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Global exchanges in fight for Asia clearing market share

No clear Australia strategy for CME while Eurex is kept waiting for a licence

While many global banks have scaled down their Asia businesses in the past three years, their exchange and clearing peers have moved in the other direction. The latest stage in this process came with the November 3 announcement by Ice that its Singapore clearing house and futures exchange would start operating on March 17 next year.

A few weeks earlier the Australian government granted US firm CME a clearing and settlement licence – making it the third such institution after LCH.Clearnet, and domestic player ASX, to be approved by regulators.

Lagging behind these three firms is Frankfurt-based Eurex: it had previously said it was setting up a Singapore clearing operation for the early part of 2015, but the drawn-out licensing process means that even a 2016 debut might not happen.

For Ken Ong, senior vice-president at brokers KGI ONG Capital, the appeal of Asia to global exchange groups and the decision by some to set up infrastructure in Singapore is obvious.

“For the big exchanges the US and European markets are saturated: the only thing left is more consolidation because it doesn’t seem like anyone is keen on setting up a new exchange given the onerous nature of the regulatory process in those jurisdictions. And with China set to become the world’s largest economy at some point they are trying to ride on that wave. From a political and economic perspective Singapore is an excellent place to situate these businesses, which is why they are coming here.”

CME conundrum

With the exception of LCH.Clearnet the major global exchange and clearing groups have said little publicly about the plans for their Asia business, and of the four the biggest puzzle is CME. Just a couple of weeks after gaining its Australia licence, CME parted company with the head of its Asia arm, Julien Le Noble, alongside two other senior figures in what one person familiar with events describes as a “purge”.

Market sources indicate that Le Noble’s exit was at least partly due to a dispute over the importance of the Asia business relative to the broader group. The US firm doesn’t break out figures for its Asia business – indeed its March 2014 10K report (a financial analysis required by the US Securities and Exchange Commission) contains just one sentence referencing Asia – and the importance of the region to the group’s global earnings is clearly slight.

It’s not obvious that gaining an Australia clearing licence will change this. This is despite the recent rapid expansion of the country’s onshore market with interest rate swap (IRS) volumes cleared by local banks increasing from 19% to 27% of the total notional principal outstanding over the first six months of 2014, according to a September financial stability report published by the Reserve Bank of Australia.


So far this business has been captured by LCH.Clearnet, with local clearing players and interdealer brokers agreeing that the London-headquartered firm has an “overwhelming share” of the onshore Australian dollar IRS clearing market. Estimates of its dominance range from 90% to 95%, leaving ASX credited with a 1% stake and CME holding the remainder. LCH.Clearnet claims to hold a 99% share of the market.

Given this market share, it seems surprising that the US firm chose to make Australia the first official step in its Asia strategy; the Aussie dollar interest rate market may be expanding but it is finite. One Sydney-based fixed-income dealer simply asks: “Why would you bother?”

This view was echoed by a local clearing broker, who welcomed the increased competition that CME’s onshore licence would bring, but was sceptical there is sufficient market demand for three players.

“Australia is a wonderful place and I can see why people want to come here – but in terms of revenues and business opportunities is the potential really there? To think that three central counterparties can thrive in the Aussie dollar market is just plain stupid.”

Indeed a number of market insiders say that CME’s Australia licence isn’t part of a grand plan and instead the group was “encouraged” by regulators to submit to local oversight.

One Asia-based derivatives expert says: “The authorities said to them, ‘if you are systemically important in Australia, you have to get a licence. But we’re not telling you what this means – and if you wait to apply for a licence until we tell you that you are systemically important you are probably going to have to halt your business for a year and a half.’ It’s effectively saying that if you want to do any Australian business or to connect to ASX you need to get regulated locally.”

A CME spokesman says that the firm is “pleased to be awarded a clearing and settlement facility license in Australia”. He points out that “market participants in Australia now have the option of directly accessing CME’s clearing house in the US”. The Reserve Bank of Australia declined to comment.

Change of plan

This is not the first attempt by CME to broaden its Australia footprint. News leaked earlier this year of a tie-up between CME and ASX which now appears unlikely to go ahead, meaning a licence was the inevitable next step, according to the fixed-income dealer.

