CME Span risk margining system, first introduced in 1989, has now been licensed to 52 global exchanges and clearing organizations and has now become the industry standard for assessing portfolio risks;
Our highly successful collateral management programs, which enable intermediaries to enhance yields on performance bond deposits have been shared with the industry to extend the availability of these yield enhancing programs at other leading CCPs;
Our industry efforts to drive standardization of the FIXML standard, which will ultimately reduce intermediaries’ interface costs across multiple CCPs; and
Our leading role in developing information sharing and cooperation arrangements that ensure effective crisis management and systemic risk containment on an industry-wide basis.
These are just a few examples of the ways in which CCP behavior ─ rather than the ownership and governance structure of CCPs ─ may be a more appropriate focus for ensuring the competitiveness of European securities markets.
In conclusion, there is no evidence that either a vertical or horizontal market model is “right” in all situations. Nor, is there evidence that either model is “wrong” in all situations. The only way to ensure that markets develop efficiently is to focus regulation on financial soundness and allow market forces to determine the structures and solutions that work best.
From my perspective, market participants must have a voice in the governance of a clearing house. At CME, our market-driven approach allows for the integrated control of execution and clearing services by a publicly held company, as we believe that best serves the public interest. I leave you with this thought: what better way to ensure that clearing and settlement providers truly serve the public interest than by having them be owned by the public?
Thank you for allowing me to be with you today, and for giving me the opportunity to provide you with CME’s perspective on how market-driving solutions can lead to more efficient clearing and settlement systems.