Back-office plumbing will take a front seat in LSE-Deutsche Boerse's potential tie-up.
The business of clearing and settling trades has always looked dull compared with the racier business of buying and selling. But it's likely to be at the heart of whether regulators approve a tie-up between Deutsche Boerse and London Stock Exchange -- and whether the financial system will be riskier or safer as a result.
Since the 2008 financial crisis, regulators have been agonizing over how to better protect markets from the risk that a major investment bank or broker like Lehman Brothers goes bust -- "counter-party risk" in jargon.
Improving capital levels and financial strength at the banks or counter-parties themselves was one half of the story; driving more trades through central clearing (a neutral middle-man who takes on the risk of a trade failing) was the other.
The growth in central clearing has been dramatic. In 2014, more than half of the notional amount outstanding of derivatives transactions was centrally cleared, almost twice 2009 levels, according to a paper by the Bank for International Settlements.
LSE and Deutsche Boerse are behemoths in this world: LSE owns LCH.Clearnet, which is dominant in interest rate swaps, while Deutsche Boerse's derivatives platform Eurex controls more than half the market in the trading and clearing of listed European derivatives. Both are expected to benefit further from an increased push in Europe for more central clearing in coming years.
A tie-up between Deutsche Boerse and the LSE immediately raises concern that competition in clearing and settlement will be reduced. This will surely draw the attention of antitrust regulators. But systemic risk is an equally important issue for regulators: they need to decide whether letting one player dominate the market will be safer than keeping them apart.
The BIS has already warned that clearing-houses could go from shock absorber to amplifier in a market rout -- especially if the value of collateral posted suffered a big decline or if inadequate risk management led to a sudden spike in margin requirements. If a dominant clearing-house were to blow up, strong banking counter-parties could themselves dragged down as funding lines are called and assets are sold to raise cash.
Both antitrust and systemic risk concerns may force LSE and Deutsche Boerse to offer remedies to regulators such as keeping their two clearing operations separate. Both sides want maximum cost savings with the minimum additional funding or capital requirements -- and if European authorities push back on either, the deal may quickly become much less attractive to shareholders.
Deutsche Boerse will therefore need to persuade regulators that a bigger pan-European clearing house would be safer than a fragmented network of smaller ones.
It's not an impossible case to make: for regulators, a united LSE-Deutsche Boerse might be easier to monitor than two distinct parts of the puzzle in London and Frankfurt. Traders might also prefer to post collateral with a single entity than manage default funds at several bodies. The world today is different to 2008: capital levels have risen across the banking industry and a series of small negative shocks might be better absorbed by a more densely connected network.
It's not yet clear how regulators will juggle these issues of competition, complexity and financial stability. Systemic risk didn't figure in the failure of previous mergers between London and Frankfurt. It's likely to play a much bigger role this time than investors anticipate.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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