“My understanding was that the original plan was to offer Australian clients access to CME via ASX, which was the worst-kept secret in the Australia market. When that didn’t go ahead they just activated plan B, and that required them to get an onshore licence,” says the fixed-income source.

But it’s not all bad news for CME. While LCH has a strong grip on the current Aussie dollar clearing market this is currently almost entirely an interdealer activity, with the buy side not expected to start until a mandate comes into force. And Australia’s buy side is huge: its pension sector has US$1.6 trillion of pension assets under management in 2014, according to actuarial consultants Towers Watson, providing a sizeable stream of business for whichever clearing house can capture it.

According to market participants, the trigger for buy-side clearing will be a mandate. Australian, and potentially US, authorities are expected to mandate Aussie IRS clearing at some point next year, and when this happens it will have a significant impact on pricing, says a clearing provider for a bank in Sydney.

“In the absence of a mandate and with brokers and the sell side still lacking a sophisticated model to completely price the return on assets (ROA) from their clearing business, there aren’t different prices for a cleared and uncleared swap.”

While ASX is now executing client clearing, the volumes are insignificant so currently there are not different prices for operating there or on LCH.Clearnet. “Pricing differentials will emerge but I don’t expect this will happen for the next 12 months. A mandate will come in before pricing drives people to clear in Australia,” says the clearing provider.

Not everyone agrees. Marcus Robinson, Australia country head for LCH.Clearnet, says onshore players now have a greater understanding of the costs involved in clearing which will soon feed through to pricing, irrespective of when a mandate starts.

“We expect to see the buy side start clearing from next year with banks starting to price in the different capital charges and collateral costs for cleared versus uncleared swaps. This hasn’t happened in the Australia market yet, but it is coming closer to reality – particularly as local banks are now direct members of SwapClear, rather than accessing it via clearing brokers, and are therefore able to more accurately calculate the costs involved.”

While the buy side’s approach to clearing will be critical to the development of the market, how that will evolve is unclear at the moment.

“Only 60% of the vanilla Aussie dollar swaps that can be cleared are being cleared and most of that is on the interdealer market. There is only a small handful of client business – and that’s really just the likes of Pimco and BlackRock, which are using CME. There’s a lot more volume out there that is not being cleared, and that portion of the market is up for grabs between CME, LCH and ASX. How is it going to pan out? I’ve got no idea,” says the clearing broker.

Singapore future

The uncertainty over the direction of the Australian swap market is not matched in Singapore, where Ice has revealed a March 17 launch date for its Asia clearing house and futures exchange, having acquired an Asian hub last year through the $150 million purchase of SMX. Ahead of its launch announcement Ice had been road-testing the type of contracts it would offer with a number of senior industry participants, subject to what one source described as “stringent” non-disclosure agreements.

Several market participants told that Ice is looking to launch five separate contracts: Brent mini, Asia oil, and gold, plus two further agricultural contracts, which are potentially cotton and cocoa. While all these commodities are heavily traded in Asia, there is not sufficient demand for a local exchange and clearing house, according to one Singapore-based clearing head whose firm is considering joining Ice’s new venture. He also questions the decision to launch in just a few months’ time.

“Exchanges feel they need to get in early, but I doubt there is a huge market demand, certainly not from the conversations that we have had with our clients. I doubt they will be able to convince everybody from day one and you will certainly not see all the big names involved right from the beginning.”

The Asia-based derivatives expert says that the proposed oil and gold contracts are “safe bets”, while the agricultural products are “more experimental”. But he is unclear over how Ice intends to develop its new institutions in the Asia derivatives market.

“The logical strategy would be to ask, ‘what are my existing strengths?’ and bring those over – which in Ice’s case is energy. Likewise Ice owns Liffe so agricultural products are also an obvious move.

“But energy products are already cleared at Ice Europe, and all major players will already have access to that platform, so does it really make sense to fragment that liquidity? On the agricultural side there are two choices – either make existing products more global, or try and build Asian versions of these commodity contracts, which is what Ice is trying to do here.”

Balancing act

However the derivatives expert warns that the directional nature of the Asia agricultural market – each country is either heavily a producer or buyer of soft commodities – may create difficulties in structuring a contract that appeals to both the buy and sell side.

