The financial crisis has added a new dimension for increased competition in clearing and settlement.

MANY OTC DERIVATIVES deals were under collateralized or not collateralized at all and thus played a role in the financial crisis. As a consequence, the Obama administration has proposed mandating central counterparty (CCP) clearing of standardized OTC derivatives. Should this, and similar rules under consideration elsewhere, become law, the opportunities for clearinghouses will be enormous. Clearinghouses, however, must find ways to compete based on cost or differentiated products and services.

A few institutions control the pricing flow in the OTC interest rate derivatives market, which according to a mid-year 2008 International Swaps and Derivatives Association (ISDA) survey grew by 34% in a year to $464.7 trillion in mid-2008. Secondary players typically take revaluations from the larger players, but those revaluations are biased to reflect their trading books so a neutral third party is needed. Currently, both the London Clearing House and the International Derivatives Clearing Group (IDCG) are among those vying to fill this gap.

While the reputation of credit default swaps (CDS) may have been tarnished by the financial crisis, the market is growing. Although the ISDA survey shows a decrease in the notional amount outstanding of credit derivatives, the market grew by 20% to almost $55 trillion between mid-year 2007 and mid-year 2008.

There appears to be more scope for competition amongst clearers in Europe than elsewhere in the world. The European Code of Conduct for Clearing and Settlement, introduced in 2006, is a voluntary agreement between clearinghouses and the EU to encourage interoperability and to stimulate competition through more choice and transparent pricing.

Two factors stand in the way of clearing competition in Europe. Clearinghouses have strong franchises and are essentially national or geographically based monopolies in their region. Those monopolies need to be broken up to create competition. The scope of the Code of Conduct is limited to cash equities and does not cover fixed income securities, commodities or derivatives.

THE EUROPEAN COMMISSION is growing impatient with the industry’s lack of progress, particularly with the time it is taking to achieve interoperability. It may soon threaten to introduce legislation to enforce competition and cost reduction. Clearinghouses need to reassess their business models to determine what they can accomplish without having new legislation imposed on them.

The Code of Conduct implies that there can be price or service competition among CCPs. Price competition is emerging in the equities markets. In April 2009, EuroCCP, the London-based subsidiary of the DTCC, reduced its clearing fees from 6 euro cents to 5 euro cents per side. European Multilateral Clearing Facility (EMCF), formed in 2007 to provide competitive CCP clearing services for growing multilateral trading facilities, cut its UK clearing fees to 3 euro cents in April. This compares to 26 euro cents as the average clearing price-per-side of a transaction in Europe in mid-2008, according to a DTCC study.

Some clearinghouses differentiate their services by catering to niche markets. “ICE is well known for its expertise in the commodities markets and is becoming established in the CDS market,” says Thomas Kroon, Post Trade Industry Expert, at NASDAQ OMX. “Moreover, Nord Pool and NASDAQ OMX Commodities are well known as specialized energy marketplaces.”

CCPs can also exploit technology to set themselves apart. Clearing is an administratively intensive function, and CCPs can leverage flexible, robust, multi-currency systems to deliver superior customer service.

THE CODE OF CONDUCT is clear, however, that CCPs should not compete based on risk coverage or measurement. In particular, initial margin levels set at imprudently low levels to attract market participants may jeopardize risk management.

“Collateral management and capital costs are high, so clearinghouses need to deploy sophisticated methodologies and systems to avoid over margining,” says Henrik Paulsson, Head of European Derivatives and Derivatives Clearing at NASDAQ OMX. “But, at the same time, they need to be conservative to avoid exposing the clearinghouse and market to too much risk.”

Striking this balance can be a source of differentiation. Clearinghouses can deploy advanced modeling techniques to fine-tune their variation margin algorithms and parameters for members with a specific profile, just as insurers use actuarial models to calculate policy premiums.

Competition is coming to the clearing and settlement business. Anticipating a mandate for CCP clearing, several US and European clearinghouses are becoming established in the OTC derivatives markets. Because European regulators will likely enforce clearing competition – at least in the equities markets – if the industry does not make progress soon, clearinghouses need to recognize and embrace change as a revenue-generating opportunity.