“If it’s a balanced contract then Singapore is a good place to situate it but achieving that will be very difficult. These products are perishable, they spoil easily and are dense but low in value so it makes more sense to locate their related derivative contracts either in the home of the main buyer – in this case China – or where they are produced.”

However, Thomas McMahon, Singapore-based chief executive at UD Trading Group, is more positive about the potential for Ice to succeed in Singapore, particularly on the agricultural side which he says offers significant structural reasons to support a contract tied to Asia fundamentals.

McMahon says “there is no reason” why Ice can’t capture Brent business. He points to a natural group of potential Brent crude hedgers already being based in Singapore – for example Chinese oil majors such as CAO and PetroChina have their offshore hedging and trading desks based in the city-state.

“Plus you have the multinational oil firms such as Shell and BP, which have their Asia businesses based in Singapore, not Hong Kong, Tokyo or Shanghai. Singapore is the Asia leg of the global crude oil trade.”

KGI’s Ong agrees with McMahon that there is potential for Ice’s new Asian venture to build on Singapore’s strategic position in the commodity sector.

“For Asia most of the energy business passes through Singapore, especially on the broking side, which means there is a core of customers already here. We were previously an SMX member and have signed up with Ice and think the combination of its brand name, expertise and the products they will roll out, will make the launch a success.”

However, the derivatives expert described contract launches as a “dark art”, and has doubts over the success of Ice’s venture.

“Ice is extremely efficient at execution and they have stated they will list a handful of products. They need to get one of those products to work and that is 99% luck and 1% hard work – they have certainly put the work in and have great technology, so who knows?”

Ice declined to comment.

One exchange that is currently in need of luck with its Asia strategy is Eurex. Its original plans to go live with its Singapore-based clearing house in the first quarter of 2015 now look wildly optimistic. Instead the city-state’s regulatory authorities are caught in the dilemma of looking to increase Singapore’s attractiveness as a financial centre for global firms while protecting the existing national champion in the form of SGX.

These difficulties were conceded by Deutsche Borse chief executive Reto Francioni during a media briefing with journalists in Frankfurt in November. He confirmed that Eurex had hoped to begin operating in Singapore at the start of 2015, but said this would now be delayed “by a number of months because of regulatory hurdles, but I don’t have any more details of the specifics”.

A number of players with an understanding of the Singapore market and its licensing regime, however, suggest that a “number of months” is probably a best case scenario, with all but one that spoke to saying they didn’t expect Eurex to gain approval until the first quarter of 2016. Global exchange groups may be keen to expand in Asia – how that will happen remains unclear.

Australia: principal versus agency

The exact timeline to start clearing is not the only area of opacity facing buy-side derivatives users in Australia; which structure to operate under is also open to debate. There are two basic client clearing models: the SwapClear clearing member (SCM) or principal model, and the futures commission merchant (FCM) or agency model. There are numerous differences between the two but the most important are that in the SCM the clearing broker faces the central counterparty whereas in the FCM the client has a counterparty relationship with the clearing house. Broadly speaking the FCM approach is used by US firms while the rest of the world operates on an SCM model.

According to a clearing provider for a bank in Sydney, at least one superannuation fund has a legal opinion that says it can only trade via an FCM, and while he emphasises that this view has not yet been tested in court a number of large buy-side firms are believed to harbour concerns about going down an SCM route.

One large buy-side OTC derivatives user says that such concerns are historic. He claims that a better understanding of the true counterparty risks of an SCM view has emerged due to discussions between clearing houses and the industry. The FCM approach has one crucial advantage for Australian buy-side firms – familiarity, with the majority used to trading on a futures basis.

This view was backed by an Australian fixed-income source who says that in this instance familiarity with the FCM will breed contentment for local buy-side derivatives users.

“There are a raft of differences between the SCM and FCM model – at least 30 or 40 – but the important factor in this case is the buy side’s greater familiarity, and ease of integration, with the futures one.

“From a bank’s perspective, the FCM model is more restrictive because of the different risk profile: for example, a futures contract which rolls over every three months comes with a limited amount of risk. A lot of the buy side like the FCM model and to some degree show a preference for CME.”

Likewise, other clearing figures spoke to say that the approach to segregation under the SCH model could be more attractive to parts of the Australian buy-side sector.

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